August 8, 1994
TO: BOARD OF GOVERNORS NO. 73-94
RE: TWO ARTICLES CONCERNING MUTUAL FUNDS AND FINANCIAL
STABILITY
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The Federal Reserve Bank of Kansas City recently published two
articles concerning the effect that mutual funds have on financial
stability. Copies of the articles are attached.
In the first article, Henry Kaufman observes that the average
mutual fund investor has never experienced a prolonged bear market.
He predicts that, "after repeated bouts of volatility" and an
increase in interest rates, CDs or other money market instruments
"will no longer be looked at contemptuously by many investors, new
inflows into mutual funds will dry up, and many individuals may
become net sellers." Kaufman argues that these developments will
force funds to sell their holdings regardless of the price impact
or "whether other buyers of equities and bonds step forward quickly
to buy." Expressing concern that "excesses originating in the
mutual fund area may be the source of an economic shock should an
asset price bubble be suddenly burst," Kaufman concludes that "the
time has come when we have to be concerned not only with the issues
of fraud and abuse, which is the conventional focus of the SEC, and
consider the systemic implications of the explosion of mutual
funds." Kaufman proposes that investors be required to give 60 to
90 days' withdrawal notice to increase investor awareness of mutual
fund risks and "introduce a useful brake on exaggerated reactions
to abrupt price movements."
In the second article, Donald P. Morgan, senior economist of
the Federal Reserve Bank of Kansas City, argues that concerns of
the sort expressed by Kaufman are exaggerated. Morgan presents
evidence that individuals have shifted their investments into
mutual funds primarily because they have reached the age at which
they will save for retirement. Because these households have long-
term investment goals, their shift to mutual fund investments
should not be destabilizing. Moreover, Morgan demonstrates that
previous shifts to stocks and bonds did not destabilize consumption
and that households' foreign investments, by diversifying risks
abroad, could help stabilize consumption.
We will keep you informed of future publications on these
issues as they come to our attention.
Matthew P. Fink
President
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