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 Banking, Bonds, ETNs, Futures, Insurance, Options, Stocks

In times of financial turmoil, it is crucial to know what financial products/instruments you are holding andwhether they will be protected from bank failure.
Over the last decade, the products and services offered by banks and brokerage firm s have become more similar, but there are important differences in the
regulatory and insurance protection offered for different products. This article will explain the similarities and differences between the two bodies that provide
this protection: the Federal Deposit Insurance Corporation (FDIC) and the Securities Investor Protection Corporation (SIPC). W ill one of these bodies step
in and repay your losses if your bank fails? Read on to find out.



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To get a sense of what's protected by the FDIC, let's think for a moment about the primary functional difference betweenbanks and brokers. The function of
banks is to 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 Federal Deposit Insurance Corporation (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 Mrs. Jones has an individual account at XYZ bank as well as a joint account with her husband, both accounts wouldbe covered separately.
Furthermore, if she has 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 insurancepremiums 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, the
re has never been a loss of
insured funds to a depositor of a failed institution. (For more information, go toFDIC.gov or check out a
  

 
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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.

The Securities Investor Protection Corporation (SIPC) was created by Congress in 1970, and unlike the FDIC, it is neither anagency 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 actually held in physical form at a brokerage firm. They are held by SEC-approved depositories or trust companies. Most
commonly, they are held in electronic form by the Depository Trust Company (DTC). The purchase and sale of Treasury bonds, for example, is entirely
electronic and ownership records are actually held at the Treasury. The old days of issuing physical certificates for bonds and/or stocks to individuals are
rapidly coming to an end because it's easier and safer to hold these securities in electronic form. It also facilitates the settlement of trades among brokerage
firms when securities are bought and sold. (To find out more about physical certificates, read ë  
  


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The SIPC covers shortfalls in customer accounts up to $500,000, including $100,000 in cash. This coverage kicks in only when customer securities are
missing when the brokerage firm fails. In addition, most large brokerage firms maintain supplemental insurance for much morethan the $500,000 insured by
the SIPC. The excess coverage maintained by each brokerage firm is different, so it is worth asking about when opening a new account. (To learn more,
read a



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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
@ 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 in instances where a failed broker is the counterparty to a number of uncompleted trades to a solvent broker, or in
cases w here the failed broker did not maintain adequate records. In these situations, the actual settlement ofclaims can be delayed as the correct
information is obtained. (For more on how to resolve a problem without getting the lawyers involved, see 

 
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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.)


 

 

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. (Read more in

 

 
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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.


   

Both the FDIC and the SIPC become involved in the case of a bank or brokerage failure. The preferred solution for both is afriendly 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.

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

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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.

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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 w ere 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 va
lue 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 notbe 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 will work with a federally-appointed
trustee to liquidate the firm. To the extent client securities or cash are missing, the SIPC willuse its own funds to make up the difference. Additionally, if any
client held cash and securities in excess of the $500,000 covered by the SIPC, any excess funds generated by liquidating thefirm 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.
(For more information, go to SIPC.org.)

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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.




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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 wi
ll usually be prominently displayed in the firm's office, in
its literature and on its website.
Other important issues include the following:

@ How long the institution has been in business
@ How much capital it has versus its regulatory requirements
@ The business's credit rating
@ Whether it has supplemental insurance




The instances of 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 system s 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.

  
(Contact Author | Biography)

    
  
  
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 Banking, Bonds, ETNs, Futures, Insurance, Options, Stocks