Mutual Funds: Impact on Bank Deposits and Credit Availability (Letter
Report, 09/22/95, GAO/GGD-95-230).

Pursuant to a congressional request, GAO examined whether the movement
of funds from bank deposits into mutual funds affects the availability
of credit for residential, consumer, or commercial purposes.

GAO found that: (1) the amount of money in mutual funds grew from $994
billion at year-end 1989 to $2,172 billion at year-end 1994, mainly due
to an increase of net customer inflows; (2) during the same period, bank
deposits declined from $3.55 billion to $3.46 billion; (3) as much as
$700 billion of the growth in mutual funds may have come at the expense
of bank deposits between 1990 and 1994; (4) the movement of money into
mutual funds has resulted partly from the relatively lower interest
rates paid on bank deposits, but this should have little effect on the
total supply of loanable and investable funds, since mutual funds also
lend or invest a major portion of the funds they receive; (5) there was
insufficient data on whether the different categories of borrowers were
affected by the shift of money from bank deposits to mutual funds; (6)
all categories of borrowers have recently increased their access to
financing obtained through the securities markets; and (7) flows of
deposits out of smaller banks could reduce the availability of finance
for small businesses whose primary source of finance is loans from such
banks.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-95-230
     TITLE:  Mutual Funds: Impact on Bank Deposits and Credit 
             Availability
      DATE:  09/22/95
   SUBJECT:  Bank deposits
             Mutual funds
             Deposit funds
             Interest rates
             Securities
             Lending institutions
             Funds management
             Economic analysis
             Investments
             Credit

             
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Cover
================================================================ COVER


Report to Congressional Requesters

September 1995

MUTUAL FUNDS - IMPACT ON BANK
DEPOSITS AND CREDIT AVAILABILITY

GAO/GGD-95-230

Mutual Funds

(233422)


Abbreviations
=============================================================== ABBREV

  ICI - Investment Company Institute
  SIA - Securities Industry Association
  GDP - gross domestic product
  CD - certificate of deposit

Letter
=============================================================== LETTER


B-259968

September 22, 1995

The Honorable James A.  Leach
Chairman
The Honorable Henry B.  Gonzalez
Ranking Minority Member
Committee on Banking and
Financial Services
House of Representatives

This letter responds to the Committee's request that we examine
whether the movement of funds from bank deposits into mutual funds
affects the availability of credit for residential, consumer, or
commercial purposes.  Our objectives were to (1) assess the extent to
which flows of money into mutual funds were affecting the amount of
deposits at banks and (2) determine what impact such flows might have
on the availability of finance for the economy as a whole and for
residential, consumer, and business borrowers. 


   BACKGROUND
------------------------------------------------------------ Letter :1

Both mutual fund companies and banks are financial intermediaries,
that is, they raise funds from savers and channel these funds back to
the economy by investing them.  Banks generally use their deposits
either to make loans or to invest in certain debt securities,
principally government bonds.  Mutual funds do not make loans, but
they do invest in securities, primarily bonds and stocks.  Money from
these funds, in turn, flows either directly (through primary
securities markets) or indirectly (through secondary securities
markets) to the issuers of such securities. 

Long before the recent mutual fund boom, the relative importance of
bank loans as a source of finance had been declining.  As early as
the 1960s, some large businesses had been replacing their usage of
bank loans by issuing short-term securities called commercial paper. 
Subsequently, more companies found ways to tap the securities markets
for their financial needs, lessening their dependence on bank loans. 
For example, corporations' reliance on bank loans as a percentage of
their credit market debt declined from 28 percent in 1970 to 20
percent in 1994. 

The household sector (generally residential and consumer borrowers)
also has become less dependent on bank loans for the ultimate source
of financing.  Beginning in the mid-1970s, and to a much greater
extent since the early 1980s, major portions of home mortgage
portfolios have been sold by banks and thrifts to financial
intermediaries who use them as collateral for marketable securities
and then sell the securities to investors.  More recently,
significant amounts of consumers' credit card debt and automobile
loans have been similarly financed by securities instead of bank
credit.  Through securitization, banks and thrifts provide the
initial financing for these mortgage, credit card, and automobile
loans.  However, once the loans are sold, it is the securities market
that is the ultimate source of financing. 

More broadly, the term securitization describes a process through
which securities issuance supplants bank credit as a source of
finance, even if the borrower originally received funds from a bank. 
In addition, the relative importance of bank loans has been further
diminished by the increased provision of direct loans by nonbank
financial intermediaries, including securities firms, insurance
companies, and finance companies. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :2

During the 5 years from year-end 1989 through year-end 1994, the
amount of money in mutual funds\1 grew from $994 billion to $2,172
billion, a rise of almost $1.2 trillion.  While this increase in
value included some price gains for mutual funds that own stocks and
bonds, about 90 percent of the rise stemmed from net customer
inflows.  In contrast, bank deposits\2 had declined during this same
period.  At the end of 1994, total bank deposits amounted to $3,462
billion, $89 billion less than at year-end 1989.\3

These differences in the growth of mutual funds and deposits are not
coincidental.  There is compelling evidence that some portion of the
growth in mutual funds came at the expense of bank deposits during
the period 1990 through 1994.  Although the available data are not
sufficient to quantify this impact precisely, it was probably less
than $700 billion. 

The movement of money into mutual funds rather than bank deposits has
been, at least in part, the result of historically low interest rates
paid on bank deposits and could change as those rates increase
relative to expected returns on mutual fund investments.  In any
case, while the movement of money between bank deposits and mutual
funds may change the intermediaries through which finance flows, it
should have little if any effect on the total supply of loanable and
investable funds.  This is because both banks and mutual funds
generally lend or invest a substantial portion of the funds they
receive. 

Available data do not show whether the different categories of
borrowers--residential, consumer, and business--were or were not
affected by the shift of money from bank deposits to mutual funds. 
With this movement of money, it might be expected that those who
issue securities would enjoy advantageous access to finance compared
with those who do not, because mutual funds mainly invest in
securities.  However, in recent years all three categories of
borrowers have increased their access, direct or indirect, to
financing obtained through the securities markets.  For example,
although households do not issue securities, providers of mortgage
and other credit to households do; thereby, significant parts of
households' borrowing needs are indirectly funded by securities
issuance.  Indeed, because the growth of mutual funds has rechanneled
so much money into stocks, bonds, and other securities, mutual funds
themselves have helped to foster the securitization of finance in the
United States.  Nonetheless, there remains a possibility that flows
of deposits out of smaller banks could reduce the availability of
finance for those small businesses whose primary source of finance is
loans from such banks. 


--------------------
\1 In this report, the phrase "mutual funds" refers to money market
mutual funds that invest in short-term debt obligations and to mutual
funds that invest in stocks and bonds. 

\2 In this report, references to "banks" as well as to "bank
deposits," "bank loans," etc., pertain to all depository
institutions, including savings institutions and credit unions. 

\3 Dollar amounts in this report are in current dollars except where
noted.  If converted into 1989 constant dollars, mutual funds grew in
real terms by $836 billion from year-end 1989 through year-end 1994,
while deposits declined by $633 billion. 


   SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :3

In this report, discussion of the "impact of mutual funds on
deposits" or of the "movement of money from deposits to mutual funds"
refers not merely to direct withdrawal of deposits by customers for
the sake of investing in mutual fund shares but also to customers'
diversion into mutual funds of new receipts that otherwise might have
been placed in deposits. 

To assess the impact of mutual funds on deposits, we examined and
compared available data published by industry sources and the bank
regulators.  Data on deposits in banks are routinely reported to and
published by the bank regulators.  Data on mutual funds are gathered
and published by an industry association, the Investment Company
Institute (ICI).  Moreover, the Federal Reserve maintains and
publishes the Flow of Funds Accounts, which is an attempt to capture
the entire framework of financial transactions in the economy,
including all major groupings of participants and instruments.  This
publication includes the bank data and mutual funds data that we used
(the Federal Reserve obtains the mutual fund data from ICI). 

In the Flow of Funds Accounts, the Federal Reserve presents
statistics on (1) the amounts outstanding at the end of each quarter
and each year and (2) the net flows during each quarter and each
year.  For bank deposit information, the change of the level from one
period to the next is used to determine the net flows into or out of
deposits during that period.  The same method is used for money
market mutual funds, where the funds' managers intend to maintain the
value of a share constant at one dollar on a daily basis.  For
longer-term mutual funds, however, the period-to-period change in the
fund's value generally does not equal the net flows during the period
because the value fluctuates with (1) the flows of customer money,
(2) the changing prices of the stocks and bonds held by the mutual
funds, and (3) the reinvestment of dividends and interest in the
fund.  In the Flow of Funds Accounts, the net flows into mutual funds
are calculated from industry data on changes in amounts outstanding
and adjusted for movements of security-price averages. 

To assess the impact of mutual funds' growth on the total supply of
loanable and investable funds, we examined the Flow of Funds Accounts
data on the sources of finance for the economy.  In addition, we did
a literature search for research articles examining (1) how
residential, consumer, and business borrowers obtain financing, not
only from bank loans or securities issuance but also from other
sources and (2) how lenders, including banks as well as nonbank
providers such as finance companies, funded the financing they
provided and whether they sold or securitized their finance. 

We supplemented our search of the statistical sources with other
material.  We used research articles published by the Federal Reserve
and documents published by securities industry sources over the last
5 years.  In addition, we interviewed Federal Reserve experts on the
previously mentioned topics.  We also drew upon information gathered
from banks and mutual fund specialists who were interviewed for an
ongoing related GAO assignment. 

The Federal Reserve provided written comments on a draft of this
report.  These comments are discussed on page 15. 

We did our review in Washington, D.C., from March 1994 to November
1994 in accordance with generally accepted government auditing
standards. 


   MUTUAL FUNDS ATTRACTED MONEY
   FROM DEPOSITS
------------------------------------------------------------ Letter :4

The Federal Reserve and the Securities Industry Association (SIA)
agreed that the flow of funds into mutual funds has had a significant
impact on bank deposits.  Although some observers dispute the
magnitude of this impact, the evidence we reviewed supports the view
that mutual funds have attracted sizable amounts of money that
otherwise might have been placed in bank deposits. 

At year-end 1994, the amount of money in mutual funds ($2,172
billion) was considerably less than that in bank deposits ($3,462
billion).  The mutual fund total, however, had risen by almost $1.2
trillion since year-end 1989, most of it from net new inflows, while
the deposit total was $89 billion less than at year-end 1989. 

Despite these data, some observers maintain that deposits have not
been a major source of the flow of money into mutual funds in recent
years.  For example, one study\4 by a securities firm claims that
"mutual fund inflows do not depend on outflows from the banking
system," arguing that "net new savings"\5 are more important.  ICI, a
mutual funds industry association, stated that "CD [certificate of
deposit] proceeds play [a] minor role as [a] source for investment in
stock and bond mutual funds," and that "current income" and "the
proceeds from other investments" were far more important. 

Nonetheless, most observers whose studies we reviewed agree that
mutual funds have had a significant effect on bank deposits.  Federal
Reserve publications state that there has been a movement from
deposits into mutual funds.  The same view is propounded by SIA. 
Moreover, in a 1994 survey\6 of 205 bank chief executives, nearly
half said that their banks had started selling mutual funds in order
to retain customers. 


--------------------
\4 Merrill Lynch, "Weekly Economic & Financial Commentary," January
17, 1994. 

\5 "Net new savings" is a term used to describe funds that are not a
movement of funds from one account to another but represent an
increase in the value of a firm or household's net worth. 

\6 Survey conducted by Dalbar Financial Services, cited in American
Banker, July 20, 1994. 


      DIFFICULT TO QUANTIFY THE
      IMPACT ON DEPOSITS
---------------------------------------------------------- Letter :4.1

We did not find any reliable quantification of the full impact of
mutual funds on deposits, including both the direct withdrawals and
customers' diversion of new receipts that otherwise might have been
placed in deposits.  We assessed two quantitative approaches:  (1)
the total net flows into mutual funds and (2) ICI's estimate of the
impact on deposits.  Because both approaches were incomplete, we
examined a third alternative:  the relationship between deposits and
overall economic activity.  This third approach also has limitations
because there are a variety of factors that affect the relationship
between deposits and gross domestic product (GDP).  Nonetheless, it
provided a more comprehensive look than the other approaches.  Using
the ratio of deposits to GDP as a benchmark, we estimated that--for
the period 1990 through 1994--the total impact of mutual funds on
deposits may have been sizable, but probably less than $700 billion. 

The total net flows into mutual funds from all sources during 1990
through 1994 were $1,067 billion.\7 (See table 1.) The impact on
deposits had to be less than this amount because the evidence
indicated there were also flows into mutual funds from nondeposit
sources.  For example, some of the money placed in mutual funds by
the household sector probably derived from the sales of stocks and
bonds since, in 1991 and 1993, the household sector sold more
individual securities than it bought.\8 (See table 2.) Another
possible source of flows into mutual funds was the frequent
occurrence of sizable lump-sum distributions to individuals from
retirement plans and job-termination arrangements.  According to both
the Federal Reserve and SIA, much of this money was placed in mutual
funds by the recipients. 



                                Table 1
                
                      Net Flows into Mutual Funds

                         (Dollars in billions)

                                                                Total\
Investors                     1990   1991   1992   1993   1994       c
---------------------------  -----  -----  -----  -----  -----  ======
Household sector\a            $ 66   $124   $105   $183   $104    $582
Institutional investors\b       60     61     91    152     78     442
Nonfinancial business            9      8     21      4      2      43
======================================================================
Total\c                       $135   $193   $217   $339   $184  $1,067
----------------------------------------------------------------------
Note:  "Net flows" equals purchases less withdrawals.  Increases or
declines in asset prices are not reflected in these data. 

\a Includes nonprofit organizations. 

\b Insurance companies, trusts, pension funds, funding corporations,
banks, and credit unions. 

\c Components may not add to totals because of rounding. 

Source:  Federal Reserve. 



                                Table 2
                
                  Net Amount of New Investments by the
                            Household Sector

                         (Dollars in billions)

Net flows breakdown               1990    1991    1992    1993    1994
------------------------------  ------  ------  ------  ------  ------
Deposits\a                        $ 43   -$ 52    $ 13   -$ 11    $ 21
Mutual funds                        66     124     105     183     104
Stocks and bonds                   161     -24     105     -23     287
Pension funds                      165     360     250     309      96
Other                               29      23      54      39     -10
======================================================================
Total\b                           $465    $432    $526    $497    $498
----------------------------------------------------------------------
Note 1:  The data also include nonprofit organizations. 

Note 2:  "Net investments" equals purchases less withdrawals. 
Increases or declines in asset prices are not reflected in these
data. 

\a Includes currency. 

\b Components may not add to totals because of rounding. 

Source:  Federal Reserve. 

SIA's estimate of the impact of mutual funds on deposits was
incomplete because it dealt only with the direct impact, i.e., the
withdrawal of existing deposits for the sake of investing in mutual
funds.  Even this estimate of the direct impact was incomplete
because it was primarily based on net withdrawals of banks' time
deposits, rather than total deposits.  Using time deposits as a
measure, SIA stated that the flow from deposits into mutual funds
could have been about $200 billion in 1992 and 1993 combined.  In
fact, during this period declines in time deposits were largely
offset by increases in demand deposits.  Since there is no reporting
of either the destinations of deposit withdrawals or of the origins
of deposit placements, we cannot be certain whether time deposit
withdrawals went into mutual funds or if part of them went into
demand deposits.\9 In any event, we found no estimates of the
indirect effects, i.e., the diversion of new receipts into mutual
funds rather than into deposits.  Such a measure is more important in
a growing economy because, even if deposits are growing, they may not
be growing as fast as they would absent the diversion to mutual
funds. 

We attempted to derive a reasonable estimate of the combined direct
and indirect impact of mutual funds on deposits by examining the
relationship of deposits to total economic activity, as measured by
GDP.  In figure 1, the solid line shows that the relationship of
deposits to GDP remained fairly stable for most of the last 30 years. 
With only one exception, it stayed within a band of 63 percent to 73
percent every year from 1963 through 1990.  Large flows into mutual
funds in the 1980s (shown in figure 1 by the gap between the solid
line and the dotted line) did not push the deposit-to-GDP ratio
outside this band.  However, in the early 1990s the deposit-to-GDP
ratio moved significantly below the band, dropping to 51 percent in
1994. 

The ratio of mutual funds to GDP has been rising since the early
1980s, but only since the late 1980s has the rise in mutual
funds-to-GDP ratio been roughly equal to the decline in the
deposit-to-GDP ratio.  This apparent substitution or movement of
money into mutual funds rather than bank deposits has been, at least
in part, the result of historically low interest rates paid on bank
deposits compared to expected risk-adjusted returns on mutual fund
investments.  If the gap between deposit rates of return and expected
mutual fund rates of return narrows, this movement of funds out of
deposits could slow or even reverse itself. 

   Figure 1:  Deposits as a
   Percentage of GDP

   (See figure in printed
   edition.)

Source:  Federal Reserve

We calculated what the deposit volumes would have been had the
deposit-to-GDP ratio stayed at the lower end of its previous band,
i.e., 63 percent.  Using this benchmark, total deposits would have
grown $695 billion during 1990 through 1994.  Because deposits
actually declined by $89 billion, this indicates a potential impact
of $784 billion.  Comparing actual deposits with the low end of the
previous band is conservative.  A deposit-to-GDP ratio nearer the
middle of the band would indicate a larger shortfall.  Nonetheless,
it must be stressed that the deposit-to-GDP ratio has been pushed
down by a number of factors in addition to a movement of deposits
into mutual funds.  These factors include a dramatic downsizing of
the savings-institution industry, a decline in loans at commercial
banks,\10 and a shift by banks into greater use of nondeposit funding
sources. 

We were unable to determine exactly how much of the decline in the
deposits-to-GDP ratio can be attributed to the impact of mutual
funds.  Nonetheless, on the basis of the above analysis, we concluded
that a reasonable estimate of the impact was sizable but probably
less than $700 billion. 


--------------------
\7 This figure was taken from the Flow of Funds Accounts and excludes
price gains for the securities held by the mutual funds. 

\8 In spite of these net sales, the total value of households'
securities holdings continued to rise during these years.  This
reflected the rising prices of the stocks and bonds still held. 

\9 We explored the possibility that money moved from deposits into
mutual funds might have been placed back in bank deposits by the
mutual funds themselves.  The data show that there was only a small
rise in mutual funds' holdings of bank deposits in these years. 

\10 Many banks entered the 1990s suffering from loan losses while
facing pressure to restrict balance-sheet growth in order to achieve
higher capital ratios that were expected by the marketplace and/or
required by the regulators.  Banks desiring to hold down
balance-sheet growth would not offer competitive interest rates to
gain deposits.  In addition, there were ongoing losses of lending
market share to nonbank providers of credit. 


   TOTAL SUPPLY OF LOANABLE AND
   INVESTABLE FUNDS SHOULD NOT BE
   AFFECTED DESPITE SHIFTS AMONG
   INTERMEDIARIES
------------------------------------------------------------ Letter :5

The movement of money from bank deposits to mutual funds should have
little if any effect on the total supply of loanable and investable
funds available to the economy, even though this movement may have
shifted the intermediaries through which finance flows.\11 Both types
of intermediaries (banks and mutual fund companies) generally invest
a substantial portion of the funds they receive. 

As noted earlier, the share of bank loans in total finance was being
reduced by securitization of assets long before mutual funds surged
to prominence as competitors for customers' dollars.  Mutual funds
have further advanced this securitization process.  Both mutual funds
and banks generally invest a substantial portion of the funds they
receive, with the mutual funds investing mainly in securities and the
banks investing in loans and certain kinds of securities.  Thus, at
the same time that a sizable amount of customer money went from bank
deposits to mutual funds, the funds' purchases of securities became a
greater source of new finance to the economy than bank lending.  In
1992 and 1993, about two-fifths of the net new funds flowing to the
domestic nonfinancial sectors of the economy came via mutual funds,
while the share that flowed via banks was about one-fourth of the net
new funds.\12

By and large, it was not possible to determine who "receives" the
mutual funds' investments.  Unlike bank lending, where the money goes
directly from the lending bank to the borrower, mutual funds'
investments largely flow through the securities markets, since most
of the funds' purchases are of tradable securities.  (A relatively
small but interesting exception occurs with so-called "prime-rate"
mutual funds, which purchase securitized bank loans.) As large
amounts of customers' money flowed into mutual funds in the early
1990s, the funds' investments in securities added liquidity to the
securities markets generally.  This liquidity not only improved
conditions for existing issuers desiring to raise additional money
but also may have made it easier for a broader range of borrowers to
tap the securities-issuance markets. 


--------------------
\11 There could be an impact on total availability of finance if the
movement from bank deposits to mutual funds led to a net flow of
investment into or out of the United States.  To ascertain this, it
would be necessary to identify the change in the country's net
foreign assets, i.e., the difference between any reduction in banks'
foreign loans and any increase in mutual funds' foreign investments. 
We could not find data that allowed a comparison of these effects. 

\12 The provision of more new financing by mutual funds than by banks
is especially striking in the context of the larger absolute size of
banks.  At the end of 1991, bank and thrift assets totaled $4,089
billion, and assets of mutual funds stood at $1,345 billion. 


      IMPACT ON DIFFERENT SECTORS
      NOT QUANTIFIABLE
---------------------------------------------------------- Letter :5.1

Availability of finance for the three different borrower
sectors--residential, consumer, and business--could be
disproportionally affected by the movement of funds out of bank
deposits and into mutual funds, even when the total supply of
loanable and investable funds is not affected.  Because mutual funds
invest mainly in securities, it is possible that those who issue
securities might increase their access to finance at the expense of
those who do not.  Unfortunately, there is no way to measure the
extent to which this has occurred from the statistical information
available.  All three sectors obtain some of their financing through
the securities markets, either through their own issues or via the
intermediaries from which they obtain credit.  Because significant
amounts of finance flow through the latter intermediaries, we were
unable to determine to what extent, or even whether, any of these
sectors may face more difficulty in obtaining finance than they had
previously experienced. 

However, we were able to determine that all three sectors increased
their access to finance raised in the securities markets, although
the degree varies by sector.  In addition, we can describe the
indirect channels through which securitization affects the
availability of credit for these sectors, even though these indirect
effects cannot be quantified. 

Residential finance has been extensively securitized.  Although
individual homeowners go to banks, thrifts, or mortgage companies for
their mortgages, most residential mortgages are written in a way to
facilitate their subsequent securitization.  By the end of 1994, only
34 percent of the total value of home mortgages outstanding was
directly held by commercial banks and thrifts, down from a two-thirds
share in 1980 (see table 3).  Nonetheless, banks and thrifts are now
also providing indirect financing to homeowners:  in addition to
their (reduced) direct holdings of mortgages, they invest in
mortgage-backed securities. 



                                Table 3
                
                 Holders of Home Mortgages and Share of
                     Value Outstanding at Year ends

Holders of home mortgages                 1980    1985    1990    1994
--------------------------------------  ------  ------  ------  ------
Depository institutions\a                  67%     52%     41%     34%
GSEs and securitized\b                      17      31      42      55
Other                                       16      17      16      11
======================================================================
Total\c                                   100%    100%    100%    100%
----------------------------------------------------------------------
\a Includes commercial banks, thrifts, and credit unions.  Excludes
holdings of mortgage-backed securities. 

\b Some government-sponsored enterprises (GSE) guarantee and/or
purchase home mortgages. 

\c Totals may not add to 100 because of rounding. 

Source:  Federal Reserve. 

Consumer credit is still largely provided by commercial banks.  As of
year-end 1994, 63 percent of consumer debt (nonmortgage) was held by
depository institutions.  Banks continue to actively originate
consumer credit.  Since the late 1980s, however, banks and other
providers of consumer finance have securitized some of their
automobile loans and credit card receivables, resulting in the
securitized portion of consumer debt rising from zero in 1985 to 14
percent in 1994.  (See table 4.) Moreover, consumers have another
avenue of indirect access to the securities markets:  borrowing from
finance companies.  These companies obtain two-thirds of their funds
by issuing their own securities. 



                                Table 4
                
                    Lenders' Shares of Consumer Debt

Lenders                                   1980    1985    1990    1994
--------------------------------------  ------  ------  ------  ------
Depository institutions\a                  69%     71%     65%     63%
Finance companies and other lenders         31      29      25      23
Securitized                                  0       0      10      14
======================================================================
Total                                     100%    100%    100%    100%
----------------------------------------------------------------------
\a Commercial banks, savings institutions, and credit unions. 

Source:  Federal Reserve. 

We examined the supply of finance to the corporate sector for the
years 1990 through 1994, when the greatest inflow into mutual funds
occurred and when deposit growth was small or negative.  During the
first 4 years of this period, the amount of outstanding bank credit
to nonfinancial corporations declined every year.  (See table 5.) Not
all corporations reduced their bank loans, of course, but the
declines outweighed the increases.  In 1994, for the first time
during this period, there was an increase in outstanding bank credit
to nonfinancial corporations. 



                                Table 5
                
                  Net Change in Finance for Corporate
                               Businesses

                         (Dollars in billions)

                                                                Total\
Source of credit              1990   1991   1992   1993   1994       c
---------------------------  -----  -----  -----  -----  -----  ======
Depository institutions\a    -$ 11  -$ 36  -$ 20   -$ 7   $ 44   -$ 30
Securities issuance             -4     80    105    114      3     298
Other\b                        139      2     37    -16    143     305
======================================================================
Total\c                       $124    $46   $122    $91   $190    $573
----------------------------------------------------------------------
Note:  Nonfarm, nonfinancial corporate business. 

\a Commercial banks, savings institutions, and credit unions. 

\b Major components are mainly trade debt and foreign sources. 

\c Components may not add to totals because of rounding. 

Source:  Federal Reserve. 

In the first year of this period, 1990, the corporate sector did not
offset declining bank loans by increased issuance of securities.  In
fact, the sector redeemed more securities than it issued. 
Thereafter, however, corporations far surpassed previous records for
raising new funds on the securities markets.  Net issuance averaged
$100 billion annually in 1991 through 1993, compared with a previous
single-year record of $55 billion.  In 1994 there was a sharp falloff
of net securities issuance by the corporate sector along with renewed
growth in bank loans. 

The flow of liquidity from mutual funds into the securities markets
enhanced the capacity of the securities markets to absorb these new
issues.  From 1990 through 1994, mutual funds made net purchases of
corporate securities averaging $104 billion annually.\13 Mutual funds
not only purchased the securities of large corporations.  They also
were major purchasers of shares of smaller companies issuing stock
for the first time as well as major purchasers of bonds issued by
companies whose debt was not highly rated (so-called junk bonds). 

For those business borrowers who are unable to issue securities,
there are indirect ways in which funding from the securities markets
can flow to them.  For example, just as finance companies channel
funds from the securities markets to consumers, it is common for
finance companies to lend to middle-sized companies that otherwise
would borrow from banks.  Even in the "noncorporate, nonfarm business
sector," where the borrowers tend to be quite small, finance
companies supply about a fifth of total market debt.  As another
example, some business financing is funded by certain mutual funds
that invest primarily in business loans bought from the originating
banks. 


--------------------
\13 This is the amount mutual funds paid for securities purchased,
minus what they received for securities sold.  It excludes subsequent
gains or declines in the securities' prices. 


      POSSIBLE IMPACT ON SOME
      SMALL BUSINESSES
---------------------------------------------------------- Letter :5.2

There is a possibility that those small businesses that are primarily
dependent on small banks for their loans could experience reduced
credit availability if their banks lost deposits to mutual funds. 
This could happen if neither these businesses nor their banks could
readily obtain financing from other credit suppliers or from the
capital markets. 

Available evidence shows that small businesses are more dependent on
bank loans than large businesses.\14 Whereas bank loans comprise
about one-eighth of the debt of the corporate sector as a whole, a
1989 survey cited by the Federal Reserve suggested that small
businesses get almost half of their debt financing from banks. 
Nonetheless, by implication, the average small business gets about
half of its debt financing from nonbank sources. 

Some small businesses raise money by issuing securities.  According
to the Federal Reserve, many of these firms probably benefitted from
the more receptive conditions in the markets in recent years. 
However, small businesses with less than $100 million in annual sales
generally would not be able to sell securities.  Nonetheless, small
businesses can be indirect beneficiaries of mutual funds'
investments, via the securities issued by finance companies that
extend credit to small businesses.  As another conduit, one
securities firm has extended about $1 billion in credit lines to
small businesses. 

Regarding the access of small businesses to bank loans, the movement
of money out of deposits and into mutual funds does not necessarily
mean that the availability of bank loans will be reduced.  If the
lenders are regional banks or larger, they may be losing some of
their loan volume to securitization either because they are
securitizing their own assets or because their corporate customers
are turning to securities issuance.  In this case, more of the
remaining deposits of these banks should be available for lending to
small businesses. 

Nonetheless, presumably there is some portion of small businesses
that is solely or heavily dependent on small banks for their credit. 
These borrowers might be affected if their banks lose deposits to
mutual funds.  Because some small banks' borrower base is
concentrated in small business, their clientele is not likely to
reduce loans by switching to securities issuance.  Thus, a cutback of
these banks' funding sources would probably not be accompanied by a
reduction of loan demand.  Therefore, some small banks might have to
respond to a loss of deposits by cutting back on loans outstanding. 
However, such cutbacks are only a hypothetical possibility. 
Recently, banks with $250 million or less in assets have had ample
liquidity in the form of their holdings of bonds and other securities
in their investment accounts.  The ratio of securities to total
assets averaged over 33 percent in 1993 and 1994 compared with an
average of about 28 percent for much of the 1980s.  If faced with a
loss of deposits, a number of small banks presumably could fund
existing and new loans by selling these securities. 

In sum, the channels of financing are quite varied; for the most
part, a shift of customers' money from deposits into mutual funds
need not reduce credit availability for any group of borrowers. 
There remains the possibility that some borrowers from small banks
might face credit availability constraints in certain circumstances,
but it is not clear whether those circumstances currently exist. 

We received written comments on a draft of this report from the
Federal Reserve.  In its letter, the Federal Reserve stated that the
report provides a timely review of the flow of funds between mutual
funds and bank deposits and the effect of these flows on credit
availability.  The Federal Reserve said it had no further comment
regarding the report or its content because the report made no
recommendations to the Federal Reserve. 


--------------------
\14 The Flow of Funds Accounts does not provide separate data on
small business.  Small corporations are included within the whole
corporate sector.  Available information on the small business sector
is largely based on surveys. 


---------------------------------------------------------- Letter :5.3

We are sending copies of this report to the Chairman of the Board of
Governors of the Federal Reserve System and other interested parties. 
We will also make copies available to others upon request. 

The major contributors to this report were John Treanor, Banking
Specialist, Stephen Swaim, Assistant Director, and Robert Pollard,
Economist.  If you have any questions, please contact me at (202)
512-8678. 

James L.  Bothwell,
Director, Financial Institutions
 and Markets Issues




(See figure in printed edition.)Appendix I
COMMENTS FROM THE FEDERAL RESERVE
============================================================== Letter 

