Banks and Brokerage Firms: How Safe Am I?

In light of the recent headlines around bank failures, which may have brought back some very bad memories for those investors who lived through the 2008 financial crisis, it is helpful to examine what the rules are in order to sleep better at night.


When it comes to a bank or a credit union, your deposits are insured up to $250,000 per depositor with the Federal Depository Insurance Corporation (FDIC) or the National Credit Union Administration (NCUA).  That ratio is per institution, not per account number.    As a result, opening two separate joint accounts with your spouse in the exact same title will not increase your coverage.    Additionally, adding a beneficiary such as a child or sibling onto an account will add an additional $250,000 per beneficiary.    This is called a Payable on Death (POD).   However, the FDIC limits this to a maximum of six beneficiaries.


We strongly encourage individuals to stay within the FDIC/NCUA limits allowable.   Recently, the FDIC has extended unlimited deposit insurance to institutions such as Signature Bank and Silicon Valley Bank.  However, there is no guarantee this will be the case with all banks.   The manner in which these banks saw increased FDIC limits is already in question.  Under the 2010 Dodd-Frank bill, the Federal regulators have the authority to raise the deposit cap to cover all accounts should a “liquidity event” take place.   However, this is only after an expedited vote by the U.S. Congress, which hasn’t yet happened.


The selection of certain banks to have unlimited deposits as opposed to other banks creates a number of rather obvious potential problems.   However, permanent unlimited deposit insurance creates a whole host of other longer-term issues.  Imagine if all deposits were unlimited.   Savers would likely overwhelmingly chase the highest rates, which would place more money in the institutions that take the highest risk, thereby encouraging more risk in the financial system.


As a saver and investor, it is important to know how and where you are protected.   When you are a depositor at a bank, your deposit is your asset.  To the bank it is a liability.   The deposits in your name are subject to the creditors of that bank in the event of a default over whatever the allowable insurance limits are over that time.   This is because banks lend out their monetary base as much as a 10-1 ratio under the Fractional Reserve Lending System.   The mechanics of that system are quite complicated and beyond the scope of this article.  What is important to know is that your deposits above the limit can very much be at risk.


Let’s then compare this to how a broker-dealer works in terms of their custody of your assets.   A brokerage firm is required to legally segregate client assets from firm assets.   This means when you examine the balance sheet and profitability of a brokerage firm, they can’t list your stocks and bonds as an asset on their balance sheet.  As a result, in the event of a liquidation of the firm, your accounts simply receive a new custodian.   During the 2008 financial crisis, we witnessed Lehman Brothers, a 158-year old investment firm that catered to some of the wealthiest investors in the world go out of business in a couple of weeks.   As scary as this was at the time, it’s important to note that 100% of client assets were returned to them as multiple divisions of Lehman were split up across many companies.   This does not mean that the value of your securities are inherently safe.   If you own 10 shares of stock in Amazon, and the stock declines, it is still worth less to you.  It only means that your 10 shares of Amazon will be returned to you simply because they are not subject to the creditors of the brokerage firm.   This is true with your employer 401k and other retirement plans as well.


Does this mean that brokerage firms don’t need insurance?  Absolutely not.    Brokerage firms maintain insurance via the Securities Investor Protection Corporation (SIPC).    SIPC covers you up to $500,000 per investor.   However, the way in which SIPC works is it insures you in the event of something like fraud.  If a firm is liquidated and the client assets are being returned to them, but somehow you uncover that shares are not there, then the SIPC would begin coverage.  A famous example would be the Bernie Madoff case, in which he provided clients with fictitious statements of their balances. The SIPC coverage reimbursed them up to the $500,000 limit.   Additionally, most major brokerage firms offer additional private coverage that can sometimes be unlimited protection from such examples of fraud or missing securities.  In the case of Madoff, he did not maintain any additional insurance above the SIPC limits, most likely because they would have uncovered the fraud much sooner.


As a result of the way insurance on deposits actually work, it could be argued that a cash position above the FDIC limits in a brokerage firm sitting in a money market is actually quite a bit safer than a bank.   Money markets are essentially mutual funds that invest in cash like short-term debt instruments that are maturing usually between 30-90 days.  As a result, they are highly liquid.   The risk with a money market has more to do with the underlying debt and the risk of default.   It is extremely rare for a money market to default.  However, an investor concerned with such a risk could choose a money market that invests only in government backed securities, or more specifically just US treasury T-Bills.  This eliminates the default risk, with the exception of the US Government declaring a default.  If such a thing were to happen, it really wouldn’t matter very much where you put your cash anyway, as it would be worthless paper and nothing more than kindling for the fireplace.


While more bank failures may be possible, we would highly encourage investors to stay within the legislated FDIC limits.  However, understand that the way in which a brokerage firm segregates your assets is very different from that of a bank.