The next bank failure could be around the corner. Are your clients protected?

We tend to think about bank failures as once-in-a-generation events, like the 2008-09 financial crisis or the Great Depression. 

Sadly, that's not the case. Since 2001 to date, there have been 564 bank failures, or an average of more than 25 per year. While most of these failures — 389 — occurred between 2008 and 2010, there were only five years (2005, 2006, 2018, 2021 and 2022) in that time frame with no bank collapses. The most recent bank failures generated significant attention, not for the rarity of these types of events, but rather for the size of these failed institutions: First Republic Bank, Silicon Valley Bank and Signature Bank were the second-, third- and fourth-largest bank failures in U.S. history, respectively, coming in behind only the collapse of Washington Mutual in the early days of the Great Recession.  

Given the relative frequency of bank failures, financial advisors would be smart to counsel their clients on where to keep their cash and how, just as they would on every other aspect of their financial lives. The Federal Deposit Insurance Corp. guarantees bank deposits up to $250,000 per depositor, per account type, per bank charter. If a depositor exceeds those limits, they are leaving a portion of their savings unsecured, meaning that in case of a bank failure, clients may not recoup the entirety of their cash. Since clients hold cash primarily for safety and liquidity, they shouldn't be taking any risk with their cash. Fortunately, there are solutions available that can help clients keep their cash balances fully insured and fully liquid. In the process, clients can pick up substantially higher yields, too.

Beware brokered deposits
For years, banks and brokerage firms have tried to concentrate client relationships — and earn some scrape along the way — by offering cash sweep programs that promise to increase FDIC insurance coverage through the use of a deposit broker. Increasingly, they are targeting these programs at registered investment advisory firms. Unfortunately, these programs expose clients to hidden risks to both safety and liquidity.

Under a brokered deposit program, a financial institution (or sometimes a fintech such as a robo-advisor or crypto trading platform) promises to provide its clients with increased FDIC coverage by spreading their deposits across a network of other banks. In doing so, the originating institution earns a fee for reselling the client's cash. But however simple or clever such a program may sound, the fine print reveals several problems with this heavily marketed structure.   

First, deposits are held by the originating institution in a master omnibus account. If that institution fails, depositors can lose access to all their money until the resolution process is complete, which could take days or weeks (or potentially longer in the event of the bankruptcy of a fintech that takes custody of funds). Last year, the FDIC served cease-and-desist letters to five crypto firms for providing "false and misleading statements." One firm on that list was FTX, the now-failed $32 billion crypto exchange. If you see the word "omnibus" or "custodian" in the fine print, you may be putting your clients' funds at risk by taking on single-point-of-failure risk — a risk that's entirely avoidable by steering clear of brokered deposits.

Second, since clients using brokered deposit programs have no control over the banks to which their cash has been sold, they could inadvertently exceed the FDIC limits if they already hold cash on deposit at one of the banks that's part of the deposit broker's cash sweep network. In such a case, the cash that the client thought was fully insured might not be insured, exposing the client to unnecessary risk.

Lastly, like many fee-for-service products, brokered deposit arrangements pose an inherent conflict of interest because the bank or brokerage firm that's brokering deposits takes a portion of the interest off the top – a hidden fee which often isn't disclosed to the client. The result: Clients earn less than they could elsewhere while the custodian or broker earns a large scrape. This product that's marketed as "free" isn't free at all; the fee is simply buried and obfuscated, to the detriment of the client. While that might align with the business models of broker-dealers, RIAs owe a fiduciary duty to their clients and thus should understand the products that they're offering.   

Brokered deposits are advertised as a great way to obtain both yield and protection. But the reality is these services don't maximize either — they leave clients with less yield than they could earn on their own due to all the embedded fees, while opening clients up to added risks they wouldn't otherwise encounter if they were simply to hold their cash in their own bank accounts, held directly in their own names. 

Diversify client cash
Clients who choose to hold large cash reserves do so to seek safety and liquidity. If a client can't immediately access their cash to make an important purchase, pay taxes, meet capital calls, or buy securities when the market dips, they're negating the purpose of keeping substantial cash reserves in the first place. 

When it comes to managing large amounts of cash, the best way to safeguard a client's savings is to ensure that their money is held directly in their own name, spread across several FDIC-insured financial institutions, with same-day liquidity and no single point of failure. 

While cash might seem like a simple asset class, keeping cash safe and liquid is vitally important.  Since not all approaches to cash management are the same, it pays to read the fine print.