Banks or Brokerages: Which is Safer for your Cash?
With the recent failure of Silicon Valley Bank, many are wondering if more failures will come, and if their own deposits are at risk. I think it’s prudent to review the technicalities and protections of banks as compared to brokerage firms.
Silicon Valley Bank is (was) a highly niche player in the California technology space, and hence has a narrowly focused customer base. Many of their corporate accounts were flush with cash via the tailwinds of venture capital and initial public offering projects. Younger technology companies historically rely on borrowing to grow. The abrupt rise in interest rates (the swiftest pace of hikes in decades) drastically slowed this industry disproportionately as compared to other sectors. When these companies don’t have access to credit, or rates are dramatically high – they must default to raiding their corporate checking accounts.
SIVB chose to back these deposits with long term bonds (20 and 30 years+). Such a drastic rise in interest rates resulted in compounding bond losses. Rather than properly hedging or diversifying hedging strategies, SIVB managed risk poorly. The situation also failed to have proper oversight by state regulators. SIVB was forced to liquidate the bonds at a loss. As such, their capital ratios became grossly misaligned to that of peer bank entities. Customers, mainly technology outfits with accounts in excess of the FDIC insured levels, caught wind of the situation and came in droves to pull their capital from the firm. Word spread, and as others followed suit, a modern day, social media fueled bank run caught wind over the weekend. The FDIC stepped in to seize the bank and halt activity. While stocks across the banking section have faced news-fueled losses, many of these banks’ balance sheets remain as strong as ever.
Enter fractional reserve banking: Here is the problem with banks – they are only required to keep marginal deposits on hand. When you give the bank cash, most of it is lent to other customers or utilized to purchase bonds (or other investments). Very little remains in-house for withdrawal: This is how the bank makes money. If everyone demands their cash on the same day, the bank simply can’t provide it. The FDIC protects these deposits up to $250,000 per account holder. Special situations can be created in which multiple accounts spread risk across many locations. From our research, not many of the aforementioned did this. The risk remained centralized. Some corporate accounts held tens of millions in cash at SIVB that was uninsured. The extent of the damage is not yet completely understood. What if a company, or individual wanted to keep more than $250,000 and keep it insured?
Enter brokerages: Examples of brokerages are Fidelity, Merrill Lynch, Morgan Stanley, E-trade, and Charles Schwab. As an independent RIA, I primarily use Charles Schwab. The main function of the brokerage is several-fold. Access to the marketplace that buys and sells securities (stocks, bonds, mutual funds, etc.), custody and clearing of trades, and issuance of proper reporting such as statements and 1099s are all functions that quality brokerages provide. If I buy 100 shares of McDonalds stock in my Schwab account – those shares are 100% mine. The broker, Schwab, cannot reach to those assets in any circumstance (for instance – to cover large bond losses and provide themselves liquidity!). Of course, the client has risk of loss if McDonalds stock were to fall in value. Brokers utilize their own version of FDIC insurance known as SIPC, which protects client assets (up to $50 Million at Schwab) in the event of broker failure or fraud from the broker or its employees. Again, this does not protect investment losses due the underlying investments.
Most people use investment advisors and brokerages for their long-term assets such as stocks and use their banks for short-term savings. However, now is the time to look at brokerages for short-term savings and cash. I recently set up a second “short-term” brokerage account for a client designed entirely for his emergency fund. His main account consisted of stocks, ETFs, and mutual funds for long term growth – but everyone needs an emergency fund that is liquid, accessible, and safe.
Within this account style, we are buying third party money market mutual funds from Vanguard and Fidelity that are now paying over 4%. While not FDIC insured, the money market accounts that I use have never lost value. We can also buy treasury bonds and FDIC insured CDs that yield very close to 5%. We can buy CDs from various banks in chunks of $250,000 to ensure FDIC protection, not only spreading risk across multiple entities, but also providing virtually unlimited FDIC insurance to our clients. Treasury bonds have never failed and can be purchased in unlimited amounts, all in one account, and are considered risk-free by most. Money market accounts are as liquid as they come - funds can be transferred via ACH within a few business days. CDs and Treasury bonds must wait until maturity (with caveat of penalties upon early liquidation).
Had the corporate customers of SIVB parked their cash in brokerages as described, no losses would have surmounted. If your bank is not paying fair rates on savings, if you have over $250,000 in one account, or a combination – consider utilizing your brokerage as a new facility.
As always, please contact me if you have questions on your personal situation.