Deposit insurance maximization as a service

Patrick McKenzie (patio11)

The recent banking crisis has made many companies acutely conscious about the limits of deposit insurance for their operational funds. Many financial service providers have so-called treasury management solutions which they sell against these needs. Let's explore how this is possible as a product offering and how it is... complicated from the perspective of analyzing systemic risks in the banking system.

Obligatory disclaimers: I worked for Stripe for six years and am still an advisor there. My opinions (and any errors here) are my own. I do not endorse any particular provider of financial services, including the ones named below. Commentary below is mostly about systemic issues in the financial industry; claims are sourced from publicly available documents rather than anything I know on a privileged basis from commercial discussions.

Deposits are a priced product of the financial services industry

We've previously covered deposits as a financial product. To briefly reiterate recently salient points:

Deposits are a liability of the bank, yadda yadda yadda, but deposits are also a product that can be sold. You, whether you are a retail user or company, choose to open a deposit account somewhere, much like you choose to open an email account or choose to engage an attorney. If you are a large, sophisticated company, it will not surprise you that attorneys charge money for their services.

You may have a “free” email account, perhaps even if you are a company, but that is produced by one of the largest tech firms in the world and you were given it as part of a cross-sold bundle. It was not an act of charity! You made compromises about other interests, small compromises but compromises nonetheless, to get that email account!

The dominant way deposits are sold, qua products, is as part of a cross-sold bundle with “core banking services.” The core banking services include branches you can walk into, customer service reps a phone call away, the ability to move money in the financial system, and the floors full of attorneys and engineers and compliance people that make this all possible.

Many people think core banking services are free or at least close to it, and these people are… insufficiently curious about how the world works. This is understandable when they’re simply users of the financial system and a bit professionally vexatious when they’re financial journalists or regulators.

Why would a startup with tens or hundreds of millions of dollars want to keep it in cash in a bank account? Isn’t that profoundly stupid treasury management? Reader, it is not. Someone at the startup sat down with a banker, who is a commission-compensated sales rep for banking services, and asked for banking services. If that banker was selling SaaS or trash removal, there would have been an explicit request for a quote and an invoice. You can get quotes from banks for many of their services and many sophisticated customers do.

A part of the commercial negotiation with the commission-compensated sales rep is “Are you going to keep your deposits here? How much?” People profess to be shocked, shocked that this happened. Very similar conversations happen every day at every bank in the country. Banking services are factually not nearly free, universally available commodities. At the higher end in particular, they are bespoke services work. They are priced like bespoke services work.

That price is actually extracted, in material part, as net interest margin on deposits that are bundled with the other services. This is revenue no less real than if the customer were simply invoiced monthly for services.

Some products banks offer have an explicit price or a contractualized monthly minimum commitment, like a SaaS subscription might. For historical, cultural, regulatory, and customer relationship reasons, though, banks find it difficult to convince people to pay appropriate amounts for core banking services, so revenue for them largely comes in less explicit ways. (In addition to net interest margin, debit card interchange is a pretty interesting topic, which we've covered before.)

“But Patrick, clearly sophisticated customers should have purchased banking services which don’t have credit risk.” Yes, that is also something that the financial sector equips its commission-compensated sales reps with! If you care profoundly about credit risk, say the word and you will be sold a solution for it! This will cost money and has tradeoffs, much like all the other products on offer!

OK, rant over, let’s talk about sweeps. (Not the kind from Merry Poppins, but they do deserve a rousing song.)

A brief explanation of sweeps

To oversimplify for the sake of clarity, the FDIC insures all deposits up to $250,000 per depositor per financial institution. Also oversimplifying, all deposits (be they under that limit or not!) are assessed an insurance premium. You’re paying for protection either way (technically, the bank is, but this is baked into the prices they charge and rates they offer you), but might not be getting much of it.

Clever financial engineers decades ago put their expensive educations to use and figured out extremely complicated mathematics to maximize insurance coverage: fourth grade multiplication and division. If you want $1 million in coverage at a bank, and the FDIC only offers $250,000 per bank, then you need four banks.

You could, hypothetically, simply open accounts at four banks. Actually, that is not hypothetical at all, many individuals and companies do this. This would complicate your life, though, so the financial industry came up with a product innovation to do the account management for you, such that it feels like you have one bank account but the FDIC perceives you as having no more than $250,000 in any bank regardless of your actual balance.

There are a few ways to do this, but an old operational quirk of financial institutions gives the name to it: cash sweeps. Right before the bank closes for the day, it could “sweep” your balances from one account to another, to accomplish some goal for you.

One goal which motivated the development of this capability, again many decades ago, is that some banking customers are simultaneously creditors and debtors. They have operating cash, because of course they do, but they also have lines of credit that are partially utilized.

Banks said “We like selling you valuable products and services, and we think we will buy more if you are happy with us. Here is a new product improvement you'll like! That cash balance you have? Every night, before we calculate accrued interest, we’ll sweep some or all of the cash into your line of credit, partially repaying your balance. We’ll do this, hmm, a minute before we close for the day. Then, the next morning, we do an offsetting draw from the line of credit, sweeping the cash right back to where it was a minute before we closed. From your perspective, nothing about the world has changed, because as you’re painfully aware you can’t use money in a bank account overnight. (The banking system needs its beauty sleep.) The only impact is you’ll accrue less interest. We do so appreciate your business and welcome you to come in and talk to our commission-compensated sales reps at any time. We will even give you free coffee!”

So that is cash sweeps as a function. Like any technological primitive, it can be employed to service many user needs. Financial institutions offer sweeps in many places, though this fact is not particularly widely known.

Do you have a low interest rate checking account and a higher interest rate money market fund? If you hypothetically complained to your banker about that, and they wanted to keep you happy, they could do what every other commission-compensated sales rep would do given a price objection: consider giving you a discount. In lieu of making that discount a growing drag on their performance or permanent, they could offer you “OK, how about we sweep $X from checking to the money market account daily, then sweep right back? I just saved you $Y,000 a year on banking, now don’t bother me for another year, OK?”

This is sweeping within one financial institution, but nothing except absence of plumbing prevents sweeping from working between financial institutions. And given a market demand for it, the financial industry is very good at implementing plumbing.

Conducting a financial services symphony with software

You know how financial services are products that have to be sold? Financial services firms also sell financial services to financial services firms. This means they have to describe how they work in sales collateral, for extremely sophisticated users. Which means I can confidently narrate how one insurance-maximizing sweeps product works without worrying anyone that I got it from internal discussions.

I’m not endorsing this product, claiming this is the only way to skin the cat, or making any claims as to appropriateness. I’m just giving you one expert’s view on financial infrastructure which is described publicly. The exact name of the product is StoneCastle’s Federally Insured Cash Account (FICA) and it has a public spec sheet written to answer the questions of banking professionals.

This product has four user personas involved: Customer, who is a business with a lot of cash they want to insure. TechCo, who is in the business of selling software and operational expertise for money. TechCo could in principle also be a regulated financial institution but they don’t have to be. Custodian, who definitely is a regulated financial institution. And then Banks, which there can be an arbitrary number of, and which are each regulated financial institutions.

You are going to stand-in for an up-and-coming product manager at TechCo. You have spoken to some customers and they identify worries about deposit insurance as a problem they have. You come up with a creative solution, which many other product managers have come up with before.

You go to a number of banks. You talk to their most senior commission-compensated sales reps, and say you want to buy so much financial services from them. The commission-compensated sales reps listen very carefully to your proposal! And then you say that the thing you want is to place brokered deposits in return for collecting a spread.

Readers probably know which bank keeps your deposits, and you’re probably far more likely to care about interest rates on those deposits than the typical customer. But I claim, perhaps controversially, that you care less than you think you do, because you didn't choose where you bank based on the interest rate. How do I know? What if you were utterly indifferent to any fact about the deposit other than the interest rate? Then you would bank differently than you do. Instead of having the bank account you’d have, you’d go to a profesional specialist in maximizing interest earned, and you’d say “Just put this money in the regulated U.S. financial system at whatever combination of bank accounts maximizes for the interest rate I receive. Keep a bit of interest for your trouble of recruiting the banks, moving the money around, etc.”

That professional is called a "deposit broker." They predate the sort of product we're discussing here, but the existence of their model paves the way for it.

TechCo tells each bank to sign a contract with the Custodian. Each bank makes one, count them, one new savings or money market account.

That account will be operated by mostly by software, titled to the Custodian, but assets in it will be owned by a large list of Customers. TechCo’s integration people will patiently walk Bank through creating one single account in their core system representing these deposits, and signing contracts specifying in great detail who actually owns the deposits. The Bank will not know the names of those ultimate customers at this point. They don't have to.

If you're wondering about KYC compliance, the answer will round to "We underwrote Custodian, which is one of the largest and most reputable financial firms in the world, according to our policy. We bound them contractually to have a Customer Identification Policy regarding ultimate owners. They of course have that because they are bound by the same laws we are. They passed our process with flying colors, because nothing is more legible to banking regulation than banks are. Their Compliance people had the right answers for our Compliance people to all the questions! If it were only always this easy!"

“What’s the catch?”, the Bank asks. And it is the usual catch for brokered deposits: the rate on them (a cost to the Bank) is higher than the rates the Bank offers for normal deposits. They are like every other demand deposit in that they could vanish at any time but unlike every other demand deposit in that there is a watching professional who stands ready to hit that button at all times. But everyone in this part of the negotiation is sophisticated and knows this score.

Now, TechCo is not having this conversation with one Bank. They are having this conversation with many Banks. Custodian will open an account with each of them.

Then, TechCo and Custodian put their engineers, lawyers, and commissioned sales reps in a room for a bit, and they come up with some automation that works like this:

Every night, TechCo and Custodian are going to do some very rapid computerized book transfers. A book transfer is a $10 banking word to mean “We’re going to do two database entries that offset each other, are entirely internal to us, are very, very fast and are effectively free.”

For each Customer, Custodian is going to rapidly make book transfers from an originating pile of money, a very large pile of money, well above the FDIC insurance limits, to a series of subaccounts. They will now show that Customer now owns $250k in a subaccount corresponding to money at Bank A, $250k in a subaccount corresponding to money held at Bank B, etc. This gets recorded in Very Important And Official Banking Systems because that fact will perhaps be important in the future.

Customers will periodically try to use their money. Darn customers, banking would be so much more lucrative if they didn’t have unreasonable expectations like this. Anyhow. Custodian will transfer them the money as they use it. (There is some operational detail with who between TechCo and Custodian fronts the liquidity here, how much of it there is, and where exactly it sits. We'll ignore it.)

Then, every day banks are open, Custodian maths the mathy math to aggregate how much money they should have in total at which Banks. It then nets out the accumulated activity of all the Customers and either withdraws money from each account with a Bank or deposits it.

So there is a lot happening at Custodian and a lot of transfers between Custodian and Customers. No money ever moves directly from a Bank to a Customer. There is only one transaction between Custodian and each Bank every day.

Custodian has someone standing by ready to answer each Bank's people if they have questions about that one transaction. Which they shouldn't but, hey, bankers gonna bank.

These balances held at each Bank bounce up and down, but they’re designed to be stable-ish. They go down on payday, yadda yadda, but this is the boring business of banking. Now those accounts could be cleaned out on any given Tuesday, that is the nature of demand deposits, but everyone involved is a professional and knows this is a risk.

What happens if a Bank fails on a particular Friday? Customer might be worried, if they remembered they owned any deposits at that bank, which they very probably have forgotten by now. They have never spoken to anyone at Bank, do not hold an account at Bank, and probably only learned Bank’s name in the fine print on a contract they signed with TechCo and Custodian. From their perspective, their money is “at” TechCo. OK, OK, so maybe it’s at Custodian? Or something? Whatever, I was told it was all insured.

It really is all insured.

Because when the FDIC takes the Bank into receivership over the weekend, they will get a call from a team of very seasoned professionals at Custodian. They have one job: make the FDIC’s life easier.

“We represent 1,728 insured depositors at the now-failed bank who will really need their money Monday morning. Most had precisely $250,000 on deposit. We live to serve your mission of getting these insured depositors their statutorily mandated money back and after you cut one wire to us you’re done with them; we’ll take it from here. If you need anything from us to get this done, well, we’re one of the largest regulated financial entities in the world, trusted absolutely by you and everyone else who matters, and have a team already in the war room to work on anything for you. Need a spreadsheet or contracts? We have all the spreadsheets and all the contracts.”

What happens if two banks fail? More phone calls. Ten banks? Still more phone calls. No customer money is lost or even inconvenienced because the United States Federal Government is actually operationally competent at keeping this particular genre of promise.

What happens if Custodian fails? Well, ahem, plausibly the world ends in fire and blood. This is why Custodian was specifically chosen from the ranks of a count-on-your-hands number of the largest financial institutions in the world. This isn’t even the thousandth most important thing that breaks if Custodian breaks. Custodian cannot be allowed to break. Custodian is Too Big To Fail.

Many people, hearing this sketch, will wonder whether someone has pulled the wool over the FDIC’s eyes here. This was specifically proposed to them, by deposit brokers generally over decades, and then by TechCo and Custodian specifically. The FDIC has extensive procedures for working with deposit brokers. There exists a heck of a lot of paper signed by important people who said “Yep, the law is the law, our regulations are our regulations, and if one of your banks goes under, we will pay out exactly as described.” Many of those pieces of paper are stapled to the sales literature for this financial product because frequently decisionmakers at Company believe this story is too good to be true.

So TechCo offers this product as a charitable service to for-profit firms in the economy, right? No, of course not. They have a contract with Custodian which specifies a formula for how much interest they earn for the galactically large amount of deposits they have aggregated from many Customers. Custodian earns interest daily from the program Banks. They remit a portion to TechCo and earn the difference (the spread) for themselves.

The Customers probably earn a lower interest rate than if they walked in the front door of one of the Banks and haggled spiritedly with a sales rep. The difference in the rate they could have gotten and the rate they do get is the price for this service, paid to a constellation of software companies and financial services firms.

In the market

As I predicted earlier, many software companies and financial institutions (“but I repeat myself”) have quickly taken this (existing and well-understood!) solution, or similar ones, and started selling it aggressively to customers who are in the market for it.

The above sketch is not the only way to structure a treasury management product, and I make no representations as to the exact mechanics from any individual seller of financial services, but Mercury quotes $5 million in coverage, Schwab is cagier than they have been previously but lower bounds it at $750k, etc etc.

If you desire to purchase banking services I direct you to the commission-compensated sales rep your choice, who can answer questions and make commitments as to the products they offer.

Other ways to skin the cat

Treasury management professionals wake up and go to work every day trying to balance immediate liquidity needs, risks (including counterparty credit risk), and the interest their employers can earn on operating cash. Many businesses with a lot of money lying around choose to employ them. Another option is renting a collection of software and contracts from a large financial services firm that does some subset of what they do, like the above cash sweeps product.

What do treasury pros do all day? Well, there are many different ways to put money to work while minimizing credit risk.

Some corporate treasurers will keep immediate liquidity needs at a bank or network of banks while keeping not-exactly-immediate funds in e.g. rolling short duration U.S. government debt. This debt is defined by convention to have no counterparty risk (the U.S. always pays its debts or fire and blood), has minimal exposure to interest rate risk, and can be trivially sold into the most liquid market in the world at almost no cost any time banks are open.

As a data point, my brokerage quotes me 0.2 bps on Treasury trades up to $1 million in face value and 0.01 bps above that, and spreads are extremely tight for treasuries. You can get much better pricing than this, the same way sophisticated financial professionals expect to get it: negotiate with your friendly neighborhood commission-compensated sales rep. If you’re buying and selling $50 million a day you don’t pay list price, just like your colleagues in Purchasing don’t expect to pay list price for email accounts or office furniture.

There are many, many other options in the toolbox, and you probably don’t care about them unless you’re a treasury management professional.

Should companies have all deposits insured at all times?

It is unlikely that all companies will choose to have all deposits insured at all times. That would require tradeoffs that are unpalatable to decisionmakers at those companies, at their banks, and in broader society.

At the margins, though? I expect that it is a good time to be, effectively, selling deposit insurance. Hurricane insurance salesmen do great business in the weeks after a hurricane, too. Nothing concentrates the mind about risk management like Mother Nature replanting a tree in a neighbor’s living room by accelerating it through the wall.

Many professional commentators have expressed surprise that startups with single digit millions or tens of millions of dollars did not have treasury professionals employed already. I am less surprised and, fundamentally, not scandalized.

I also think that, if one were to cast their gaze across the breadth of the world economy, one would find a lot of diversity in the sophistication of treasury management practices at companies of all shapes and sizes.

One of the constituents of AppAmaGooBookSoft had, within the last two decades, more money than you can conceive of in a regular old checking account. Why? Who cares. (You’ll forgive me for not elaborating on how I came to know this, and you'll have to take me on faith here.) Was that terrible risk management? Eh, if their bank goes under, the world ends in fire and blood. AppAmaGooBookSoft do much more risky things routinely; we depend on them to.

Many commercial real estate operators in your neighborhood keep amounts well in excess of FDIC insurance limits on deposit at one or more banks, including banks which do not historically have a de facto government guarantee of a rescue. Bank sales reps made this a condition to get loans done in favorable fashions at favorable prices. (Sometimes this condition is called a “loan covenant” and carries contractualized damages if breached. Sometimes it is just a gentleman’s agreement. Sometimes contracts are more like a gentleman's agreements if gentlemen don't expect you to continue existing to enforce your rights under them.)

This fact makes commercial real estate operators keen observers on the health of banks. If you look at the recent history of banks in trouble, you will find commercial real estate operators reacting very quickly to bad news. One of the reasons deposit flight affected, and is affecting, many more than a small set of financial institutions is that many banks bank commercial real estate operators. There is strong mutual dependence between community banks and the real estate industry; most of the country only has apartments and offices because of this symbiosis.

Stepping back to the systemic view

Deposits are a product that are sold. The sales process for products introduces correlations between the people who end up owning the product. This is as true for banks as it is for every other product which is sold.

Your branches have a geographic footprint, and your deposits get owned by people and firms who exist in the geographic footprint. Those people have correlated risks, by nature; if a hurricane hits your branch footprint they’re all going to want to do very similar things with their money on the same day in a way which was utterly unlike typical behavior two weeks before.

Your sales reps are armed with prospect lists, which you generated with marketing efforts that introduce correlation. Your compliance people develop expedited procedures for the industries you focus in, which introduces correlation, particularly among your largest and most important accounts. You bundle deposits with your other products, and the largest consumers of those other products become your largest depositors.

You do a good job for your customers and they refer their friends and business partners to bank with you. Every satisfied customer introduces more correlation to your deposit base, one message to group chat at a time.

Your bank has a strategy and when executed effectively that strategy will cause correlation within the bank’s deposit base.

Correlations within the bank’s deposit base are a known risk. This is the boring business of banking. You can diversify, to a point, but every bank has a strategy. At any of them smaller than the largest firms in the world, those strategies result in customer books where many of the customers rhyme with each other.

This month, people are very worried about correlated risks in bank deposit bases. And they are also very worried whether people and, particularly, firms have sufficient deposit insurance coverage. Those are two worries which pull in opposing directions.

I refer you to that sketch above about how sweep programs work. It replaces many customers who have correlations with each other, but minds and staffing and schedules and business needs of their own, with one professional controlling one account. That professional works for Custodian, is nearly perfectly informed relative to typical bank customers, and is absolutely ruthless in carrying out their fiduciary responsibilities to the many depositors aggregated by the firm offering enhanced deposit insurance.

The existence of this one professional is a great thing for consumers of deposit insurance. They solve your uninsured deposits problem at a reasonable cost. Done.

If you were a bank risk manager or, say, a financial regulator, does the existence of that one professional with their fingers on a potential kill switch make you more or less happy? I think the answer is pretty obvious. This has long been a criticism made of deposit brokers, and bank supervisors have attempted to counsel banks to keep their levels of brokered deposits as a percentage of total funding to prudent levels. We are perhaps recalibrating on what percentage would be prudent, at a time where demand for brokered deposits is going up quickly, because of how these sweep products operate.

There are heady policy tradeoffs here! We would prefer companies to not go bust simply because a bank went under! We want the financial industry to successfully offer products which minimize spillover damage to the real economy! We want the financial industry to do prudent risk management!

We also want the deposit insurance fund to be adequately capitalized to avoid taxpayers needing to backstop it. This relies on charging large depositors insurance premiums and then… not insuring them. That is a subsidy from Capitalism, Inc. to the taxpayer mediated through the banking system in times of crisis. "No bailouts with taxpayer money!" is an appealing slogan for many politicians. I could go either way on it, but I cannot remember any bills proposed to refund insurance premiums charged for uninsured deposits.

Prudent risk managers in the financial industry, understanding that that is the pitch, listen attentively and then reject it. Oh, shucks, we know we said we wanted them to be cautious, look out for their customers, and be good with math but not like that. We presently count on that subsidy. Changes in how Capitalism, Inc. banks threaten to reduce the size of the subsidy. Someone will have to pay in the absence of it, and the options are everybody (via increased premiums on deposits with cost passed through to everyone who has money in the financial system) or everybody (via taxpayer-funded bailouts).

Anyhow: the financial system and regulatory state will muddle through their problems here. Expect some tinkering around the edges vis brokered deposits.

The financial industry is keenly aware that customers and firms need safe access to liquid cash. It will continue bringing products to market which offer that. Society cannot function without something here. Historically, we call that something "bank deposits", but who knows what creatures of software and contract law can be cooked up by creative product managers.

If you or a firm you operate are a consumer of financial services, you can broadly expect them to do what they say on the tin. The sweeps products, and similar offerings, pretty much work. If implicit guarantees by government about extraordinary intervention in mid-market banks don’t mollify your concerns, feel free to chat up your local commission-compensated sales rep.

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