WASHINGTON -- If federal regulators move as Paul Schott Stevens fears they will, they could drive up costs and undermine investor confidence in the largest U.S. mutual funds, a cornerstone of Americans' retirement savings.

Stevens, the president and CEO of the Investment Company Institute, issued an urgent warning about the potential designation of large mutual funds as so-called systemically important financial institutions, or SIFIs, this week at the group's General Membership Meeting.

At issue is an ongoing review underway at the Financial Stability Oversight Council, a consortium of regulatory agencies that grew out of the Dodd-Frank Act, which is considering which financial outfits are so integral to the overall health of the financial system that they should be subjected to additionally scrutiny and tougher capital requirements.

"There's every indication that the FSOC is proceeding down a path to regulate mutual funds like they were banks, and the implications of this are very worrisome indeed," Stevens said. "By designating mutual funds as SIFIs, the FSOC would impair the single best tool available to average Americans for retirement savings and individual investment, as well as a key source of financing in our economy."

The concern, at this point, is somewhat hypothetical, as the FSOC has only designated AIG, GE Capital and Prudential Financial as nonbank SIFIs, though it is rumored to be evaluating asset-management companies like BlackRock or Pimco.

The issue remains the subject of active debate, revisited this week at the FSOC's asset management conference on Monday, and again Tuesday before a House committee hearing, where Vanguard Chairman and CEO F. William McNabb was on hand to argue against saddling fund companies with the expanded regulations.

Supporters of nonbank SIFI designations contend that the financial collapse of 2008 was the product of irresponsible behavior on the part of a broad range of actors -- not just banks -- and that the enhanced scrutiny that SIFI status carries would help stabilize the system.

Stevens doesn't buy it. He argues that the fund space is already heavily regulated under established securities law, and that in the event of failure, a single fund can exit the market in an orderly process that entails relatively little disruption, unlike banks.

Adamant though he is that SIFI designation is unnecessary for ICI members, Stevens becomes more animated when he contemplates the negative consequences that could arise from that level of regulation, particularly in the retirement space.

He cites ICI data indicating that half of all stock and bond fund assets are held in retirement plans such as IRAs or 401(k)s. Of the investors with fund holdings outside of retirement plans, 80% "rely on professional financial advisors who help them as investors stay the course through proper diversification and asset allocation, especially at times when the markets are in turmoil," Stevens said.

With the SIFI designation, mutual funds would be required to hold "bank-level" capital of 8%, and shoulder the costs of Federal Reserve oversight, along with payments to support the FSOC and its research arm. "All of these costs would flow through to fund investors," Stevens said.

What's more, if one SIFI fails and can't cover its debts, the other designees are on the hook to make up the balance. To Stevens, that provision would create a nervous environment where investors in SIFI-designated funds would be exposed to additional risk.

"The law was intended to keep the costs of bank bailouts from falling on taxpayers ever again," Stevens said. "But dropping that burden on retirement savers and other shareholders in a large mutual fund is just a taxpayer bailout by another name."

He envisions a regulatory regime where the feds could insert themselves into the day-to-day management of funds, potentially leaning on the portfolio management team or the fund's advisors. In the event that a particular bank was in trouble, he suggested that the Federal Reserve could prevail on funds not to withdraw financing, even if the fund's managers felt it prudent to do so.

"You might think that this concern is fanciful. But it's in fact not," Stevens said, recalling the criticism directed at funds when they pulled out of teetering Bear Stearns and Lehman Brothers. "The Fed could substitute its prudence for the fiduciary judgments of SIFI-designated fund's investment advisor."

The focus on the biggest fund companies -- presumably those that would be the most likely candidates for SIFI designation -- would also deal a sharp blow to an already spare business model, Stevens argued.

"The largest U.S. funds are highly efficient and relatively low-cost within their asset classes.
Indeed, you take the top 11, they have an average expense ratio of just 31 basis points. So it really wouldn't take much of a SIFI premium to increase the fees of these funds significantly. That would make it hard for them to compete against het many similar funds that are not designated SIFIs," Stevens said.

"In our wildly competitive fund marketplace, designation won't make a fund too big to fail," he added. "It will render it too burdened to succeed."

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