This article about cash is by former hedge fund manager turned author Lars Kroijer, an occasional contributor to Monevator. He also wrote Investing Demystified.
Although interest rates are very low, many investors still hold large deposits in cash at their financial institutions.
I would caution against blindly doing this.
Often such savers do not consider credit risk – that is, the risk that for some reason they won’t get back all the money they deposited.
About 120 countries in the world have a system whereby the state (or a body legislated by the state) guarantees deposits with financial institutions up to a certain amount in cases of default.
While this varies by country, it means for example that the first £85,000 (in the UK), $250,000 (in the US), and €100,000 (in many EU countries) of deposits with a bank is guaranteed.
These guarantees are in place to lend confidence to the financial system and so avoid runs on the banks.
Without a bank guarantee, we ordinary cash savers would be general creditors to the bank. We would therefore have to gauge bank credit risk, which is something most depositors are not equipped to do.
Of course, if you have your money with a bank deemed ‘too big to fail’, then the bank won’t fail without the government also failing. That may offer some additional comfort.
Financial Services Compensation Scheme: Diversify your exposure
If you hold cash deposits with one or more financial institutions in excess of the deposit insurance limit, then you become a general creditor of that institution in the event that it fails.
For instance, if you have £200,000 in deposits with a bank and the credit insurance is only for £85,000, then the last £115,000 is not covered.
It’s important to note that in some jurisdictions, the credit insurance offered such guarantees are on a per institution basis.
For example, the UK’s Financial Services Compensation Scheme (FSCS) is a statutory compensation scheme for customers of FCA and PRA authorised firms. The FSCS is funded by levies raised from such firms. Under the FSCS your cash deposits are protected to the tune of £85,000 per person, per authorised institution.
This means that if you spread £200,000 in cash over four wholly separately FCA licensed firms with £50,000 in each then you would be fully covered for each of them, albeit at the cost of an administrative headache.
Do check if this applies in your country before opening several accounts.
What is an FCA Authorised Institution? Note that the £85,000 FSCS compensation limit does not apply to any particular bank, let alone to multiple accounts you may have with the same bank. Rather, it is applied per FCA registration licence number. This is important because banks you perhaps do not realise have anything to do with each other may in fact be owned and operating under the same licence (e.g. Barclays and The Woolwich) while other banks that you know are connected by ownership may actually operate under distinct licences (e.g. Lloyds Bank and Halifax). See Money.co.uk for a list of the different UK firms and the single licences under which they operate.
Bad things can happen
Just before the 2008 crash, a good friend of mine sold his successful IT business for a very large cash amount.
My friend was never really that interested in finance, and he left the money in an account with his financial institution while he took some time off.
This was a large, double-digit, multi-million-dollar amount and the financial institution was the insurance company AIG. He got concerned when one morning he read in the Financial Times about all the issues with AIG and how it could potentially go bust.
When my friend contacted AIG there was initially some confusion about the kind of account he held, and for a while he thought his money with AIG was going to be lost into the general abyss of a spectacular financial collapse.
In the end, he along with all the other creditors of AIG was returned his money. But the experience certainly put the statement that an investment is ‘as good as money in the bank’ into perspective.
On a much smaller scale, I had some cash in a lesser-known bank in excess of that country’s government credit guarantee.
I had agreed to put most of the money on time deposits where I would get a slightly higher interest rate of 2.5%.
Coincidentally, I discovered that the bank’s bonds were trading in the market at a yield of approximately 5% a year.
In simple terms, the market was telling me that I was taking a credit risk on the non-government guaranteed portion of my deposit that the market estimated at 5% a year, but I was getting paid 2.5% for it.
Not a great idea!
Who backs the deposit insurance?
A deposit insurance scheme is only as good as the institution that has granted this guarantee.
If you were holding cash with a Greek bank and relied on the deposit insurance protection from the Greek government, you would clearly not be as secure as with the same guarantee from the German government.
In the 2013 bailout of Cyprus, the restructuring that was initially suggested involved depositors both above and below the guaranteed amount taking a cut in their deposits (although in the end, only larger depositors had part of their holdings confiscated).
This suggests that bank depositors in that country were indirectly exposed to the creditworthiness of that government, in addition to the creditworthiness of the bank holding their money.
Local banks fare horribly if the government defaults. The banks are tied strongly to the local economy, which is suffering. On top of facing a poor economic climate, the banks will have lost a lot on their holding of government bonds.
The correlation between the troubles of your government and your bank is thus very high – and the protection you were hoping for may be absent as a result.
This is bad news, particularly as your bank and government default may well happen at the same time as other things in your life are also being negatively affected by the same economic factors: you may have lost your job, your house may decline in value, and so on.
It is exactly for these circumstances that you want the diversification of investments and assets provided by the sort of well-diversified portfolio I’ve previously advocated.
Bonds may be better
One way to address the potential lack of security of cash in a bank is to buy securities like AAA/AA government bonds, or other investment securities that closely resemble cash such as money market funds.
Importantly, securities like these still belong to you even in the case of a bank default. While the process of moving that security to another financial institution could be cumbersome, you are no longer a creditor to a failed bank, which gives you far greater security in a calamity.
Even so, while investments like stocks and bonds held in custody at a bank continue belong to you if the bank goes bust, you should still be careful about holding too many assets at risky banks.
Once an institution defaults, the process of finding out exactly who owns what can take time. There have even been cases where the segregation between client assets and bank assets was less firm than it legally should be. That will render it even harder to regain the investments that are legitimately yours – in the face of bank creditors claiming that the same assets belong to them.
What’s more, in a future bailout like the ones we have seen in Southern Europe it may be that not only your cash is confiscated, but that institutions find a way to take some of your securities as well.
It’s all a mess worth avoiding, so unless there is a compelling reason not to do so I would encourage you to only place your cash and investment assets with very credible banks.
You should also read up on investor compensation schemes in your country. They may – as is the case in the UK – have different rules and limits compared to the cash guarantees we’ve been discussing in this article.
Don’t bank on Bitcoin! Crypto currencies like Bitcoin offer an interesting but highly volatile alternative to cash in the bank. But please consider that this is almost by definition an unregulated asset class, and you are offered little protection against fraud or losses. That said, I would not be surprised to see crypto currencies go up in value during general turmoil or panic. I also expect them to generally become more common. So I will follow progress with great interest, perhaps especially as a transactional tool. However I wouldn’t consider Bitcoin any sort of straight substitute for cash.
Chasing yield
Particularly before the upheavals of 2008, some lesser-known banks offered very generous interest rates on deposits compared to the more conservative traditional banks. (The latter turned out to not be so conservative either, but that’s another story).
In the UK, the Icelandic banks in particular were guilty of this, but there were many others.
The interest rate differential provided the potential for profits from the perspective of the depositor – at the expense of the soundness of the banking system.
If the depositor guarantee was indeed iron clad – that is, the government would not try to get out of the depositor guarantee under any circumstances – then depositors were incentivised to withdraw cash deposits from the more conservative High Street banks in order to deposit the money with the banks that offered higher deposit interest rates.
If the gun-slinging bank later went bust (just as some did) the government would ensure the depositor would not suffer. And if the gun-slinging bank stayed in business, the depositor would benefit from higher rates.
A couple of years ago I was approached by someone who was planning to start a bank. His pitch did not involve great new markets or interesting products, but rather what he called an ‘arbitrage’ on the credit insurance of the government.
His arbitrage involved offering customers extremely high deposit rates, but only up to the amount of the government deposit insurance. He would thus attract sizeable deposits. He planned to then use the deposits to offer loans to renewable energy investments that also had government guaranteed rates of return, while capturing a spread for the bank (and himself presumably) in the middle.
The would-be banker claimed that his scheme was entirely legal and within banking regulations. I suggested he double-check this.
I don’t know if this man was able to start his bank, but it gives a good picture of the kind of thinking that can drive some of the more gung-ho banks out there.
It also shows how important it is for governments to get bank regulation right in the face of the many people who constantly try to game the system. This is not an easy task.
Questions for cash
I feel like a pessimist in writing about the dangers of cash deposits. It is certainly the case that in more than 99% of cases the thought behind the term ‘safe as money in the bank’ or ‘cash is king’ is exactly right – that the cash is entirely safe.
My logic is based more on how things fit together, and in trying to avoid several bad things happening at the same time.
If you consider the unlikely scenario of the bank where you hold most of your deposits going out of business, that scenario probably involves a lot of things that are also not good for your investing life happening at the same time.
Regardless of what your risk profile is as an investor, you should always be sure that you get properly compensated for the risks you are taking.
Always think about what happens in a calamity. The case of a bank default is no different.
Summary
- Cash deposits are not entirely without risk. Don’t hold cash in excess of that which is guaranteed by the government at one bank, and do worry about which government has issued the deposit insurance on your cash.
- By holding investment securities like government bonds instead of cash with a financial institution, you could be in better situation to recover these securities in the event of a bank failure.
Lars Kroijer’s book Investing Demystified is available from Amazon. He is donating all his profits from his book to medical research. He also wrote Confessions of a Hedge Fund Manager.
