FREE NEWSLETTER
I MAY BE WRONG, but I’m pretty sure Vanguard Group doesn’t have a secret plan to control the U.S. banking system. Not everyone is so confident, however.
There’s a federal regulation that no investor can buy more than 10% of the shares of a U.S. bank without regulatory approval if it’s seeking to “control” the bank. Thanks to the popularity of its index funds, Vanguard funds collectively owned 12.5% of State Street’s shares as of June 30. They also owned 9.9% of Bank of New York Mellon and 9.4% of JP Morgan Chase.
Does that worry you? It does one Washington, D.C., regulator.
Jonathan McKernan, a director at the Federal Deposit Insurance Corp., suggests that FDIC regulators may need to supervise Vanguard’s bank share purchases to ensure they aren’t “improperly influencing [bank] operations.” Such reviews can take months to complete.
They would also end an informal understanding that investment companies can break the 10% limit so long as they stay passive investors. There’s a similar regulation against owning too much of a utility’s shares. The Federal Energy Regulatory Commission can undertake regulatory approvals if an investment company seeks to acquire more than 20% of an electric company’s shares.
Vanguard says that it isn’t trying to control banks and meets the passive investor test. This April, Vanguard told fund shareholders that regulatory hiccups could disrupt the smooth operation of its index funds.
“These ownership restrictions and limitations can impact a fund’s performance,” Vanguard wrote. “For index funds, this impact generally takes the form of tracking error, which can arise when a fund is not able to acquire its desired amount of a security.”
Vanguard is exploring workarounds, like buying derivatives to stand in for any bank shares it couldn’t buy directly. Such tactics could add to the costs and risks of its funds, not to mention depress the value of bank shares it couldn’t buy. The ownership limits could also crimp BlackRock’s and State Street Global Advisors’ index funds. Together, the so-called big three own nearly 25% of the shares of many U.S. companies.
In a speech last January, the FDIC’s McKernan cited a study suggesting the big three money managers could one day own 40% of publicly traded shares in U.S. banks if present trends continue. In theory, the big three indexers could call the shots at America’s banks when they vote stock proxies on behalf of fund shareholders.
Domination of the banking system, though, doesn’t get a mention in Vanguard’s published guidelines on how it votes proxies. Instead, Vanguard says it seeks to support four pillars of good governance: board effectiveness, oversight of strategy and risk, the size of executive pay and issues related to shareholder rights. The plank about the size of executive pay could get spicy. Still, overall, Vanguard’s proxy policies sound like they’re intended to help companies make money for shareholders.
A few years ago, fund companies got a bit chirpy in supporting ESG—environmental, social and governance—issues when voting proxies. The attorneys general of some states, who didn’t share the same views, sued, arguing fund managers were violating their fiduciary duty to put shareholders’ interests first. That sparked a slow retreat by the fund industry to avoid such conflict going forward.
The FDIC’s McKernan linked the threatened enforcement action to ESG votes in his speech last January. “The Big Three insist their index funds are passive. If that were truly so, there might not be much issue under the banking laws,” McKernan said. “But to the extent the Big Three leverage their purportedly passive index funds to advance ESG objectives or otherwise influence corporate policy, then there is a real and significant problem here, and it’s one that the FDIC and the other banking regulators need to get in front of quickly before the influence of the Big Three grows even larger.”
Vanguard and other fund companies will have to step up their lobbying presence in Washington to head off such regulatory headaches. In the meantime, index investors like me may wonder if Jack Bogle’s ingenious invention will be left unmolested to work its magic. Its delicate machinery can deliver riches to millions—provided it’s allowed to work freely.
Greg Spears is HumbleDollar’s deputy editor. Earlier in his career, he worked as a reporter for the Knight Ridder Washington Bureau and Kiplinger’s Personal Finance magazine. After leaving journalism, Greg spent 23 years as a senior editor at Vanguard Group on the 401(k) side, where he implored people to save more for retirement. He currently teaches behavioral economics at St. Joseph’s University in Philadelphia as an adjunct professor. The subject helps shed light on why so many Americans save less than they might. Greg is also a Certified Financial Planner certificate holder. Check out his earlier articles.
Want to receive our weekly newsletter? Sign up now. How about our daily alert about the site's latest posts? Join the list.
Good article. Thank you
it occurs to me, at least from my own experience, that if vanguard’s customer service doesn’t improve, they won’t have to worry about large ownership in individual stocks.
Definitely a good point. Difficult to get an advisor on the phone, you have to leave a message and hope for a call-back in a day or two. Same wait time for email messages.