For America’s financial system to function properly, savers and investors must be confident in the safety of their capital. Extensive government regulation helps to ensure that the institutions tasked with holding such capital are prudently managed and adequately capitalized. However, financial institutions cannot be made entirely free of risk, and failures can and do occur. Thus, the Federal government has created two entities, the FDIC and the SIPC, to provide insurance for client capital in the event of bank or brokerage failures. In this Navigator, we discuss the important role these entities play in the financial system, as well as some of the specific rules related to the services they provide to savers and investors.
Bank deposit insurance is not a topic that typically sits top of mind for many of us. However, earlier this year, as First Republic Bank, Silicon Valley Bank, and Signature Bank became the second, third, and fourth largest banks in U.S. history to fail, deposit insurance became the subject du jour for depositors and investors across the country.1 With Federal Deposit Insurance Corporation (FDIC) coverage limited to $250,000 per customer per bank, these failures put billions of dollars of customer deposits in jeopardy and likely caused some very tense moments for depositors at other banks that also appeared to be under duress. Indeed, customers of banks and brokerages nationwide began to question the safety of their capital as a result of these bank failures. Ultimately, the FDIC, with backing from the Federal Reserve, agreed to guarantee all deposits at the three failed institutions in order to calm markets and avoid systemic risk in the banking sector. But this episode served as a stark reminder that deposit and brokerage insurance is, in fact, a very important topic that investors should fully understand and consider when deciding where and how to hold their capital.
Bank Deposit Insurance
The United States banking industry uses a fractional reserve system in which only a portion of each customer’s deposits is kept by the bank while the remainder is lent out or used in some other way (e.g., investing in securities) to generate revenue for the bank. Currently, the reserve requirement (the proportion of a customer’s deposits that must remain with the bank) is 10%, meaning that up to 90% of a customer’s deposits may be used by the bank at any given time for revenue generating purposes. Thus, only a fraction of a bank’s total deposit base can be made available for withdrawal at any point in time while the majority of customers’ funds are effectively “at risk.”
Many Americans tend to think of their bank deposits as “safe” and that they’ll be available for withdrawal when needed. Certainly, bank deposits tend to be far less risky than traditional equity or fixed income investments because they are not subject to price volatility, but they are not entirely free from risk. Bankers can and do make poor lending or investing decisions with depositor capital at times, leading to bank losses. These losses (or the fear of such) can lead to panic among depositors that results in a rush to withdraw deposits. But as discussed above, banks do not keep 100% of customer deposits on-hand. Thus, when too many depositors demand their money back at the same time, banks can suffer a liquidity crisis. This is commonly referred to as a “bank run,” and it can lead to bank failure since no bank can satisfy all depositors if they try to withdraw their money all at once.
Unfortunately, bank runs were all too common during the early years of the Great Depression, and hundreds of banks failed as a result. To restore faith in the banking system, the Federal government created an entity that would be tasked with insuring bank deposits (up to a certain level). This entity was the Federal Deposit Insurance Corporation, or FDIC. Each bank in the United States is required to pay premiums to the FDIC, and those premiums are used to backstop client deposits in the event of bank failures to limit systemic risk. As noted above, FDIC coverage is currently limited to $250,000 per depositor per bank. This means that deposits in excess of $250,000 at any single banking institution would be capped at $250,000 of insurance coverage, but a single person or entity could deposit up to $250,000 per bank at multiple banks and have those funds insured entirely by the FDIC. Thus, it is prudent for depositors holding deposits greater than $250,000 to spread this capital across more than one bank.
Of course, it is worth mentioning again that, in the case of the failures of Silicon Valley Bank, Signature Bank, and First Republic Bank, the FDIC agreed to guarantee ALL deposits, including those in excess of the $250,000 coverage limit. It is possible that the FDIC will continue this practice in the future and provide 100% deposit coverage in the event of further bank failures. However, we do not believe depositors should count on this being the case, as the recent bank failures were exceptions to a long-standing rule. Instead, we encourage clients not to exceed the $250,000 coverage limit at any one bank so as to avoid potential losses in the event of a bank failure.
Brokerage Insurance
While many banks also have investment brokerage businesses, the brokerage business is markedly different from the banking business. While customer capital is used directly by banks to generate revenue through lending and securities purchases, brokerages are legally barred from using client capital for their own purposes. Instead, brokerages generate revenue through other means, such as custodial fees, trading commissions, and account maintenance fees, to name a few. The law requires that client capital be held in segregated accounts that cannot be commingled with the brokerage’s own capital. If a brokerage company mismanages its business and fails, client capital is theoretically unaffected because it is kept separate from the company’s corporate funds. Thus, while client capital is often at risk of investment loss (this is the nature of investing), it is not at risk of loss through the actions of the brokerage itself, except in the case of error or outright fraud (both of which can, unfortunately, happen in either the banking or brokerage business ).
While the law goes a long way in protecting brokerage customers from capital loss, it is a simple fact that errors happen and laws are sometimes broken, rendering these legal protections insufficient. Though rare, there have been occasions throughout history of brokerage firms commingling client assets with company assets to make risky bets, ultimately resulting in loss of client capital (the 2011 MF Global brokerage firm bankruptcy is a prime example). Significant errors have also occurred, leading to client harm. In fact, it was a series of material errors on the part of brokerages, due to a huge uptick in trading volume, that led to the creation of the Securities Investor Protection Corporation (SIPC) in 1970. The SIPC was created by the Federal government and tasked with insuring brokerage client capital. Much like the FDIC, the SIPC is funded through premiums that are paid by member brokerages in order to cover losses that may occur due to broker malfeasance or negligence.
In the event of a brokerage failure, the SIPC is responsible for first trying to recover client assets. Assuming assets are properly segregated, client assets should be recoverable and would be moved to another brokerage firm. However, if client assets are not recoverable for whatever reason, then the SIPC will reimburse clients of the failed brokerage up to $500,000 for lost securities and up to $250,000 for lost cash assets.2 Importantly, SIPC protections do not apply to securities that are not registered with the SEC, even if they are custodied by the failed brokerage. Protections also do not apply to futures contracts, commodities contracts, or annuities. And, of course, the SIPC is not responsible for insuring against ordinary investment losses.
As noted previously, the bank failures that occurred earlier this year caused many bank depositors to rethink the safety of their capital. Given the limited nature of FDIC coverage, many depositors whose capital exceeded these limits rushed to protect the uninsured portions of their deposits for fear of further bank failures. Some simply spread their deposits across multiple banks in order to keep the balances below the FDIC limit at any one bank. But another strategy employed by many was to move cash out of bank deposits and into brokerage accounts. While this strategy provided the key benefit of segregation (the capital was no longer at risk in a bank failure), it also provided the added benefit of greater potential yield on the capital. Despite significant increases in the Federal Funds rate since early 2022 (currently 5.25-5.50%), average bank savings account yields remain paltry (currently 0.6%).3 Depositors who moved capital to brokerage accounts gained the ability to invest in risk-free short-term Treasury bills that offer yields far above the average bank savings account yield. We encourage clients to consider this strategy for excess cash holdings in order to take advantage of these dual benefits.
Closing Thoughts
While many investors tend to (understandably) focus primarily on the return on their capital, the return of their capital is also of great importance. Owners of capital must understand the risks posed by the institutions at which their capital is held and prudently work to mitigate those risks by making optimal use of the protections provided by the FDIC, the SIPC, and securities custody laws. If you have concerns about the safety of your capital or would like to explore strategies for maximizing insurance coverage while potentially increasing the yield on your cash assets, please reach out to your Portfolio Manager to discuss the options available to you.
1 https://www.bankrate.com/banking/largest-bank-failures/www.lawdepot.com
2 Many brokers provide securities lending services wherein clients may choose to lend their securities to short sellers, typically in exchange for a fee. Brokerage clients whose securities are lent out in this manner lose SIPC coverage on those securities until they are returned by the borrower. However, brokers typically require borrowers to post collateral that is at least equal to the value of the borrowed securities, which may help cover client losses on these uninsured hypothecated securities in the event of a brokerage failure.
3 https://www.bankrate.com/banking/savings/average-savings-interest-rates/
This article/video is prepared by Pekin Hardy Strauss, Inc. (“Pekin Hardy”, dba Pekin Hardy Strauss Wealth Management) for informational purposes only and is not intended as an offer or solicitation for business. The information and data in this article does not constitute legal, tax, accounting, investment or other professional advice. The views expressed are those of the author(s) as of the date of publication of this report, and are subject to change at any time due to changes in market or economic conditions. Pekin Hardy cannot assure that the strategies discussed herein will outperform any other strategy in the future, there are no assurances that any predicted results will actually occur.
