How Safe are Brokerage Assets
This spring has brought more than just crazy weather. With two of the three largest bank failures in U.S. history people should step back and ask questions.
A few questions we have received are:
“How does a bank fail?”
“The majority of our assets are in brokerage accounts. What prevents them from a similar failure?”
Whether Silicon Valley Bank, First Republic, or Signature, these failures were all federally regulated banks. Conversely, Charles Schwab, Fidelity and Vanguard are all large brokerages.
Banks accept deposits from customers. This deposit is a bank asset and liability. It is assumed that people can return and withdraw funds at any time. This creates a liability. However, banks don’t just sit on deposits. Generally, they make loans and purchase fixed income securities for their own portfolio. This is an asset.
Banks make money acquiring cheap deposits and lending out at a higher rate. Simplistically, the spread between these two is the profit.
Most days this is a boring process that works just fine. However, it requires adherence to regulatory procedures. It also requires balance between short-term deposits and longer-term securities and loans.
This is what got Silicon Valley in trouble. They accepted massive deposits that could be withdrawn quickly and invested them into long-term securities. Although this is an oversimplification, they mis-matched the time commitment of assets and liabilities.
Additionally, there is an inverse relationship between fixed income asset valuations and rising interest rates. This made the current value of the long-term fixed income assets worth less as the Federal Reserve aggressively raised rates.
When Silicon Valley management said they needed to raise capital due to short-term losses on their fixed income portfolio, people panicked and rapidly withdrew money. Given that many depositors were very large, tech-concentrated firms, they reacted quickly resulting in a “run” on the bank.
In comparison, Schwab, Fidelity and Vanguard are some of the largest brokerages. Similar to a bank, they accept deposits into client investment accounts.
Brokerages then facilitate buying and selling of securities and report on the activity. Brokerages also frequently sponsor different investment products (mutual funds or exchange traded funds) that customers can buy.
Schwab is easier to study since it is publicly traded. When funds are given to Schwab or another broker, the money is not an asset or liability of that firm. The brokerage cannot lend those funds out like a bank. In the process, funds deposited with a broker are not exposed to the creditors of a brokerage.
Schwab has over $7 trillion of assets held for clients, but they do not show up on their financial statements as an asset or a liability. Again, they are not exposed to creditors. Furthermore, the funds are held by a third-party custodian. In the case of Schwab, their external custodian is State Street.
All of this serves as a multi-layered system of checks and balances to protect assets in client accounts.
Unfortunately, 2008-09 offers real examples of brokerage failures. During this time of tremendous stress on the financial system Merrill Lynch, Bear Stearns and Lehman Brothers all failed. And yet, no brokerage assets held for individuals were impacted.
How should you go forward?
No bank depositor has lost money in an FDIC-insured bank since 1933. This time, no depositors over the FDIC limit have lost any money. However, no one should assume unlimited guarantees from FDIC coverage. As such, limit holdings to $250,000 per name per bank.
If you are a common stockholder or a debtholder of a failing bank, you should never expect any protections.
If you are a business or high net worth individual, look to money market funds held in brokerage accounts.
If you work with an investment advisor, determine who the brokerage and custodial firms are. A separation of duties prevents risks for a Bernie Madoff type scam.
Obviously, none of this prevents assets inside a brokerage account from being volatile. However, it does insulate against a “run on the bank.”
Lastly, recent events have reinforced the importance of owning true battleship assets. We want to own conservatively managed businesses that dominate their industry. We want businesses that maintain and grow market share.
Although this won’t insulate short-term volatility, it keeps us in the game such that we can pursue long-term goals.