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Their options include traditional means such as money market funds or short-duration Treasury bills and more volatile stores of value, such as gold. Some investors have even gone so far as to remove all counterparty risk from their portfolios by investing in cryptocurrencies.
Each option has its own risks, but all speak to growing concerns about the true safety of the U.S. banking system.
In the first half of this year, we saw three of the largest bank failures in U.S. history, when Silicon Valley Bank, Signature Bank and First Republic all collapsed due to poor risk management. The FDIC had to step in and take over the banks, guaranteeing $549 billion in assets held in their books in the process.
Unlike the many bank failures of the 19th and early 20th centuries where depositors would have to physically line up at a bank in order to remove their funds when they felt the bank was no longer safe, this time we witnessed a new phenomenon — the digital bank run. Now, millions of dollars can be moved from one institution to another in mere seconds just by picking up a phone.
The speed at which a bank can be deemed insolvent has increased dramatically with improvements in communication and technology, which prompts businesses, institutions, and wealthy individuals to rethink ways to safely store their cash.
To be clear, this is not to sound the alarm that the collapse of the banking system is imminent. However, recent history also shows that these are different times, with different and often unknowable risks.
Until now, the government has been willing to provide a backstop to depositors caught up in a bank failure. But the ability to backstop is not infinite, does not come without significant cost to the financial system, and is subject to the political will — some might say whims — of political leaders, and cannot be considered risk-free.
In an effort to combat inflation, the Federal Reserve began aggressively hiking short-term interest rates in the first quarter of 2022 and did so at its fastest pace — from 0% at the start of 2022 to more than 5% by May 2023 — since the stagflationary period of the late 1970s. Arguably, this created the environment that caused the bank failures highlighted above.
Unfortunately for most savers, banks have been slow to raise the rate they pay depositors.
So, what have prudent investors done in response?
Smart depositors have begun moving their money into money market instruments because they more closely follow the rate of interest established by the Fed.
Historically, money market funds have done a good job of tracking the Fed’s short-term interest rates while maintaining an extremely stable value, but they are not insured by the FDIC and there is no guarantee their NAV will remain at $1. In the fall of 2008, the NAV of the Reserve Primary Fund fell below $1 when Lehman Brothers filed for bankruptcy, forcing the fund to liquidate.
For clients with account balances surpassing the FDIC limits at banks, we have been recommending allocations to Treasury bills. T-bills, issued by the U.S. Department of the Treasury, enjoy the full faith and credit of the government, making them widely recognized as one of the safest investment options available.
T-bills offer high liquidity, as they are issued with various maturity periods, ranging from a few days to one year, and can be readily traded in the secondary market. As of the time of this writing, T-bills were yielding approximately 5%, a notably higher rate compared with many similar banking products.
Higher on the risk spectrum is gold, which has been a store of value for literally thousands of years and is considered the longest-tenured store of value and exchange in the history of the world. Unlike fiat currencies, gold’s value is not set by a central banking system and for the most part is not subject to the political will of governments. Additionally, it often has been a haven for investors during times of crisis and financial instability, appreciating in value as risk increases in the financial system.
An investor can easily gain exposure to gold via very liquid ETFs which provide the ability to monetize its value very quickly but carry some counterparty risk. Gold can also be held in physical form, which limits counterparty risk but increases the cost and decreases its liquidity.
Gold also tends to maintain or increase in value during periods of a declining U.S. dollar. However, gold can be highly volatile, does not generate yield (cash flow), and in physical form can be costly to store or transact.
Cryptocurrencies, which are not issued or backed by governments and operate independently of the banking system, are gaining popularity as an investment asset. Since they are finite in nature, they are not subject to indiscriminate printing of new currency, which is a very real risk in a world fueled by deficit spending. They also provide greater, though not perfect, protection from confiscation or restriction of access than do currencies issued by a government.
However, cryptocurrencies are highly volatile and generally without yield like traditional bank products, Treasurys and money market funds. Additionally, cryptocurrencies are under regulatory scrutiny and are facing legal battles across the globe. Our firm does not have a recommendation around cryptocurrencies given the aforementioned risks. This may change as the crypto ecosystem evolves.
Considering the prevailing risks and uncertainties in the current environment, financial institutions are undertaking a reevaluation of the assets and liabilities listed on their balance sheets. Consequently, we strongly recommend that investors follow suit and contemplate diversifying their investments beyond conventional banking products. It is essential for investors to thoroughly assess the potential risks and advantages associated with various alternatives before making informed decisions.
— By Neale Ellis, a chartered financial analyst, and Matthew Michaels, a certified financial planner and chartered financial analyst. They are founding partners and co-CIOs at Fidelis Capital.