Bank Mutual Funds: Improvements in Risk Disclosure Needed (Stmnt. for the
Rec., 06/26/96, GAO/T-GGD-96-141).
GAO discussed the Federal Deposit Insurance Corporation's (FDIC) survey
concerning the risks associated with mutual fund investing. GAO noted
that: (1) sales of mutual funds through banks and thrifts have increased
dramatically; (2) the value of assets managed by these institutions
doubled from $219 billion in December 1993, to $420 billion in March
1996; (3) 2,800 banks sold over $40 billion in both proprietary and
nonproprietary mutual fund shares during 1995; (4) in February 1994,
FDIC, the Office of the Comptroller of the Currency, the Federal
Reserve, and the Office of Thrift Supervision jointly issued guidelines
on the policies and procedures for selling nondeposit investment
products; (5) these interagency guidelines require that bank and thrift
customers be fully informed of the risks of investing in mutual funds;
(6) the guidelines also require that banks' mutual fund sales activities
be physically separated from bank deposit activities; (7) the results of
the FDIC survey indicate that many banks and thrifts are not disclosing
the risks associated with mutual fund investing; and (8) all four bank
and thrift regulators are making an effort to ensure that bank personnel
pass qualifying examinations and receive better training in selling
uninsured investment products, and reexamine the current interagency
policy on mutual fund sales.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: T-GGD-96-141
TITLE: Bank Mutual Funds: Improvements in Risk Disclosure Needed
DATE: 06/26/96
SUBJECT: Banking regulation
Securities regulation
Bank examination
Mutual funds
Financial institutions
Proprietary data
Surveys
Interagency relations
Compliance
Information disclosure
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Cover
================================================================ COVER
Before the Subcommittee on Capital Markets
Securities and Government Sponsored Enterprises
Committee on Banking and Financial Services
House of Representatives
Not to be Released Before
10:00 a.m. EDT
Wednesday
June 26, 1996
BANK MUTUAL FUNDS - IMPROVEMENTS
IN RISK DISCLOSURE NEEDED
Statement for the Record of
James L. Bothwell, Director
Financial Institutions and Markets Issues
General Government Division
GAO/T-GGD-96-141
GAO/GGD-96-141T
(233504)
Abbreviations
=============================================================== ABBREV
FDIC - Federeal Deposit Insurance Corporation
NASD - National Association of Securities Dealers
OCC - Office of the Comptroller of the Currency
OTS - Office of Thrift Supervision
SEC - Securities and Exchange Commission
SIPC - Securities Investor Protection corporation
BANK MUTUAL FUNDS: IMPROVEMENTS
IN RISK DISCLOSURE NEEDED
==================================================== Chapter STATEMENT
Mr. Chairman and Members of the Subcommittee:
We are pleased to contribute to your oversight of bank and thrift
sales of mutual funds and other nondeposit investment products. Our
testimony today is based on our September 1995 report on bank sales
of mutual funds, our review of the recently issued survey of
compliance with risk disclosure requirements for mutual funds sold on
the premises of banks and thrifts that was sponsored by the Federal
Deposit Insurance Corporation (FDIC), and our discussions with
banking and securities regulators to determine what regulatory
actions have been taken since our report was issued.\1 Our testimony
focuses on FDIC survey findings that reaffirm the findings we
reported in 1995 concerning banks' and thrifts' inadequate disclosure
of the risks associated with investing in mutual funds.
Over the last several years, sales of mutual funds through banks and
thrifts have increased dramatically. From December 1993 to March
1996, the value of assets managed by bank and thrift proprietary
funds--funds over which they exercise management discretion or that
were formed or founded by a bank or thrift--has nearly doubled from
$219 billion to $420 billion. According to data reported to the
FDIC, about 2,800 banks sold over $40 billion in both proprietary and
nonproprietary mutual fund shares during 1995 alone.\2
Because it is widely known that bank and thrift deposits are
federally insured, the sale of mutual funds by depository
institutions raises special disclosure issues. Customers who
purchase investment products from banks and thrifts need to
understand the differences between FDIC-insured products, such as
money market deposit accounts; and uninsured investment products,
such as money market mutual funds.\3 In February 1994, the FDIC, the
Office of the Comptroller of the Currency (OCC), the Federal Reserve,
and the Office of Thrift Supervision (OTS) jointly issued guidelines
to banks and thrifts on the policies and procedures that these
institutions are to follow in selling nondeposit investment products,
including mutual funds. These guidelines--called the Interagency
Statement on Retail Sales of Nondeposit Investment Products--largely
paralleled guidelines that each regulator had previously issued
separately during 1993. Among other things, the interagency
guidelines require that bank and thrift customers be fully informed
of four basic risks of investing in nondeposit investment products;
specifically, that these products are (1) not insured by FDIC, (2)
not deposits or other obligations of the depository institution, (3)
not guaranteed by the depository institution, and (4) subject to
risk, including possible loss of the principal amount invested. The
interagency guidelines also require that the mutual fund sales area
of the banking institution be physically separated from the
deposit-taking area.
In September 1995, we reported to this committee that many banks and
thrifts were not adequately informing potential investors of the
risks of investing in mutual funds. We based this conclusion
primarily on the results of our "secret shopper" visits to 89 banks
and thrifts in 12 metropolitan areas during March and April 1994. We
found that only 32 percent of the institutions we visited had
salespersons who disclosed all four risks during sales presentations,
while salespersons at 19 percent of the institutions failed to
disclose any of the four risks. We also found that over one-third of
the institutions did not clearly separate the mutual fund sales area
from the deposit-taking area, further increasing the potential for
customer confusion about whether mutual funds were FDIC-insured
products of the bank or thrift.
In responding to our report in mid-1995, the Federal Reserve, OCC,
and OTS said that the banking institutions' lack of adherence to the
interagency guidelines may have been attributable to the fact that
our visits occurred shortly after the interagency guidelines were
issued. At that time, they said that bank practices generally
complied with the interagency guidelines. We recognized that banking
institutions' disclosure practices could have improved over time as
the regulators implemented their new examination procedures and as
the institutions gained more familiarity with the requirements of the
interagency guidelines. We suggested that, after an appropriate
implementation period, Congress consider requesting the regulators to
provide status reports on the results of their examination efforts.
We commend you for holding this hearing now as investors continue to
invest large amounts of money in bank mutual funds and as additional
information on bank and thrift risk disclosure performance becomes
available.
--------------------
\1 Bank Mutual Funds: Sales Practices and Regulatory Issues,
(GAO/GGD-95-210, Sept. 27, 1995).
\2 This includes equity and fixed-income mutual funds. Money market
funds are not included.
\3 Bank customers' depository accounts are insured up to $100,000 by
FDIC. Brokerage firm customers have insurance through the Securities
Investor Protection Corporation (SIPC). SIPC does not protect
investors against market risk or against losses due to poor
performance of investments. Unlike FDIC, SIPC is neither an agency
of the U.S. government nor a regulatory authority. It is a
nonprofit membership corporation, established by Congress under the
Securities Investor Protection Act of 1970, to insure the securities
and cash in customer accounts of member brokerage firms against the
financial failure of those firms. All brokers and dealers, with some
exceptions, that are registered with the Securities and Exchange
Commission are required to be members of SIPC. SIPC insures
individual brokerage accounts to an overall maximum of $500,000 per
customer, with a limit of $100,000 on cash. SIPC provides coverage
only if a brokerage firm goes bankrupt and does not have sufficient
assets to settle its customer accounts.
RECENT SURVEYS SHOW A
CONTINUING PROBLEM WITH RISK
DISCLOSURE
-------------------------------------------------- Chapter STATEMENT:1
Two "secret shopper" surveys of bank and thrift sales of mutual funds
have been issued since we released our report. One was done by a
private research organization called Prophet Market Research &
Consulting and was completed in April 1996.\4 The other was done for
FDIC by another research organization, Market Trends, Inc., and was
completed May 5, 1996. Both surveys indicated that many banks and
thrifts still were not fully disclosing to their customers the risks
associated with mutual fund investing.
The results of the FDIC-sponsored survey, which was the most
comprehensive, indicated that, in about 28 percent of the 3,886
in-person visits, bank and thrift representatives did not disclose to
the shoppers that nondeposit investment products, including mutual
funds, are not insured by FDIC.\5 The results were worse for the
3,915 telephone contacts--with no disclosure in about 55 percent of
the contacts. Similarly, in about 30 percent of the in -person
visits, bank and thrift representatives did not inform shoppers that
nondeposit investment products were not deposits or other obligations
of, or guaranteed by, the institution (about 60 percent nondisclosure
for telephone contacts). Finally, in about 9 percent of the
in-person visits, bank and thrift representatives did not tell
shoppers that their investment was subject to loss, including loss of
principal (about 39 percent nondisclosure for telephone contacts).
The survey's findings on the physical location of the mutual fund
sales area were nearly the same as ours, with about 37 percent of the
institutions not clearly having separated the mutual fund sales area
from the deposit-taking area. The survey's findings reaffirm our
earlier findings and indicate that a significant number of banks and
thrifts continue to inadequately disclose four basic risks associated
with mutual fund investing.
Neither the FDIC-sponsored survey nor ours followed the sales process
through to the point at which a mutual fund was purchased and an
account was opened. However, the interagency guidelines emphasize
that bank customers should clearly and fully understand the risks of
investing in mutual funds, and that these risks should be orally
disclosed to the customer during any sales presentation. Written
disclosures or other documentation are to be available to customers
during the sales process that may eventually fully inform them of the
risks involved. Nevertheless, making these disclosures orally during
initial sales presentations is particularly important because written
disclosures may not always be read or understood until after the
investors' funds are committed, if at all.
--------------------
\4 Second Annual National Bank Securities Service Audit, Prophet
Market Research & Consulting, Apr. 1996. Prophet did nearly 700
in-person visits to 50 of the nation's largest bank brokerage firms
between April 1995 and April 1996, in 36 states and the District of
Columbia. Prophet also did an earlier "secret shoppers" survey that
was issued in September 1994, before our September 1995 report.
\5 The FDIC-sponsored survey was a nation-wide survey of the sales
practices of FDIC-insured institutions that sell nondeposit
investment products, including mutual funds, to find out what bank
and thrift customers were being told about these products. The
survey was done from January to October 1995, and included 7,801
in-person and telephone contacts of 1,194 institutions selected from
the universe of all FDIC-insured depository institutions that had
reported sales of mutual funds and annuities as of September 1994.
REGULATORY ACTIONS TO IMPROVE
DISCLOSURES
-------------------------------------------------- Chapter STATEMENT:2
In responding to our report, the Federal Reserve and OCC indicated
that bank practices generally complied with the interagency
guidelines by mid-1995. However, FDIC's survey results indicated
that many banks and thrifts still need to improve their compliance
with the guidelines so that their customers are adequately informed
of the risks associated with mutual fund investing. According to
banking and securities regulators, additional actions are being
planned or taken to improve disclosures to bank customers.
Some of these actions affect only those banks or thrifts under one
regulator's jurisdiction--such as FDIC's efforts to improve its data
systems to provide its examiners up-to-date information for more
targeted examinations, or each regulator's efforts to improve its
examination guidelines. Other efforts are also being undertaken by
all four bank and thrift regulators. These interagency efforts
include
-- efforts to adopt requirements that bank personnel engaged in the
sale of nondeposit investment products take the securities
industry's standard qualifying examinations,
-- better training for bank personnel selling uninsured investment
products, and
-- reexamination of the interagency policy statement on mutual fund
sales.
The FDIC-sponsored survey found that investment representatives in
banks who were certified by and registered with the National
Association of Securities Dealers (NASD) more frequently made the
disclosures required by the interagency guidelines than did
investment representatives who were not. To be certified by and
registered with NASD, a person must be associated with a
broker-dealer, acquire a background in the securities business, and
pass relevant qualifications examinations administered for the
industry by NASD. The Securities Exchange Act of 1934 excludes banks
from its broker-dealer registration requirements. As a result, banks
have been able to choose whether to have their own employees sell
mutual funds without the need to be associated with a Securities and
Exchange Commission (SEC)-registered broker-dealer or subject to NASD
oversight.\6 If bank employees are to take NASD's qualifying
examination as the banking regulators propose, they are not to be
registered with NASD because they would not be associated with a
broker-dealer. However, under the proposal, they will have met the
same initial qualifications as NASD-registered representatives. In
addition, to maintain their qualifications, they would be subject to
the same continuing education requirements imposed on NASD-registered
representatives.
FDIC officials told us that, in addition to the NASD testing and
education requirements, the banking regulators plan to do further
training to improve bank and thrift employees' awareness of the
importance of complying with the interagency guidelines. They said
that although they found better compliance by NASD-registered
representatives, the difference between these representatives and
other employees was small, indicating that additional training might
help further improve compliance.
Banking regulators told us that efforts to reexamine the interagency
policy statement are focused on clarifying (1) what situations do or
do not constitute a sales presentation and (2) what the institution's
obligation is in assuring that an investment recommendation meets the
customer's needs. An FDIC official told us that the banking
regulators want to make the interagency statement less vague so that
banks and thrifts can better understand what is expected of them and
their employees.
In addition to the efforts of the bank and thrift regulators, NASD
and SEC are also working on proposed rules governing registered
broker-dealers operating on the premises of banks and thrifts.\7 In
our September 1995 report, we pointed out the controversy generated
by these proposed rules, which were first released for comment in
December 1994. The controversy revolved around the NASD proposed
rules that differed from the bank regulators' existing interagency
guidance. Specifically, NASD's proposed restrictions on brokers' use
of confidential financial information from bank or thrift customer
files were stricter than the interagency guidance and NASD's proposed
prohibition on the payment of referral fees by broker-dealers to
employees of the bank differed from the interagency guidance, which
allows payment of these fees.
After analyzing nearly 300 comment letters, NASD made changes to its
proposed rules. The revised proposal defines confidential financial
information and allows its use, but only with the prior written
approval of the customer; the prohibition on referral fees remains.
NASD forwarded its revised proposal to SEC for approval. SEC
published the proposal for public comment and received 86 comment
letters by the end of the comment period in May 1996. Most of the
letters were from banking organizations or bank-affiliated
broker-dealers. SEC is currently analyzing the comment letters
before deciding whether to approve the proposed rules.
--------------------
\6 Thrifts are not exempt from the definitions of broker and dealer
in the Securities Exchange Act of 1934; therefore, all securities
sales personnel in thrifts must be registered representatives of a
broker-dealer. Brokers are agents who handle public orders to buy
and sell securities. Dealers are principals who buy and sell stocks
and bonds for their own accounts and at their own risk.
\7 Our September 1995 survey found that more than 90 percent of the
people selling mutual funds for banks were registered broker-dealers.
ADDITIONAL OPTIONS TO HELP
IMPROVE RISK DISCLOSURE
-------------------------------------------------- Chapter STATEMENT:3
Ensuring that salespersons provide bank customers with appropriate
risk disclosures during all mutual fund sales presentations presents
a difficult challenge to regulators and to banks and thrifts. Over
time, this task may become easier as distinctions among financial
service providers continue to fade and customers become more aware of
the differences between insured and uninsured products. The bank and
securities regulators' proposed actions for additional training of
investment representatives, requiring testing of employees, and
reexamining the interagency guidelines should help improve bank and
thrift compliance with disclosures required by these guidelines.
However, additional steps, which may have the potential to help
improve compliance with the risk disclosure guidelines, could also be
taken. Such actions, for example, could include regulators (1)
continuing to monitor bank and thrift disclosure practices through
periodic secret shopper surveys, (2) encouraging banks and thrifts to
adopt this kind of testing procedure as part of their own internal
compliance audits, if legal concerns can be overcome and it is cost
effective; and (3) segmenting and publicizing the results of
regulatory reviews of compliance with the interagency guidelines,
including the results of secret shopper surveys, when appropriate.
Examinations of banks and thrifts are an important part of regulatory
oversight. However, they do not directly measure the adequacy of
disclosures made during oral sales presentations. Rather,
examinations of bank sales of mutual funds assess whether appropriate
risk disclosure policies and procedures are in place. Examiners
normally do not monitor sales presentations between customers and
bank employees, and they would have difficulty doing so without
affecting the customer's privacy or the performance of the employee.
FDIC reported that it plans to evaluate the need for another secret
shoppers survey on the basis of the results of bank examinations over
the next 2 years. Because of the difficulty in monitoring oral sales
presentations through examinations, it seems to us that decisions
concerning the need for secret shopper surveys should not be based
solely on examination results. Instead, using such surveys to
supplement examination results could give banks and thrifts an
additional incentive to better ensure that their personnel are
providing proper disclosures.
Bank regulators told us that some banks are using secret shopper
surveys to monitor their own employees. A Federal Reserve official
said that banks could make them part of their internal compliance
audits. The need for federal regulators to do such surveys may
decrease if more banks and thrifts do their own and if disclosure of
mutual fund risks improves. Federal regulators could encourage banks
and thrifts to adopt these surveys as part of their internal
compliance audits if legal concerns can be overcome and it is cost
effective. For example, some self-assessment activities, like
self-testing, pose a dilemma for lending institutions in that under
current law the results of self-testing programs may not be
privileged or protected from disclosure to federal regulatory
agencies or private litigants. Hence, despite the obvious
preventative benefits to be gained from having lenders adopt
continuous self-testing programs, many institutions are reluctant to
undertake such programs out of fear that the findings could be used
as evidence against them, especially by third-party litigants. One
way to help resolve this issue would be to remove or diminish the
disincentives associated with self-testing by alleviating the legal
risks of self-testing when conducted by banks who, in good faith, are
seeking to improve their mutual fund risk disclosures. Banking
regulators suggested to us that they might also encourage depository
institutions to consider methods other than secret shopper surveys to
test compliance with disclosure requirements, such as calling their
customers to determine if the sales person made the proper
disclosures.
Bank and thrift regulators do not publicize the results of their bank
examinations, in part because of concerns about the effect such
disclosures might have on the perceived safety and soundness of the
banking institution or the industry. However, bank and thrift mutual
fund sales are securities activities that are more likely to affect
individual investors than they are the safety and soundness of a
depository institution. Therefore, bank and thrift regulators may
want to consider the feasibility of segmenting the results of their
reviews of compliance with disclosures required by the interagency
guidelines, including the results of any secret shopper surveys, from
other examination results and of making those results available to
the public. Such segmentation and disclosure is already required in
connection with regulators' assessments of bank and thrift compliance
with the Community Reinvestment Act.
------------------------------------------------ Chapter STATEMENT:3.1
In summary, the results of our survey and the more recent surveys,
indicate that there may be a persistent problem with many banks and
thrifts failing to make the basic risk disclosures required under the
interagency guidelines. These disclosures are important because they
can help investors fully understand the risks of investing in bank
mutual funds. Banking regulators and some banks and thrifts are
taking steps to better ensure that the required disclosures are made.
While these actions are positive, other steps, which may have the
potential to help increase compliance with these guidelines and
better ensure that investors are adequately informed of the risks of
their investment decisions, could also be taken.
*** End of document. ***