The Price of Subjecting Mutual Funds to Bank Regulation

The rise of mutual funds and the decline of banks have led to repeated calls to subject mutual funds to bank-type regulation. Fortunately, the mutual fund industry is deterring efforts to impose regulatory requirements.

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Matt Fink

Matt Fink

Hans Peter Guttmann

Mutual funds have been a great American success story, permitting tens of millions of investors to obtain the same diversification and professional management, at reasonable cost, as are available to the wealthy. Over the years the fund industry has offered middle-class investors an ever-increasing array of innovative products and services. Today mutual funds have almost 90 million shareholders and assets of $11 trillion.

A key factor contributing to mutual funds’ success has been regulation under the federal securities laws administered by the Securities and Exchange Commission. The securities laws seek to protect investors, not fund managers. Thus, the securities laws are centered on full and fair disclosure, prohibitions on conflicts of interest and public enforcement proceedings in the case of violations. The securities laws do not seek to limit entry into the fund business, or to protect fund managers from competition, or failure.

Securities regulation has proven to be extremely successful in protecting fund shareholders while permitting fund managers to innovate.

Securities regulation stands in sharp contrast to bank regulation. Bank regulation is centered on assuring the safety and soundness of banks rather than protecting bank customers. Bank regulation seeks to protect individual banks and the banking system as a whole and to minimize risks to the federal government, which insures a substantial portion of all bank deposits. To promote these objectives, bank regulation limits entry into the banking business, requires regulatory approval of new products and services, and abjures regulatory actions, such as public enforcement proceedings, that might shake public confidence in individual banks or the banking system. In short, bank regulators prize stability, not innovation.

The rise of mutual funds and the decline of banks have led to repeated calls by banks and bank regulators to subject mutual funds to bank-type regulation:

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* In the early 1980s, Federal Reserve Chairman Paul Volcker called for legislation giving the Fed authority to impose reserve requirements on money market funds.

* During the same period, legislation was introduced in a number of states requiring money funds to post reserves with state bank regulators.

* In 1994, Dr. Henry Kaufman proposed legislation requiring mutual fund shareholders to give 60 or 90 day’s notice before redeeming shares, stating, “This provision would be roughly analogous to the long-standing requirement that applies to Certificates of Deposit and time deposits at banks and thrifts.”

Fortunately, in each case the mutual fund industry, often supported by consumer groups, defeated efforts to impose bank regulatory requirements on mutual funds.

In my book, The Rise of Mutual Funds: An Insider’s View, I stated in 2008: “As this book goes to press, there are relatively few calls to impose bank-type regulation on mutual funds. In the event of a crisis, I am certain policymakers will reach inside the medicine cabinet and find these prescriptions.”

Sad to say, this is precisely what is happening.

In response to the recent financial crisis Congress is considering legislation that could subject mutual funds to bank-type regulation.

Specifically, both the House and Senate financial reform bills would create a new regulatory body with authority to determine that a particular non-bank financial institution presents a threat to the stability of the financial system and therefore should be made subject to heightened prudential requirements in areas such as capital, leverage, and liquidity.

If this legislation is enacted, given the influence and biases of bank regulators, it would not be surprising if we saw new proposals to impose bank-type regulation on mutual funds.

Paul Volcker, now a senior aide to President Obama, has already called for regulating money market funds with one dollar share prices as banks.

If such a proposal succeeds, it is likely to be just the first step, followed over the years by others, such as imposition of community reinvestment standards on mutual funds and requiring fund shareholders to submit notification statements before redeeming shares.

Eventually we may see imposition of the full panoply of traditional banking regulations, such as fund chartering requirements and requiring regulatory approval of every new fund product and service.

In short, imposition of bank-type regulation on mutual funds may be seen by some as contributing to the stability of the financial system. But it would deprive millions of investors, and the economy as a whole, of the proven benefits of competition and innovation.

Matthew P. Fink is the former President of the national mutual fund association, the Investment Company Institute, and is author of The Rise of Mutual Funds: An Insider’s View.

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