March 2023 has seen the start (and hopefully the end?) of a financial industry crisis that has captivated Wall Street and many Americans. It all started on Wednesday, March 8th when Silicon Valley Bank in Santa Clara, CA announced it needed to raise capital to shore up losses on its available for sale securities portfolio.
That announcement started a bank run that ultimately resulted in regulators closing Silicon Valley Bank two days later on March 10th. Shortly thereafter Signature Bank in New York City, NY was also closed by regulators after it experienced a similar bank run.
Silicon Valley Bank with $209 billion in assets and Signature Bank with $110 billion in assets represent the second and third largest bank failures in American history behind Washington Mutual which failed during the 2008 financial crisis.
These failures have led to volatility in the financial markets and have created substantial uncertainty for many individuals who are wondering whether their investments and cash balances are safe in the financial institutions that hold them.
To answer that question, we have to start by understanding how banks operate in the first place.
How Banks Operate:
In the simplest form, banks take deposits from customers and invest those deposits by lending them out (e.g., home mortgages or business loans) or by purchasing other investments. Banks make a large portion of their money by achieving a higher return on their investments than they have to pay on their deposits as shown in the following graphic.
The key point is that banks do not keep all their customers’ deposits on hand in cash. Usually this doesn’t create an issue because rarely do a large percentage of customers want their deposits back at the same time. However, if a large number of depositors request their funds within a short window of time, banks may be left scrambling to sell investments and generate the cash that customers request.
Key Takeaway:
Banks invest customer deposits to make a return for themselves. They do not keep all their customer deposits on hand in cash.
Why Did Silicon Valley Bank and Signature Bank Collapse?
Silicon Valley Bank (SVB) was unique in the fact that they served a very concentrated customer base of venture capital firms and startups. SVB used the deposits from these customers to purchase long-term US Treasury bonds.
Up until 2022, this approach worked well; however as the Federal Reserve began increasing interest rates throughout the year, two things happened. First the higher interest rates significantly reduced the value of SVBs long-term Treasury bond investments. At the same time, the higher interest rates increased the cost of financing for venture capital and startup firms. This forced venture capital and startup firms to rely more heavily on their cash balances than external financing.
With a significant portion of venture capital and startup firms withdrawing cash to fund their operations, SVB had to sell their Treasury bond investments at significant losses to fund the withdrawal requests.
Because of these significant losses, SVB announced that they needed to raise capital to shore up their finances. This announcement created more concern for their customers and ultimately led to a bank run where customers demanded over $42 billion dollars of deposits in a single day (March 9, 2023). SVB was not able to meet the requests, and regulators stepped in and closed SVB.
In the wake of SVB’s collapse, Signature Bank which had exposure to the crypto and technology industry experienced a similar bank run with customers withdrawing over $10 billion in deposits on March 10th. This prompted regulators to move in and take over Signature bank as well.
Key Takeaway:
The Federal Reserve’s interest rate increases put pressure on SVB and Signature Bank due to unique characteristics at each bank which ultimately frightened customers and let to a deposit run on both banks.
Will More Banks Fail?
Bank runs are not a new phenomenon with many occurring during The Great Depression as well more recently during the 2008 Financial Crisis. Bank runs are often self-fulfilling prophesies where individuals concerned about the financial health of a bank withdraw their funds to such an extent that it forces the bank into financial distress.
Often this doesn’t stop at a single bank because the failure of one bank often leads customers to become concerned about other banks as well. As a result, a single bank run can expose the entire banking industry to crisis.
Given the significant damage that bank runs can pose to the entire financial system, the Federal Deposit Insurance Corporation (FDIC) was founded to provide deposit insurance for bank accounts and other similar assets. In theory if the assets are insured and there is no risk of loss, customers will not be as likely to engage in a bank run.
However, FDIC deposit insurance only covers deposits up to a set limit which currently is $250,000 per depositor, per insured bank, for each account ownership category.
SVB and Signature Bank were unique in the fact that both had a significant amount of uninsured deposits. For SVB, their uninsured deposits as a percentage of their total deposits were 93.8% and for Signature Bank uninsured deposits were 89.3%. With significant portions of their deposits uninsured, their customers were incentivized to withdraw their funds at the first sign of distress.
In the wake of the collapse of SVB and Signature Bank, the FDIC invoked a “systemic risk exception” which allows them to raise the typical $250,000 FDIC insurance limit.
In a joint statement by the Department of the Treasury, Federal Reserve, and FDIC on March 12th, the government guaranteed that all depositors of SVB and Signature Bank would be made whole demonstrating the government’s commitment to protecting depositors and removing the incentive for bank runs to spread throughout the financial system.
While this doesn’t eliminate the possibility of additional bank runs, the government’s commitment to making depositors whole significantly reduces the fear that creates bank runs in the first place.
Key Takeaway:
SVB and Signature Bank’s high level of uninsured deposits were a unique factor that played a primary role in their downfall. To stop issues from spreading to other banks, the FDIC stepped in and fully guaranteed the deposits of both SVB and Signature Bank to demonstrate their commitment to protecting depositors.
Are Assets at Brokerage Firms Safe?
As SVB and Signature Bank collapsed, other financial institutions saw significant drops in their stock prices. For example, Charles Schwab stock dropped from $76.20/share on March 8th to $51.91 on March 13th. Given the impact across brokerage firms and banks alike, many investors are wondering whether their investments held by brokerage firms are safe.
First it is important to understand the difference between a bank account and a brokerage account. With a bank account, a customer deposits cash and the bank takes the cash, comingles it with its own assets, and invests it for their own account. In return the bank promises to pay the customer a certain rate of interest for using the cash.
Conversely with a brokerage account, a customer purchases specific investments (stocks, mutual funds, bonds, etc.) within the account itself. Those investments are held by the brokerage firm specifically for the client. In other words, the assets are segregated from the brokerage firm’s assets. If the brokerage firm fails, the customer’s segregated investment assets are still available for the customer.
The key point is that a customer’s assets held in a brokerage account are not impacted by the financial health of the brokerage firm itself. As a result, a brokerage firm’s failure to return customer assets would usually be the result of fraudulent activity on the part of the brokerage firm rather than financial distress.
If a brokerage firm fraudulently fails to keep customer assets segregated and is not able to return assets to the customer (as in the case of MF Global in 2011), there is protection for customers similar to FDIC insurance.
If brokerage assets cannot be returned to customers, the Securities Investor Protection Corporation (SIPC) provides up to $500,000 of protection. In certain cases, brokerage firms may purchase additional insurance coverage beyond the SIPC limits to provide peace of mind for their customers. For example, Charles Schwab has a policy that provides up to $600 million in coverage beyond the SIPC limits for customers.
It’s important to note that SIPC and any additional coverage only protects against loss of funds due to the brokerage firm failing to return the assets held in a customer’s account and does not protect against the securities themselves declining in value.
Nevertheless, the important point is that the risk of losing assets held in a brokerage firm is typically very low because the brokerage firm is required to segregate the assets of customers from their own assets. If a brokerage firm were to fail, they would simply return their customer’s assets back to them.
This is in direct contrast to a bank which receives customer deposits, then lends or invests those funds while comingling them with their own assets, and simply promises to return the funds to the customer on demand in the future.
Key Takeaway:
Customer assets at brokerage firms are segregated and not commingled (unlike a bank). If a brokerage firm were to fail, the segregated assets are simply returned to the customers.
How Should I Manage My Cash?
In light of the recent bank failures, many individuals are questioning the best way to manage their cash balances. For cash management, there are two primary priorities. The first priority is security and the second priority is to earn a reasonable return on the cash until it’s needed. As the recent events clarified for many individuals, security should be the top priority.
Security: Generally speaking, the easiest way to protect cash balances is to ensure that all deposits are fully covered by FDIC insurance.
Since the $250,000 FDIC insurance limit is per depositor, per insured bank, per account ownership type, individuals can increase their FDIC insurance coverage by having accounts at multiple banks or multiple account ownership types (e.g., single accounts, joint accounts, trust accounts, business accounts, etc.).
For individuals who are married, having a joint account increases the FDIC insurance limit to $250,000 per co-owner; so a joint account between a married couple has $500,000 of FDIC coverage.
For many individuals, maintaining balances at multiple banks and tracking FDIC insurance coverage can be a hassle. Not to mention the added challenge of making sure that each bank is offering an attractive interest rate and moving funds when rates are more attractive at other banks.
At Prairiewood, we provide an option called Flourish Cash to our clients. Flourish Cash allocates funds from their customers to Flourish Cash’s partner banks. Flourish Cash will distribute the funds across multiple banks to maximize FDIC insurance coverage while also ensuring customers receive attractive interest rates on their deposits (as of April 1, 2023 Flourish Cash is paying up to 4.40%).
By spreading funds across partner banks, Flourish Cash is able to ensure that individual deposits up to $1.25M and joint deposits up to $2.5M are fully insured by the FDIC. Further, if a partner bank reduces its deposit interest rate, Flourish can simply move funds from that bank to another bank that is paying a more attractive rate.
At the end of the year, clients simply receive a single 1099-INT from Flourish Cash showing all the interest they earned during the year.
Flourish Cash significantly streamlines the process of effectively managing cash balances for our clients by ensuring a high level of FDIC coverage as well as ensuring that customers earn attractive returns on their cash balances.
For individuals who have cash balances in excess of FDIC limits and are not interested in spreading their cash across multiple banks and accounts to obtain full coverage, the next best option may be purchasing a money market fund in a brokerage account.
Unlike a bank account, a money market fund directly holds underlying investment assets such as short-term fixed income securities that generate the interest the money market fund owners receive.
While the money market fund is not FDIC insured, the money market fund would be held in a brokerage account and would be a segregated asset of the brokerage firm. If the brokerage firm experienced financial difficulty, the investor would still own shares of the money market fund which could simply be returned to the investor if the brokerage firm could no longer operate .
A potential risk to consider with a money market fund is the unlikely but possible scenario where the underlying assets decline in value. Typically, a money market fund trades at a constant share price of $1 per share. If the net asset value per share declines below $1, it is called “breaking the buck.” This has happened occasionally in the past, but is rare given the short-term, high-quality nature of the underlying investments. To minimize the chance of “breaking the buck,” individuals can purchase money market funds that invest only in US government securities.
Earning a Return: While earning a return is not the primary reason for holding cash balances, appropriate cash management will still maximize the available return while keeping the assets safe. Often the key to earning the best returns while keeping assets safe is simply taking the time to shop around to find the banks and money market funds that are paying the most attractive interest rates.
For individuals who prefer not to do the work themselves, using a solution like Flourish Cash can automate the search and transfer of funds to banks with attractive rates while maintaining maximum FDIC insurance coverage. For those who keep substantial cash balances, earning better returns on cash is one of the easiest ways to put extra money in their pocket.
Key Takeaway:
There are two priorities when managing cash balances, security and earning a return. Security should be the top priority and earning a return is icing on the cake.
Conclusion:
Recent events during the month of March have served as a good reminder that individuals cannot afford to be complacent when it comes to managing their cash balances.
In the case of SVB and Signature Bank, their executives made significant mistakes that were further aggravated by their customers having large levels of uninsured deposits. The combination of which led to their failure.
These failures highlight the importance of understanding general cash management principles that can help keep your finances secure. Often the answer is as simple as ensuring all cash balances are covered by FDIC insurance or holding a money market fund that is supported by the value of the underlying assets.
For individuals who have significant cash balances or are interested in solutions to streamline their cash management, we would love to connect to see if what we do is right for you.
