* Tighter capital requirements could favor banks over mutual funds
* BlackRock strikes conciliatory stance with regulators
* SEC still struggling to advance tougher rules
By Tim McLaughlin and Ross Kerber
Nov 14 (Reuters) - BNY Mellon Corp's investment management chief on Wednesday said he saw "some merit" to stiffer capital requirements and other rules for money funds proposed by U.S. regulators, in comments that exposed a schism in the $2.5 trillion industry.
BNY Mellon investment chief Curtis Arledge's positive remarks contrasted sharply with fund industry comments on Tuesday blasting new reforms proposed by the U.S. Financial Stability Oversight Council, a board of top regulators chaired by Treasury Secretary Timothy Geithner. Fidelity Investments and other major fund managers said the reforms were unnecessary and could drive away investors.
Shares in Federated Investors Inc, heavily involved in money funds, fell 5 percent to close at $18.43 in Wednesday trading as the industry schism became more apparent.
Arledge, who oversees BNY's $322 billion cash management business, said he supports requiring bigger capital buffers for riskier, less diversified funds.
"I'm not saying I would do it exactly the way it was in the (FSOC) proposal, although I think there is some merit to it," Arledge said at the Bank of America Merrill Lynch Banking and Financial Services investor conference in New York, which was webcast.
"We do actually hold economic capital against our money funds," Arledge said. "So we are actually very well positioned for the world to shift to where sponsors need to recognize they have exposures. Not everybody does, so we think we're well positioned if that changed."
The industry split may make it harder for companies to agree on a deal with regulators, said Stephen Keen, a Reed Smith attorney in Pittsburgh who has represented fund firms.
The idea that fund firms should build up capital is "the insurmountable roadblock to a compromise-most sponsors won't accept it and FSOC won't drop it," Keen said.
Funds may also have difficulty raising capital to meet new rules because of low interest rates, Keen said. "The irony is that there is currently no money for capital," he said.
Regulators are trying to settle whether money funds need more oversight after the financial crisis. In 2008 one of the industry's best-known funds "broke the buck" and reported a net asset value below $1 per share, dragged down by heavy holdings in the collapsed Lehman Brothers. Federal agencies eventually provided industry-wide backstops. In 2010, new rules required funds to become more transparent and liquid.
In August, Securities and Exchange Commission Chairman Mary Schapiro failed to win a majority of support from the SEC's five-member commission to move forward with additional changes. That sent the matter to the FSOC.
Many fund firms maintain that the 2010 reforms are sufficient. They say new rules, like a proposed shift away from the traditional $1-per-share value, would drive away investors.
Fidelity Investments reaction was typical. The proposals "do not strike the proper balance of minimizing risk to the financial system while preserving the benefits that these funds provide investors, issuers and our economy," Fidelity president of money funds, Nancy Prior, said in a statement on Tuesday.
David Scharfstein, a Harvard Business School professor who has backed some money fund reforms, said free-standing fund companies such as Fidelity, Vanguard Group and Federated Investors, might have a harder time with capital requirements than banks, which already have capital.
Lance Pan, director of investment research for Capital Advisors Group, which works with institutional investors, said firms such as Fidelity and Federated also have few other products to hold the cash of investors exiting money funds.
Banks such as BNY Mellon and JPMorgan Chase & Co, meanwhile, can offer more products for customers who might leave money funds if they don't like new rules, Pan said.
BNY Mellon and its subsidiaries managed $155 billion in money funds, No. 5 in the industry, as of Oct. 31, according to Lipper, a unit of Thomson Reuters. Fidelity was No. 1 with $418.9 billion, followed by JPMorgan with $229.6 billion and Federated Investors with $215.9 billion, Lipper data shows.
Arledge put a finer point on the differences.
"If you personally had a choice, would you rather have your sponsor be the safest bank in the largest economy in the world, or an independent investment firm?" he said. "We're a winner in the scenario where risk is actually factored in to making money funds more resilient."
In addition, BlackRock Inc, among the most vocal proponents of finding a compromise, is again engaged with regulators over the latest ideas, president Rob Kapito said on Wednesday. The New York-based firm will comment on the pros and cons of all three proposals issued by the FSOC, Kapito said while speaking later at the same investor conference as Arledge.
Though Kapito did not give any specific views on the FSOC's preliminary plan, he said it was a "good starting place."
"I'm an optimist in this regard," he said, but added "this is going to be a tough process."