About $3 trillion in customer balances at brokerage firms is not invested in stocks or bonds but sits in money market funds or FDIC-insured sweep accounts.

Despite the run-up in equity markets and a return to something approaching full investment by the general public, these balances (which I estimated from Investment Company Institute data and reports by bank-affiliated broker-dealers) are historically large, reflecting a continued bias toward conservative investing.

Yields are very low for these products but customers accept that in exchange for safety and convenience.

However, impending troubles exist in all these products:

  1. Money market funds may be forced to use floating net asset values and expose customers to risk of loss of principal. The Financial Stability Oversight Council is pushing this change, thinking it would add safety to the money market fund product. The industry argues it will drive customers out of the product in droves.
  2. FDIC-insured sweep accounts are suffering from a lack of banks to accept the deposits that brokerage firms bundle to get customers the FDIC protection and some rate of return. If analysts are correct and money market funds see customers fleeing, those customers will likely land in FDIC sweeps but there will not be sufficient capacity to accommodate them.
  3. Brokerage credit interest programs. All broker-dealers have a product to place uninvested funds in, and before money funds and FDIC sweeps were invented this was the only option for parking cash available to broker-dealer customers. However they pay a very low rate of interest, and require a broker-dealer to have capital to support the product line. Broker-dealers are still recovering from five years of mediocre results, and don't have the capital if there is a flight from money funds and FDIC sweeps into credit interest products.

The likely outcome if floating NAV is enacted will be that a large fraction of the above balances will land in bank deposits in retail form.
Banks, already way long on deposits, will end up paying even lower rates as funds flood in.  

As policy matters go, no loans will be made that would not have otherwise been made given the surplus, so the regulators' pushing money funds out of business in favor of banks accomplishes very little in economic stimulus, but may keep a downward pressure on interest rates.

For example from September 2009 until September 2012 banks' net loans and leases grew by only about $200 billion, but deposits grew by more than $1 trillion, according to Federal Reserve data.

Brokerage firms have spent the last 10 years trying to provide full services including check writing and paying interest on uninvested balances to customers so they can compete with banks. This has been in response to banks trying to steal the investment business from brokerage firms.

If we are supposed to have learned one lesson from the last five years, it should be that banks don't do that great a job of managing anything, let alone mixing lines of business.

As a policy matter, brokerage firms provide diversity and insulate customers from overconcentration of risk in a shrinking number of banks.

We should remember that money market funds were created in the 1980s as a consumer proposition and took hold because they competed with banks and paid much higher yields to customers.

If they cease to exist even when rates allow higher consumer deposit rates, banks won't pay them if they don't have money funds to keep them honest.

The regulators should stand up for the values financial advisors bring to the table and allow competition between banks and broker-dealers to thrive.

Let the money funds stay at a stable NAV and don't give the banks a freebie.

Richard Heitman is the president of Heitman Financial Services Consulting, which helps broker-dealers find partner banks for their FDIC sweep programs. He can be reached at richardhheitman (at) gmail.com.