Several weeks ago we talked about the importance of paying attention to the kind of financial institution where you hold your savings.
This week has provided us with a good reminder of just why that is so important.
Over the last few days news shows and the internet have been all abuzz about Senator Elizabeth Warren’s scathing tongue lashing of Wells Fargo CEO John Stumpf. Stumpf was in the hot seat over a massive fraud perpetrated by thousands of Wells Fargo employees over the course of several years.
The fraud involved creating new accounts for existing customers without the customer’s knowledge or permission.
But my purpose today isn’t to discuss the details of Wells Fargo’s fraud. Rather I want to take this moment where bank shenanigans are in the spotlight to highlight why I highly, highly recommend that you not hold your savings with any of these mega banks.
Before Loaning Your Savings to a Bank…
Before deciding where to hold your savings you need to remember that when you deposit your savings with a bank or credit union what you are actually doing is loaning your money to that institution.
It’s true. When you look at a bank’s financial statement, your deposit is listed as a liability (i.e. something they owe).
What’s more, you are loaning your money as an unsecured creditor.
If you don’t pay your mortgage a bank can repossess your house. However, when you loan your money to the bank, if the bank can’t pay you back there’s nothing for you to repossess. You’re just out of luck.
With that in mind, here are three considerations I make before loaning my savings to an institution:
- Will the bank be able to return my money when I want it?
- How well positioned is the bank to withstand a decline in asset prices?
- What will the institution do with my money while it’s holding on to it?
Today I want to focus on the first item.
One easy way to measure an institution’s ability to return your money is called a liquidity ratio.
A bank’s liquidity ratio is the percentage of depositor’s money being held in cash or cash equivalents (e.g. 3 month US Treasury bonds) that can be liquidated at a moment’s notice to cover customer withdrawal requests.
For example if a bank has $1000 in customer deposits on its books and it has $100 in cash it has a liquidity ratio of 10% ($100/$1000 = 10%).
This means that up to 10% of the bank’s customers could withdraw their money at any given time without a problem. If more than 10% of depositors wanted their money back the bank would have to start selling off assets or calling in loans in order to return their customer’s money.
Real World Examples
The chart below shows the liquidity ratios for a number of popular US financial institutions. In this chart the maroon bars show how much money the bank owes its depositors, the blue bars show how much cash the bank has available to repay its depositors. The green line shows each institution’s liquidity ratio which is just the amount of the blue bar divided by the amount of the maroon bar.
If you are currently holding your money in one of the three mega banks on the right side of this chart, this graph should concern you.
Bank Runs are Not a Thing of the Past
Make no mistake, there is a bank crisis coming to the US. When it will happen is anybody’s guess.
Whether it will be caused by defaults on subprime auto loans, subprime student loans, or subprime government loans is irrelevant. Eventually this reckless behavior will blow up in the bank’s faces just like it did in 2008.
And with the banks bigger and more interconnected than in 2008 it’s going to be ugly. So please don’t loan out your savings to an irresponsible bank and count on the FDIC to bail you out.
I’m not trying to be an alarmist or suggesting there will be a bank run tomorrow. This is just the logical conclusion that every scrap of data, including data generated by the banks, the government and the Federal Reserve, points to.
It’s not a reason to panic, it’s just a reason to step back and take some common sense steps to evaluate the financial partners you choose to deal with.
My Approach to Using Banks
We live in a world where it’s difficult to get by without using banks. However, we must be smart about how we use them in order to protect our hard-earned savings and maintain our financial freedom in the event of a banking crisis.
Here’s my personal approach to banking:
Big banks: I use them for convenience but only for money to pay current-month expenses or very short term savings (e.g. money for an upcoming vacation)
Family bank: Most of our cash savings are held in a “family bank.” I’ll talk about this in greater depth some other time.
Local Credit Union: Savings that are destined for investment in the near term are held in an account with the credit union shown on the chart above.
You’ll notice that when compared to the mega banks, the deposits held by the credit union are so small they don’t even show up on the chart.
That doesn’t matter.
What matters to me is the fact that the credit union keeps 8.5 times more cash on hand than Chase or Wells Fargo which makes me MUCH more comfortable loaning my money to the credit union.
Now you’ll notice that Bank of America (BoA), despite being a mega bank, has roughly the same liquidity ratio as the credit union.
Although BoA has a strong liquidity ratio, they, like the rest of the too-big-to-fail institutions, do not pass my personal tests for those other two criteria I listed above; a conversation for another day.
Evaluating Your Institution
Determining a bank’s liquidity ratio is quite simple. You can do it yourself using these simple steps:
- Go to your bank/credit union’s website and click on the link that says “Investor Relations.” Once there locate the latest annual report or quarterly earnings report. Inside that report you’ll usually find a balance sheet listing the institution’s assets and liabilities that looks something like the table above.
- Find the line that says “Cash” or “Cash and Cash Equivalents” under the “Assets” section. Write that number down.
- Now find the line that says “Total Deposits” and write that number down. (NOTE: Credit unions generally refer to deposits as “shares.” So the line you’re looking for probably says “Total Shares” or “Total Shares and Deposits”)
- Divide the total cash number from step 2 by the total deposits number from step 3 then multiply by 100 to get your institution’s liquidity ratio:
(Total Cash / Total Deposits) x 100 = Liquidity Ratio
A bank should be your financial partner, not another risk to what you’ve worked to build. When considering how/where to keep your money you don’t have to settle for a bank that isn’t worthy of your trust.
As Wells Fargo has graciously reminded us this week, in the world of finance, integrity far too often falls victim to ambition. And that is not a quality you want before making a loan to somebody.
Bottom line…Spend a few minutes to find a financial partner who deserves your trust before loaning them your hard-earned money. Don’t just deposit money with a bank because they happen to be around the corner.