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Institutional Failure In 2023, SIPC Insurance, and You

Bank Failures & SIPC Insurance Warning Image

FDIC Insurance & Regulators Come To The Rescue

Nearly two weeks have passed since the dramatic implosion and demise of the Silicon Valley Bank (SVB), a former regional bank based in Santa Clara, California, that catered primarily to the technology industry. In the days preceding the collapse, SVB’s leadership failed to shore up confidence after missteps and stemmed the most significant bank run in history, causing the second-largest bank failure. 

In an unprecedented move that kindles recollections of The Great Recession, the Federal Depository Insurance Corporation (FDIC), Federal Reserve, and US Treasury backstopped all deposits through a limited bailout to ensure the financial contagion wouldn’t spread and wipe out the businesses that had relied on SVB.

But why did the three aforementioned entities decide to backstop depositors? The simple answer is that most deposits at the SVB exceeded FDIC insurance limits of $250,000 per depositor, which would have caused many firms that used SVB as their banking institution to fail. 

Furthermore, the collapse of SVB was one of three banks that dissolved two weeks ago, causing many to worry about a potential contagion spreading through the banking industry, which the FDIC, Federal Reserve, and US Treasury want to prevent. 

However, the global banking industry has remained on edge. Over the weekend, Credit Suisse was acquired by its domestic Swiss competitor UBS as failure looked imminent for the once-storied investment bank and financial services firm. 

Stateside, the largest US banks are trying to prop up First Republic bank, which has suffered massive outflows since SVBs demise due to its similar regional bank status with financial woes. 

According to analysts interviewed by the Wall Street Journal, “First Republic still needs to raise funds or sell itself because it is sitting on [investment] losses similar to the ones that helped sink Silicon Valley Bank earlier this month.”

While politics are sometimes involved in regulatory rescue decisions, most laypeople will realize that a partial collapse of the US technology and banking sectors is terrible for the broader global economy. 

Nevertheless, compared to The Great Recession, the actions taken so far to stave off further global economic calamity only benefit depositors, not shareholders or lenders. But what does that mean exactly? Let’s examine FDIC insurance further.

Understanding FDIC Insurance

The FDIC originated during The Great Depression in the 1930s and shored up trust in the banking system after widespread bank runs and collapses that hurt Americans and businesses. 

Since then, the FDIC has continued to backstop consumer and business funds of up to $250,000 per depositor per bank. The National Credit Union Administration (NCUA) furnishes similar $250,000 deposit protection for credit unions.

While banks are not required to hold FDIC membership, most maintain it to instill consumer confidence. Similarly, the majority of credit unions are members of the NCUA. 

FDIC insurance safeguards most consumer deposits since they fall under the $250,000 guarantee. Regarding businesses, most medium-sized and larger enterprises regularly have balances exceeding $250,000. Therefore, if a bank fails, the companies and wealthy individuals banked there could lose billions of dollars and go bankrupt.

Bringing us full circle to SVB, around 94% of deposits at this bank exceeded the FDIC coverage limits, causing a bank run when it became apparent management had made strategic failures that made the bank insolvent. 

Given the potential for a banking failure contagion to become widespread due to additional bank runs and the shuttering of the companies banking with them, regulators and the FDIC stepped in, guaranteeing all uninsured deposits.

However, unlike The Great Recession, other stakeholders (such as investors and creditors) have not been rescued. They will face financial hardship despite the depositor bailout of Silicon Valley and Signature Bank by US Regulators. 

Consumers and businesses who banked or held investments at Credit Suisse can know their assets are safe due to the UBS acquisition. But, Credit Suisse stockholders will lose most of their investment from the unfavorable stock conversion to UBS shares. In contrast, its bondholders lose everything due to the unique structure of Swiss banking bonds

What happens if my brokerage or investment firm fails? Meet the SIPC

Given the collapse of SVB and the other banks, many wonder how safe their money is at their financial institutions. For those with bank or credit union accounts in the US, it is as simple as asking if your deposits are FDIC or NCUA insured. 

But what about institutions like Charles Schwab, Fidelity Investments, Vanguard, and even US investor clients of Credit Suisse? What happens if they fail or parts of their businesses fail? Meet the Securities Investor Protection Corporation, established over fifty years ago and a backstop for brokerage investors should their broker become insolvent and their assets under custody disappear. 

Unlike with the FDIC, all brokerage firms must hold SIPC membership and insurance coverage unless they only deal in select securities and investments. Consequently, most investors holding traditional assets (such as stocks, bonds, ETFs, and mutual funds) have insurance for up to $500,000 per entity (soon to be defined) per institution should the brokerage fail and customer assets go missing. 

Notably, SIPC insurance does not protect against market volatility or a specific holding going to zero due to risky investment choices. It also excludes assets such as commodity-based futures contracts and insurance products and limits cash coverage to $250,000 of the $500,000 limit.

Some brokerages have created cash-sweep programs that place client cash reserves at multiple FDIC banks to provide insurance coverage exceeding $1 million. Nevertheless, such cash sweep programs are not universal, so check with your broker if your cash-specific holdings exceed $250,000.

Example of SIPC Cash Coverage

You have full SIPC insurance coverage if you have a $500,000 brokerage account at ABC Broker, of which $250,000 is in an indexed ETF, and the remaining $250,000 is in cash. However, if you have $500,000 at ABC Broker and all $500,000 is in cash, then only $250,000 is SIPC insured. Concurrently, your funds are fully insured if you have $500,000 at ABC Broker, and all $500,000 are in an ETF.

Defining an entity for SIPC Coverage

When discussing SIPC coverage, an entity refers to the account owner or legal customer to whom it is registered. Two brokerage accounts under your name are one-in-the-same in the SIPC’s eyes. The same applies to two traditional IRAs or two Roth IRAs. However, a brokerage account, a joint brokerage account, a Roth IRA, an IRA, and an HSA are all legally distinct based on registration and ownership status. Each carries $500,000 of insurance with the SIPC for a total that could cumulatively be in the millions of dollars.

For example, John Doe might have the following legally distinct account registrations: 
•Individual Retirement Account For the Benefit of John Doe
•Individual Brokerage Account Transfer On Death – John Doe
•Joint Brokerage Account Tenants In Common – John and Jane Doe. 
These accounts are eligible for separate SIPC insurance of up to $500,000 each, totaling $1.5 million.

What happens to investments exceeding $500,000 in SIPC coverage if a broker fails?

When you first start investing, it will take time to amass a sizable portfolio. Still, with time and determination, most people aspiring for retirement and financial independence will grow their savings above the $500,000 SIPC insurance coverage limit. 

But what happens if/when your accounts at a given firm exceed $500,000 or your combined coverage amount? It depends, but usually, you will keep your investments should the firm collapse.

According to FINRA, the regulating body for the US investment industry, SIPC protection comes into play in those rare cases of firm failure where customer assets are missing.” 

This is because brokerage firms must keep customer assets segregated from their own to ensure they are safe in the event of firm failure. Brokerages must also maintain capital requirements to help prevent insolvency. Thus, the need to utilize SIPC coverage to recover lost assets is exceedingly unlikely. 

SIPC insurance only comes into play when customer assets are missing

Should the SIPC need to get involved, they will backstop customer assets and attempt to recover holdings exceeding their $500,000 limit through a liquidation process, which has historically recovered over 98% of client assets

When the SIPC recovers these funds, it returns the missing assets, not their original value. Many brokerages carry insurance policies for customers to cover the excess funds not insured by the SIPC should insolvency occur.

Oftentimes, brokerages rely on unaffiliated third-party partners to store client assets known as clearing houses. Client assets remain safe at the unaffiliated clearing house if a brokerage goes defunct. Examples of firms that use this model include Ally, Betterment, M1, and WeBull.

Other notable firms are self-clearing, owning an affiliated clearing house, or storing client assets internally. 

For example, Fidelity Investments uses its sister company, National Finance Services (NFS), to hold client assets. The parent company, FMR LLC, owns both Fidelity and NFS. In this situation, if Fidelity Brokerage Services went defunct, NFS would safely store client assets. If FMR, the parent company, or NFS became insolvent, it would require theft or the assets to be missing for SIPC regulators to step in.

In the case of Credit Suisse, SIPC coverage did not have to backstop US client funds since customer assets were not misused or stolen.

A Caveat Regarding Registration

It is important to note that SIPC coverage is limited to investor funds held in “street name” with a brokerage firm, a common practice accepted by regulators and brokerage companies alike.

Street name registration means that a brokerage firm or clearing house holds the actual stock or investment ownership and keeps records of which assets belong to customers versus the firm, as FINRA and the US Securities and Exchange Commission require.

According to Vanguard, “[Holding assets in street name is] a routine practice that allows trading to take place in a matter of minutes. Traditionally when you hold securities in your name, you have to keep them in a safe place and mail or hand deliver them to your broker whenever you want to sell them.”

Alternatives to street name registration include direct ownership registration with the security issuer or holding paper certificates.

Street name registration allows for modern-day trading that takes place seamlessly and enables trades to occur in a fraction of a second. “Investors, meanwhile, retain all the rights and benefits of being a shareholder without the burden of keeping a physical stock certificate safe from loss or theft,” according to FINRA.

Examples of firms with street name registration of client assets include Charles Schwab, Fidelity Investments, Vanguard, and Wealthfront.

SIPC coverage is limited to street name coverage because if a stock or investment registration is held under an individual’s name instead of the broker or clearing house, there is no need for the SIPC. After all, the client has custody of the asset as a paper certificate or through direct registration, mitigating a broker’s ability to misplace client holdings. 

While paper share ownership is cumbersome, direct registration is not, and some investment issuers partake in this format. Regardless of how you own the shares or assets, you can still have them documented on your brokerage account, but the speed at which they can receive liquidation depends on ownership style. 

Street name and direct registration assets are transacted quickly, while the speed of the mail and the processors at your brokerage firm will determine the speed at which you can transact with your paper certificates. 

Ponzi Schemes & The SIPC

The SIPC has limited recourse ability if a broker engages in fraudulent activity similar to the Bernie Madoff Ponzi scheme since it is meant to protect primarily against broker-dealer insolvency and misappropriation of client holdings. In Ponzi scheme situations, the Securities and Exchange Commission, Federal Bureau of Investigation, and SIPC will attempt to recover client assets through various legal mechanisms and court-ordered liquidations.

The SIPC has recovered approximately 70% of funds that were deemed allowable for claims under the Madoff scheme, amounting to a little over $14 billion. The total losses from the Madoff scheme totaled approximately $64 billion. Therefore, it is essential to custody your investments with a firm you can trust and consider not placing them all at one institution.

Closing thoughts

While times of unease are undoubtedly alarming, most investors should rest assured knowing that the SIPC will work to make them whole should their brokerage fail and that insurance policies oftentimes held by large brokers also safeguard them.

Janet Yellen, the US Treasury Secretary, stated today, “Similar actions [to those taken to backstop Silicon Valley and Signature Banks] could be warranted if similar institutions suffer deposit runs that pose the risk of contagion.” Comments like these hopefully restore trust in the baking industry since little incentive exists for another bank run.

Thanks for reading, and as always, have a great day!

Mile High Finance Guy

finance demystified, one mountain at a time

mile high finance guy

2 thoughts on “Institutional Failure In 2023, SIPC Insurance, and You”

  1. A timely and useful article my friend, this was one of the most well thought-out and resourceful articles on the topic! Many people have misconceptions about FDIC/SIPC. Crazy to think 94% of deposits exceeded FDIC limits at SVB!

    1. Thanks for the kind words, Gary.

      It is certainly unusual that such a large percentage of deposits exceeded the limits, and it makes one understand why so many companies are moving their money to larger (and hopefully more stable) banks.

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