How to Protect Your Accounts From a FDIC Default

Given the way in which the FDIC’s $25 billion in assets is considered to be too small to bail out a systemic financial collapse of the $9.3B in deposit accounts in the USA, we can start to take a look at how it is that investors can take steps to mitigate the risks of the FDIC being unable to cover out their savings accounts. Specifically, we want to look at how it is that strategies traditionally recommended by financial advisers (such as the recommendation to spread money across multiple deposit accounts) might instead be replaced with movement of funds into different types of financial institutions, and how it is that investors can still maintain their access to liquidity in the process.

One of the ways in which financial advisers will suggest for high net-worth clients to stay within FDIC requirements is to keep multiple bank deposit accounts at different financial institutions, so as to ensure that each account is individually covered under the insurance policy. However, this strategy assumes that the FDIC will not be simultaneously bailing out the deposit accounts of both of these institutions at once (which has lead to a ‘double dipping’ situation that will not likely be accommodated), and secondly, it assumes that the FDIC will have access to enough capital to pay for all of the accounts in question.

The end result is that personal savers following this strategy are still exposed to the kind of ‘black swan’ risks that they are trying to avoid by keeping their money in savings accounts in the first place. As such, savers should shift their focus to other kinds of financial institutions that don’t actually touch their savings accounts in the first place, meaning that their funds at not exposed to the risks associated with lending or derivatives.

Banks are capable of going insolvent because they use the funds in their deposit accounts to lend out money to other clients. In the event that too many of their loans go bad, the bank might not have enough money left-over to pay back to the depositors, and the savers lose out. That being said, financial investment companies, such as brokers or financial advisory companies do not lend out the money that they are holding, and therefore place their holding accounts (unless they are involved in fraud, which in an unfortunately real risk) in the names of their clients, and leave them isolated.

Even the stocks, bonds, or mutual funds of these clients are then held distinctly in the client’s name. From there, even the margin loans provided by the brokerage house are coming from the company’s own pocket, and are not associated with the funds on deposit from their clients. The end result is that, in the event that a brokerage house goes bankrupt, a client’s assets must be distinctly held, and can therefore be transferred over to the client themselves, or a third party company (ie. another broker) that is willing to take on the new business.

The end result is that the accounts are essentially safe, so long as the brokerage house has followed the legal frameworks required of them. Unfortunately, the last decade has also seen a few occasions where companies did not follow this framework, and left their deposits out of a portion of their money. As such, it is best to go with a large and reputable company, rather than a small boutique firm, in order to mitigate this risk.

The second way for a personal saver to mitigate the risks of FDIC default is to place funds inside a whole life insurance plan. In this sort of strategy, a saver pays money into an insurance policy that holds a tangible cash surrender value, and can therefore act as collateral for a loan. This latter aspect makes them invaluable products, because it means that a saver can build up their wealth (tax free at that) in the insurance policy, and access it through extremely cheap loans from their bank. Granted, this means that the customer needs to pay a small interest premium to access their long-term savings, it also means that they are on the other side of the balance sheet equation, and therefore protected against the risks of a systemic default.

Specifically, in the event of a systemic bank failure that cannot be covered out by the FDIC, the worst case scenario is that the saver is only liable for the principle of the loan, plus the small interest premium, rather than the 10-40% hair-cut that would be taken off of their deposit account in the event of a financial crisis of similar size as that which occurred in Cyprus.

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