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What Are the Differences Between Banks and Custodians?  

by
Frank Napolitano
J.D., CFP®, CFA® Charterholder - Senior Financial Advisor

April 28, 2023

The picture is of two giraffes looking in opposite directions. This represents the differences between banks and custodians.

The collapse of Silicon Valley Bank in March of this year had many effects. Most profound perhaps is this: it challenged our assumptions. People believe their money is safe at the bank. Close your eyes and imagine the word ‘bank’. What do you see? You might picture a large vault in a sanitized building with marble floors, tellers, and security cameras. You might reasonably believe that in that vault are all the savings of the depositors who’ve entrusted their money to the bank. You would be wrong.  

“You’re thinking of this place all wrong, as if I had the money back in a safe. The money’s not here. Well, your money’s in Joe’s house… You’re lending them the money to build and then they’re going to pay it back to you as best they can.” – George Bailey It’s a Wonderful Life 

Recently, concerns about banks have spilled over into a concern over brokerage custodians (or simple ‘custodians’). These are large financial institutions like Fidelity, Vanguard, and Charles Schwab where individuals keep their investments. Is it possible that the recent run on the banks could turn into a run on custodians? Is there a risk that investors wouldn’t be able to remove their stocks and bonds from their accounts just as SVB customers were at risk of not accessing their cash?  

If you would like to find the answers to these questions and more, read on. In this article I will describe the differences between banks and custodians. I will attempt to explain in clear language what each institution is, how they operate and why individuals may choose to work with them. Finally, I will explain that the risks are very different.  

What are banks? How do they operate? Why do people use them? 

At the highest level, a bank is an intermediary between depositors and borrowers. Depositors have excess funds which they lend to banks in exchange for interest and other bank services. Banks use those funds to lend to borrowers, such as George Bailey’s neighbors. Banks earn a profit on the difference between the interest rate they charge borrowers and the rate they pay depositors. At the heart of it, a bank is simply a go-between. 

So why do individual depositors lend their money to a bank? Interest payments are one obvious reason. Your money can ‘go to work’ for you at a bank that pays interest. Another reason is safety. You could keep all your cash in a personal safe at home, but what if your house burns down? What if you are robbed? Thirdly, even if there is some risk to banks, they are regulated, which means they should fail less frequently than if they were unregulated. And they are insured, which means that even if they fail deposits are protected up to certain limits. Finally, banks offer services that make living in the 21st century easier. Direct deposit makes it faster to get paid and reduces paperwork. ATMs and debit cards give us instant access to funds anywhere in the world. Online bill pay lets people pay their bills electronically, saving them time.  

What are custodians? Why do people use them? 

A custodian, or for purposes of this article ‘brokerage custodian’, holds clients’ securities – tradable financial assets like stocks and bonds – for safekeeping to prevent them from being lost or stolen. Think of a custodian as a very large safe in which clients store their valuables. 

Although their primary function is asset protection, custodians may provide other services as well. These include preparing tax filings, collecting and distributing dividends and interest, providing recordkeeping and reporting services, and handling financial security settlement. Custodians make money from fees, services and/or products they offer customers.  

Why do people use custodians? First and foremost is safety. Custodians are primarily responsible for safeguarding client assets. The SEC’s Customer Protection Rule requires custodians to segregate clients’ assets from their own. Client assets are protected against creditors’ claims if a custodian becomes insolvent. Note how different this is from money at the bank. Second, there is convenience. While in the past you could own paper stocks and bonds, today nearly all ownership is recorded electronically. Finally, as noted above, custodians often provide a menu of other services to their clients.  

How is a failed custodian different from a failed bank? 

The structure of custodians makes it highly unlikely that investors could lose their securities, even in the unlikely event of a custodian failure. When you lend money to a bank, the bank can relend it, mixing your deposit with the bank’s capital. When you custody your securities with a custodian, the custodian has a legal obligation to safeguard your assets. The protection is so strong that even if a large brokerage custodian were to go bankrupt, client assets would be beyond the reach of creditors.  

Brokerage custodian failures are rare, but they do happen. Bear Stearns and Lehman Brothers became insolvent in 2008. Share prices declined (this was 2008!), but no brokerage client lost a single share of a stock, bond or mutual fund.  

It is also highly unlikely that a massive fraud could succeed at one of the large custodians. Brokerage custodians have robust tracking systems that monitor client accounts. For such a fraud to succeed, many people would have to work together to subvert complex protocols while keeping their actions a secret.  

The Bernie Madoff case was not a custodian fraud. Madoff was an advisor who convinced his clients to allow him to receive their custodian statements. He then produced his own fraudulent statements, which he sent to clients. Clients can protect against this kind of fraud by working with an investment advisor who uses an independent custodian and by checking their account activity directly with the custodian.  

Finally, the Securities Insurance Protection Corporation (SIPC) oversees the liquidation of any SIPC member brokerage firm. In addition to administering the process in bankruptcy court to ensure investors receive their assets, SIPC provides insurance against losses up to $500,000 (or a maximum of $250,000 in cash) in the event that assets are missing from customer accounts.

In conclusion

Banks are fundamentally different types of businesses than brokerage custodians. The rising rate environment that has led to some bank closures is unlikely to affect brokerage custodians. But even if a brokerage were to fail, that would not threaten investors’ ownership interests in their securities.  

Photo by Vincent van Zalinge on Unsplash

More articles by Frank Napolitano Filed Under: Investments Tagged With: banks, custodians

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