The recent financial troubles of Silicon Valley Bank, Signature Bank and Credit Suisse have investors worried, testing the mettle of even the most seasoned investor. People want to know:
Is my money in the bank safe?
Should I worry about the custodian institution holding my investments?
Banks are in the business of taking deposits (borrowing from the depositor) and investing those deposits. They are called demand deposits because a customer can demand their money back at a moment’s notice. The bank invests that short term capital into long term investments. Long term investments pay significantly more than short term bank accounts therefore banks make money on their interest margin, the difference between the interest it pays its depositors and interest it makes from investments. Historically most of the investments were loans to home purchasers, business builders etc. Today they also invest in Treasury bonds, mortgage bonds etc. which are generally safer and more liquid than direct loans. As long as the deposits keep coming and there are profitable investments to make with those funds, the system works. It is a system built on confidence. The system breaks down when customers lose confidence and pull out their deposits en masse in a classic bank run. The cash needed to satisfy all those demands for their money back is not sitting in the bank, it is invested in loans and bonds.
Our institutional financial system has been built and changed over the years in response to various banking crises in the past. Most notably the Panic of 1907, the Great Depression, and the Financial Crisis of 2007-2008. This resulted in our current Federal Reserve and Federal Deposit Insurance Corporation (FDIC) being established as the lenders of last resort to provide the funds in the event of a systemic or localized bank run. This past week, the Federal Reserve and Treasury Department took the extraordinary step of designating SVB and Signature Bank as systemic risks to the financial system, giving regulators and the FDIC the flexibility to backstop all their deposits. The Swiss government, regulators and national bank acted in concert to push through the takeover of Credit Suisse to forestall a crisis of confidence in the greater Swiss and Euro area banking system. Regulators around the world have taken steps to protect bank deposits and hopefully bolster confidence in the banking system.
A custodian1 is a specialized financial institution that holds customers’ securities for safekeeping in order to minimize the risk of their misappropriation, misuse, theft, and/or loss. They have three primary responsibilities:
- Safekeeping of Assets: maintaining proper titling/ownership, asset valuation, accounting, and reporting of assets owned by an investor
- Trade Processing: tracking, settling, and reconciling assets that are acquired and disposed of by the investor
- Asset Servicing: maintaining all economic benefits of ownership such as income collection, corporate actions, and proxy voting
Note they are not borrowing anything, they are not investing anything. All investing and borrowing that happens is done at the direction of the investor for their own gain or loss, not the custodian’s. They are in the business of safeguarding and protecting assets and charging fees for their service. Investor assets are held separate from the institution’s assets. It is a low margin, high volume business. They are highly regulated and required to keep substantial capital on hand should anything go wrong. They maintain insurance against failing to do their safeguarding function in the form of Securities Investor Protection Corporation or SIPC insurance. There is not the same danger of a bank run since 100% of all the investors assets are available to be sold or transferred as opposed to a bank where they are not. A much more secure proposition. Of course, investments fluctuate in value significantly in contrast to the steady valuation and regular interest payments of a bank account.
I hope this provided you with a better understanding of a bank and a custodian. We at Westfield Financial Planning are maintaining a watchful eye as events unfold. Please remember, Wall Street and the media have a short attention span regarding unusual economic events and they have a financial interest in provocative headlines. That's why we carefully craft our client’s investment strategy to reflect their life and goals, their time horizon, their risk tolerance, and not those of the markets.
Feel free to reach out if you have any questions about what’s happening with the banking sector in light of recent events. I'd welcome the chance to give you my perspective on what’s happening.