Bank Failure: Will Your Assets Be Protected?

The Securities Investor Protection Corporation (SIPC) and Federal Deposit Insurance Corporation (FDIC) insure against personal financial ruin when banks or brokerages go belly up. Will one of these bodies step in and repay your losses if your bank fails? It depends. The first thing to check is whether your bank is a member of the FDIC and/or the SIPC.

Key Takeaways

  • Check whether your bank is a member of the FDIC and/or the SIPC.
  • The FDIC insures deposits (cash and CDs) up to $250,000 (principal and interest) for each account holder in a federally insured institution.
  • SIPC members include all brokers and dealers registered under the Securities Exchange Act of 1934, and protects members in the event the firm fails.

Bank Accounts and the FDIC

The FDIC is an independent federal agency insuring deposits in U.S. banks in the event of bank failures. It was created in 1933 to maintain public confidence and encourage stability in the financial system through the promotion of sound banking practices. 

The primary purpose of the FDIC is to prevent "run on the bank" scenarios, which devastated many banks during the Great Depression. To understand what the FDIC protects, let's briefly think about the primary functional difference between banks and brokers. Banks take deposits and use those deposits to make loans. Through the reserve mechanism of the Federal Reserve, banks can actually lend far more than the deposits they take in (also known as the multiplier effect). Deposits are held in the form of cash. Of course, one can also purchase a certificate of deposit (CD), but this is essentially a loan by the purchaser of the CD to the bank issuing the CD.

The FDIC insures deposits (cash and CDs) up to $250,000 (principal and interest) for each account holder in a federally insured institution. (For IRAs, the insured amount may be $250,000.) These amounts cover shortfalls in each account in each separate bank. For example, if Jones has an individual account at XYZ bank and a joint account with their partner, both accounts would be covered separately. Furthermore, if they have an FDIC-insured CD with yet another bank, that CD will also be covered separately.

The FDIC is an independent agency of the U.S. government, but its funds come entirely from insurance premiums paid by member firms and the earnings on those funds. However, the FDIC is backed by the full faith and credit of the U.S. government. Since its creation in 1934, there has never been a loss of insured funds to a depositor of a failed institution.

Brokerage Accounts and the SIPC

The Securities Investor Protection Corporation (SIPC) is a nonprofit corporation created by an act of Congress to protect the clients of brokerage firms that are forced into bankruptcy. SIPC members include all brokers and dealers registered under the Securities Exchange Act of 1934, all members of securities exchanges, and most National Association of Securities Dealers (NASD) members. SIPC coverage protects members in the event the firm fails.

While banks deal mostly with deposits and loans, brokers function in the securities markets, primarily as intermediaries. (Brokerage firms also wear other hats, but we will limit this discussion to their most simplistic function within the securities markets.) Their primary purpose is to buy, sell, and hold securities for their clients. In this function, they are heavily regulated by the Securities and Exchange Commission (SEC) and the various securities markets in which they operate. Some of the most important regulations relate to net capital requirements, the segregation and custody of customer assets, and record-keeping for client accounts.

Congress created the Securities Investor Protection Corporation (SIPC) in 1970, and unlike the FDIC, it is neither an agency nor a regulatory body. Instead, it is funded by its members, and its primary purpose is to return assets, which are usually securities, in the case of the failure of a brokerage firm.

Most stocks, for example, are not held physically at a brokerage firm. SEC-approved depositories or trust companies hold them. Most commonly, they are held electronically by the Depository Trust Company (DTC). The purchase and sale of Treasury bonds, for example, is entirely electronic, and ownership records are held at the Treasury. The old days of issuing physical certificates for bonds and/or stocks to individuals are rapidly ending because it's easier and safer to hold these securities electronically. It also facilitates the settlement of trades among brokerage firms when securities are bought and sold.

The SIPC covers shortfalls in customer accounts up to $500,000, including $250,000 in cash. This coverage only occurs when customer securities are missing when the brokerage firm fails. In addition, most large brokerage firms maintain supplemental insurance for much more than the $500,000 insured by the SIPC. The excess coverage maintained by each brokerage firm differs, so it is worth asking about when opening a new account.

Caveats to SIPC Insurance

There are certain things the SIPC does not cover. Unlike the FDIC, it is not blanket coverage. Some of the things not covered include:

  • Commodities and futures contracts, as well as options on these
  • Foreign-exchange contracts
  • Cryptocurrency exchanges
  • Insurance policies
  • Mutual funds held outside the brokerage (these are the responsibility of the mutual fund sponsor)
  • Investment contracts not registered with the SEC (private equity investments, for example, which are the responsibility of the general partner of that fund)

Although technically, the SIPC does not protect against fraud, most large brokerage firms carry stockbrokers' blanket bonds that do. (Single, limited instances are usually covered in the ordinary course of business without reliance on the bond.)

SIPC insurance becomes complicated when a failed broker is the counterparty to several uncompleted trades to a solvent broker or in cases where the failed broker did not maintain adequate records. In these situations, claims settlement can be delayed as the correct information is obtained.

Similarities Between Bank and Brokerage Accounts

Funds' Ownership

Deposits in banks and securities held at brokerage firms are alike in that client funds are segregated and are owned by the account holder. The bank can base its total loan volume on the aggregate amount of deposits it holds, but it does not directly use an individual's deposit to make a loan. In the same way, brokers cannot use client funds to support other parts of their business. The only exception to this is that a broker may pledge up to 140% of a client's securities to collateralize a margin loan to that client. (This supports a loan that the broker obtains from a bank to fund the client's margin borrowing.)

Credit Default Swaps

During times of financial stress, one of the most obvious indicators of the relative safety of both banks and brokerages is what is known as the institution's credit default swap spread. These are published periodically in the financial media, and they represent the risk perceived by other financial institutions vis-à-vis a particular bank or broker. The higher the spread, the greater the risk perceived by a very financially sophisticated group of institutions.

Warning Signals

Especially during times of financial stress, the differences among institutions of the same type can become very wide, and they can provide warning signals. A warning sign in the case of banks, for example, may be if the CD rates offered are significantly higher at one bank than at others. There may be other, market-related reasons for this, but this is worthy of further investigation.

Ideal Solution

Both the FDIC and the SIPC become involved in the case of a bank or brokerage failure. The preferred solution for both is a friendly takeover by a solvent member institution. To the extent possible, brokerage accounts and customer deposit accounts will be transferred, and the customer will be notified of the change.

Differences Between Bank and Brokerage Accounts

So what are the differences between the FDIC and the SIPC, and therefore between the safety of assets held at banks and brokerage firms?

Form of Assets Held

Assets held at a brokerage firm are rarely held in the form of cash. Except for assets in the process of settlement, most cash balances in a brokerage firm will be held in some form of money market fund run by that broker.

Form of Assets Guaranteed

Let's use an example of how the SIPC would work. Suppose that you own stocks in the amount of $600,000 and a money market fund in the amount of $150,000 on the day your brokerage firm goes out of business. The SIPC is able to find only $200,000 of your stocks and the money market account. The SIPC would insure the difference in your stock account and replace the stocks that were missing up to a total of $400,000.

Whether your $400,000 worth of stock is still worth $400,000 when you ultimately get it back is another question. You will get the securities, but the value of those securities will not be guaranteed—this is the key difference between banks and brokerage firms. Cash is cash, and if you have $10,000 in a bank account today it will be worth $10,000 tomorrow; if you own 40,000 shares of XYZ stock that are worth $10 today, they may not be worth $10 tomorrow. The SIPC merely assures you that you will get back 40,000 shares of XYZ.

In some cases (usually involving smaller institutions with poor record-keeping practices), the SIPC will step in directly or work with a federally-appointed trustee to liquidate the firm. To the extent client securities or cash are missing, the SIPC will use its funds to make up the difference. Additionally, if any client held cash and securities over the $500,000 covered by the SIPC, any excess funds generated by liquidating the firm will be prorated among those clients first (before general creditors, for example). The SIPC asserts that 99% of customers of failed brokerage firms received their assets back in full.

Name Under Which Assets Are Held

Frequently, assets held in brokerage accounts are held in street name, meaning under the name of the brokerage firm's nominee (which could be itself or another named affiliate), for reasons of simplicity and tracking. Although these assets are strictly segregated and held on behalf of the account holder, mistakes do happen. It is very important to check brokerage statements against your own records, to report mistakes promptly and to maintain these statements for a reasonable period of time. This is as important as checking your bank balance every month. Even if the chances are remote that your bank or broker will fail, having good records will speed up the process of recovering your assets if it ever does happen.

What It Means To You

Despite the many legal, regulatory, and "course of business" assurances, clients of banks and brokers should still understand the institution holding their assets. The first thing to check is whether the firm is a member of the FDIC and/or the SIPC. This will usually be prominently displayed in the firm's office, literature, and website. Other important issues include the following:

  • How long has the institution been in business
  • How much capital it has versus its regulatory requirements
  • The business's credit rating
  • Whether it has supplemental insurance

The Bottom Line

Large bank and brokerage failures have been small, and in recent decades, instances of SIPC liquidations have been few. Particularly since the terrorist attack on New York City on September 11, 2001, record-keeping systems have become much more sophisticated and protective redundancies more common. However, the possibility of financial failure remains, and doing basic research on the strength of the firm holding your assets is a financially sound practice, whether it is a bank or a broker.

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