A Primer on Securities Insurance

Over the past year, a substantial amount of media attention has focused on the status of the Bank Insurance Fund and the financial condition of U.S. banks. This attention has shaken some customers' confidence in commercial banks.

As a result, some funds have been disintermediated from insured commercial banks - into investment vehicles offered by other financial-services industries. Often, these funds end up in brokerage accounts covered by the Securities Investor Protection Corp.

Bank managers should have a basic understanding of the SIPC and how it compares with the Federal Deposit Insurance Corp.

From 1968 through 1970, difficult financial problems beset the securities industry. These problems led to voluntary liquidations, mergers, and - in some cases - bankruptcies of a substantial number of brokerage houses.

Based on FDIC Model

To protect investors against losses caused by the insolvency of their broker dealers, Congress passed the Securities Investor Protection Act of 1970, which established SIPC. The need to protect securities investors was similar, in many respects, to the need that prompted establishment of the FDIC, years earlier.

This legislation had two aims. It required broker-dealers to establish a fund to protect their customers. It also sought to strengthen the financial responsibilities of broker-dealers.

Unlike the Federal Deposit Insurance Corp., the SIPC is neither a government agency nor a regulatory authority. It is a non-profit membership corporation funded by its member securities broker-dealers. These members are registered with the Securities and Exchange Commission, and their principal business is conducted within the United States.

Excluded from the SIPC are broker-dealers whose business consists exclusively of the distribution of shares of mutual funds, the sale of variable annuities, insurance, or rendering investment advisory services to one or more registered investment companies.

The SIPC has no authority to examine or supervise its broker-dealer members. This responsibility lies with the securities exchanges and the National Association of Securities Dealers Inc., or NASD.

Key Role for SEC

The Securities and Exchange Commission, however, has certain regulatory oversight of the SIPC. For example, the Securities Investor Protection Corp. must seek SEC approval for proposed changes of bylaws and rules. The SEC may also require SIPC to adopt, amend, or repeal any of its bylaws or rules.

The structure of SIPC is consistent with the self-regulatory format of supervision over broker-dealers envisioned in the Securities Exchange Act of 1934. The securities exchanges and NASD exercise authority over broker-dealers; they are overseen by the SEC.

The SIPC has seven members on its board of directors. Five directors are appointed by the President of the United States, with advice and consent of the Senate. Three of these five directors are representatives of the securities industry and two are from the general public.

One of the two remaining directors is a staff member appointed by the Secretary of the Treasury and the other by the Federal Reserve Board.

The FDIC's board of directors consists of five members, all appointed by the President with advice and consent of the Senate. Both the Comptroller of the Currency and the director of the Office of Thrift Supervision serve as directors. The three remaining directors are appointed from the general public.

How Customers Are Protected

The SIPC protects each member's customers up to an aggregate $500,000 for cash and securities. Claims for cash are limited to $100,000 per customer. "Security" is defined rather broadly to include notes, stocks, bonds, and certificates of deposits.

Money-market funds are also protected, when held by a broker-dealer in a customer's securities account. "Security" also includes any put, call, option, or privilege on any security or index of securities.

This term does not include currency; commodity; related contract or futures contract; or any warrant or right to subscribe to, purchase, or sell any of these.

The maximum coverage for each depositor in an FDIC-insured institution is $100,000 in cash or equivalent. The FDIC does not insure a customer's securities held by a depository institution in a fiduciary capacity.

If the SIPC determines that one of its members has failed - or is in danger of failing - to meet its obligations to customers, it may take action to protect investors.

Trustees to the Rescue

First, the SIPC may initiate a liquidation proceeding, involving its member, in federal court. A court-appointed trustee is given the responsibility of returning cash to each customer, up to the level of protection offered by SIPC.

The trustee does not guarantee the value of a customer's securities, but simply returns them. The SIPC advances funds to the trustee of a failed broker-dealer, to the extent that the trustee does not possess enough property to cover all customer claims.

The trustee may also elect, subject to the prior approval of SIPC, to transfer all or part of a customer's account to another SIPC member - rather than liquidating the broker-dealer's business.

As an alternative to court-supervised liquidation, SIPC may protect customers of a failed or failing broker-dealer by paying off the customers' claims directly, with SIPC funds. This method of protection may be used in limited situations involving small firms, where the combined claims of all customers are less than $250,000.

SIPC is limited by statute to these methods for protecting customers of broker-dealer members. It does not have the statutory authority to arrange a merger of a failing member with another financially healthy member; nor may it provide direct assistance to a failing member.

The FDIC Approach

The FDIC has broad statutory authority to protect the depositors of a failed or failing depository institution. Generally, the FDIC may use several methods to achieve this purpose.

First, the FDIC may choose to liquidate an institution by paying each customer the value of his or her deposits, up to $100,000.

Second, the FDIC may elect to use a "purchase and assumption" transaction. Under this method, it arranges for a financially healthy depository institution to assume any or all deposits of the failed institution, and purchase any or all of its assets. Purchase-and-assumption transactions usually protect all depositors of the failing institution.

The FDIC may take one more step to prevent the failure of a depository institution or to lessen the risk it faces from an institution with "significant financial resources." In such cases, the FDIC can offer some form of financial assistance to the institution.

Instead of closing the failing institution, the FDIC would thus assist it directly, or through another institution qualified to merge with it.

Before the FDIC may use this open-bank assistance transaction, it must determine either that the assistance is less costly than outright liquidation or the continued operation of the institution is essential to its community. All depositors of the failing institution are fully protected, just as they usually are in a purchase and assumption transaction.

Sources of SIPC Funds

The SIPC is funded primarily by assessments on its members; but interest on investments in U.S. government securities is also included. Any confirmed lines of credit that the SIPC maintains are also considered part of the fund.

The present SIPC assessment is three-sixteenths of 1% of gross revenues per year. As of Jan. 1, 1991, the SIPC fund totaled $569 million in cash and U.S. government securities.

As a supplement to its fund, the SIPC has obtained a $500 million revolving line of credit from a consortium of banks. In the event the SIPC fund is insufficient to meet its purposes, it could rely on government assistance.

The SEC is authorized to lend up to $1 billion to SIPC, with funds from the U.S. Treasury. However, the SEC must first determine that a loan to the SIPC is necessary for the protection of customers of broker-dealers.

Meeting Future Needs

The SIPC board of directors believes it would be appropriate to build its fund to $1 billion, "subject to reduction of that goal if SIPC finds other, more efficient ways to achieve that level of protection."

To meet future needs, the SIPC has commissioned a study of how an "appropriate" level of its fund can best be met and maintained. This study will also review the assessment structure on its members.

Similarly, the FDIC's Bank Insurance Fund is funded by assessments on insured banks and by interest received from investments in U.S. government securities.

The present assessment rate is 19.5 cents per $100 of domestic deposits per year. However, the FDIC has recently increased the assessment rate to 23 cents per $100 of domestic deposits per year, effective July 1.

As of January 1991, the BIF had around $8.4 billion in reserves. To supplement this amount, the FDIC may also borrow up to $5 billion from the U.S. Treasury.

The FDIC is also allowed to borrow additional funds to support the BIF. However, all borrowings must be in an amount that will not reduce the net worth of the BIF to less than 10% of FDIC assets (plus the $5 billion loan from Treasury).

Because of the important role that banking and securities industries play in the nation's economy, Congress has authorized the Treasury Department - when called upon - to provide assistance to each organization in times of financial stress.

Brad G. Welling is associate federal administrative counsel for the American Bankers Association in Washington. This comment reflects his own views, not necessarily those of the ABA.

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