What do Banks, Custodians, and Brokers actually do?
The last few weeks have brought heightened scrutiny of the companies we trust with our money. Each time there are high profile bank failures – today, 2008, the S&L crisis – savers, investors, and regulators are forced to ask questions about how our system is organized, regulated, and insured.
Leaving the question of what should be done for later, let’s start with the institutions we have today, and what they do for us.
Banks are the most familiar to us, but still seem to surprise us from time to time. In a simple bank, when savers deposit cash in a checking or savings account, the money goes into one pile at the bank (think of the vault in the old days). Then, the bank uses some of that pile to loan out, traditionally to home buyers through mortgages and business owners through loans. Some of the interest paid by the borrowers (about 6% today) is paid out to the depositors as interest on their savings (anywhere from 0% to 4% today). The difference between those two rates is the profit the bank gets to keep.
The depositors can withdraw their cash at any time, but the loans often have a term of many years. If a depositor wants their cash back, the bank can’t go to a homeowner and ask them to pay back their mortgage ahead of schedule. This mismatch in timing is the source of risk in banks and is behind every bank run in history. Essentially, when we deposit cash, we are trusting bankers to invest well in loans and pass some of the interest along to us.
Custodians hold our investment assets and cash. For most of our clients, that means Charles Schwab & Co. When we deposit funds in an investment account, and buy stocks or bonds, those investments are held in our account. Think of it like a safe deposit box as opposed to a vault in the bank example. This is enforced by SEC Rule 15c3-3, which requires client assets be segregated from other investors as well as the custodian’s own assets.
The custodian cannot take the investments in our account and do anything else with them. Doing so would be fraud. If a custodian went bankrupt, the assets of investors are still there and can be administered by another entity. Additionally, a bank run style crisis is impossible to create since each investor’s assets are separated. So a large number of investors transferring their assets from Schwab to another custodian would not create a bank run on Schwab, just an impact on their profits.
Finally, we have Brokers, who actually do the trading of investments. Often these are the same companies as the Custodians. That is the case for our clients, where all trades are made with Schwab as the broker. There is little risk in these companies since the transactions are broadcast nationally, and delivered quickly to the destination accounts.
In the 15 years since the last wave of bank troubles, a lot has changed with technology and how people interact with their cash and the banks. This latest incident is causing many people to rethink what is safe for their cash, and how to balance their daily cash needs with that safety and minimize the drag of inflation. In a letter to follow, I’ll explore some of those options.