Some bankers still avoid aggressively pushing mutual funds in their lobbies due to fear of "disintermediation" of their deposits to other investments.

Consultant Kenneth Kehrer, of Kenneth Kehrer Associates, Princeton, N.J., explains this phenomenon: "The concern is the stereotype of a stockbroker who might pillage the bank's customer base and convert all deposits to investment sales."

The increasingly prevalent school of thought among bankers, though, is if they don't offer customers investment products, including mutual funds, business will leave the bank.

Kehrer knows about disintermediation of deposits to investment products very well. He has been studying this issue, a longtime controversy at banks, since 1990.

Bankers should not be concerned that sales of mutual funds and variable annuities will lead to a high level of disintermediation, Kehrer stressed in a recently published analysis. So, investment companies seeking to convince banks to more aggressively push their mutual funds and variable annuities might find ammunition in his study.

It's true that over the past two decades, the banking industry's share of total U.S. household assets fell 52% to 10.6%, Kehrer Associates' study acknowledges. By contrast, the bank channel's share of mutual funds increased 13 times to 9.1%.

Annuities the Real Threat

However, the total cannibalization of bank deposits by the sales of mutual funds and variable annuities is less than 1% annually, Kehrer insisted. The researcher bases his conclusions on annual data collected since 1990 on more than two-thirds of all bank investment sales.

Even with the cannibalization of bank deposits, Kehrer said, "The typical bank makes more in fee income from selling mutual funds and variable annuities than they will ever make from a CD."

If there is any disintermediation problem, it arises when CD depositors are sold higher-rate fixed annuities offered by the bank.

Kehrer's study indicated that in 2000, the typical bank had a gross disintermediation rate of 34%. However, subtract money that was leaving the bank anyway, and the net disintermediation rate is just 26 percent. "This is substantially lower than some alarmists believe," the study reported.

The bulk of that disintermediation, which Kehrer projected will increase, is due to the renewed popularity of fixed annuities.

Fixed annuities are much more similar to CDs than mutual funds or variable annuities, and thus, most apt to cannibalize deposits. The disintermediation has little to do with mutual fund or variable annuity sales, he maintained.

The report also shows that the greater the bank's fixed annuity sales, the greater the disintermediation of bank deposits.

Where fixed annuity sales account for more than 38% of bank sales, the disintermediation rate is 47%. Where they represent less than 10% of a bank's sales, the disintermediation rate is just 14%.

Licensed to Sell

Currently, 57% of banks supplement their broker sales forces with licensed bank employees, Kehrer said. Licensed bank employees get paid investment product commissions ranging from 5% to 10%, while brokers earn 30% to 40%.

"Licensed bank employees tend to disintermediate more than brokers do," Kehrer observed.

In 2000, licensed banker sales forces registered a gross disintermediation rate of 38% -- eight percentage points higher than broker-only programs.

One chief reason is that licensed bank employees typically sell fixed annuities, he explained. They also are more apt to encounter a customer who has a CD maturing. "The customer is asking them, Should I roll the CD over, or should I invest in something else?'

"The broker is more apt to be confronted with a customer looking for more general financial advice," he noted.

Contrary to popular belief, Kehrer's study also found that bankers fearing disintermediation might actually have less to fear if they hire the most productive brokers.

Banks with the most highly productive brokers had 37% of investment sales funded by the bank's own deposits - three percentage points less than banks with less productive brokers.

Hidden Talent

That might not sound like much difference. But Kehrer's analysis also found that more productive brokers were more than twice as effective as less productive brokers in identifying money leaving the bank anyway to buy investments. Seventy percent of the domestic deposits converted to investment sales in the banks with the most productive broker sales forces were leaving anyway. This compares with just 31% in banks with less productive brokers.

One reason for the high interception rates among highly productive brokers, the study suggests, could be that the bank has customers investing, anyway. That could also explain why a bank was able to attract better broker reps, it said.

If banks fear that investment products might cannibalize bank deposits, they might limit their fears to fixed annuities, the study indicated.

Whether a bank truly needs to worry about cannibalization of CDs depends largely on the commissions they're earning from products they're selling and the spread on CDs, Kehrer said.

"In general, for short-term CDs, in a competitive marketplace, you have a narrower spread," Kehrer said. "To the extent to which you have CDs with maturities of five to 10 years and with a relatively high net interest margin, a CD might be more profitable in the long-run."

Although some banks have tried to curb disintermediation by paying less incentive compensation for cannibalized deposits, that largely doesn't work.

The study cited a 1997 study, at which time, banks providing sales incentives not to disintermediate deposits had gross disintermediation rates of 57%. That was 16 percentage points higher than banks that did distinguish among incentives.

"Deposit disintermediation is more closely tied to the competitiveness of a bank's CD rates and the performance of alternative investments," the study said.

For bankers who think they need to worry about disintermediation to investment products, Kehrer's analysis advises:

* Disintermediation can be contained by having licensed bank employees sell mutual funds or variable annuities rather than just fixed annuities.

* Banks can curb disintermediation by recruiting top-producing broker reps.

* Improving referrals to the investment sales staff also can help stem disintermediation of deposits.

Meanwhile, the report hinted, in this bear market and with mortgage rates so low, don't expect banks to sell mutual funds or variable annuities very aggressively anytime soon.

"The number of banks targeting deposits for investment sales does seem to be cyclical," the report noted, "rising during periods of slack loan demand."

Unfortunately, with mortgage rates hitting record lows, loan demand has been high.

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