Money Market Funds: Alternative to Deposits Amid Bank Failures

The collapse of Silicon Valley Bank (SVB) in March first appeared as a rare event consequence of an undiversified customer base, uninsured deposits, and liquidity concerns compounded with high interest rates driving down its portfolio’s longer duration bond value. Now, with First Republic Bank failing as the third U.S. lender to crash in two months, the once deemed extraordinary SVB closure may have marked a broader banking crisis beginning. Fortunately, just like they bailed out depositors after prior failures, the FDIC, Federal Reserve, and Treasury have stepped in to broker a required buyout of First Republic Bank by JP Morgan to protect affected clients. Their intervention eases the public concern only so much in this alarming time, and depositors are likely focused on keeping access to their liquidity. An alternative to bank deposits, utilizing Money Market Funds (MMF) may be an option to maintain liquidity and avoid reliance on FDIC insurance for cash.

Understanding Bank Deposits.

Saving money in a bank’s standard checking or savings account is the most popular and convenient way to save money, yet understanding what happens to deposits is valuable. When a banking customer deposits money into a standard checking or savings account, their money does not merely sit in the account waiting to be withdrawn. Instead, the deposit acts as an agreement between the depositor and the bank; the bank pays interest in return for the legal right to use the deposit in investments elsewhere.

By regulation, the bank is required to keep a small portion of their total deposits as cash in reserve to be available for immediate withdrawals and mitigate the probability of a bank run. Historically, the reserve ratio set by the Federal Reserve ranges between 0% and 10%; currently, the ratio has remained at 0% since the onset of the pandemic but is subject to change dependent on economic conditions.

The proportion of total deposits not held in reserve is loaned out to fund personal and corporate loans or invested in other assets. This proportion of total deposits becomes a liability on the bank’s balance sheet. Because of this, the Federal Deposit Insurance Corporation (FDIC) federally safeguards customers insuring up to $250,000 per depositor for most FDIC member banks. In the most recent banking events, many of the depositors either exceeded the $250,000 insured amount or did not fulfill the requirements to be insured. Luckily, the FDIC and government intervened to protect customer deposits of these specific banks; however, investors may want to consider alternatives given the current unstable banking sector to mitigate impacts of potential future bank collapses.

Money Market Funds in Contrast.

Money Market Funds (different than a Money Market Account) may offer a more suitable choice for saving money than standard bank accounts. The key distinction between a Money Market Fund and standard bank checking or savings accounts is MMFs are entirely backed by assets whereas banking deposits are not. This type of fund acts like a mutual fund that is specifically comprised of near-term securities with little credit risk and durations less than 397 days. The securities held in a Money Market Fund may include cash, cash equivalents, and other high credit rated, debt-based assets.

An investor purchases fund shares at $1 Net Asset Value with the manager’s goal of maintaining this value at par. To prevent volatility, federal regulators require the fund’s securities to be short-maturity, low-risk investments resistant to market movements and investor sentiment. Infrequently, shares may dip below the $1 NAV per-share-target provoking regulatory action to protect investors. On the other hand, if the $1 NAV per share is exceeded, the fund distributes its dividends to investors. Money Market Funds are often brokered through non-banking investment institutions, such as Fidelity.

Money Market Funds’ most time-relevant advantage, given current events, are their high liquidity and independence from FDIC capabilities or government action to preserve investors shares. Investors may likely withdraw money at any time – only restrained by the frequency of withdrawals within a certain time period. Fraud insurance overlays add an additional level of protection for investors concerned about investment security. Although acting like mutual funds, money market fund investments are intended to be a stable alternative to maintaining “deposits” in nearly risk-free status and may offer protection against today's banking turmoil.

Money Market Fund Types.

Understanding the different types of Money Market Funds and nuances to each is important to choosing the proper fund for an investor’s portfolio. Fund types differ based on the underlying instruments it holds. Government MMFs include only cash and U.S. Treasuries plus repurchase agreements collateralized by government securities in some cases. Each Government type fund heavily weights U.S. Treasuries or a combination of U.S. Treasuries and repurchase agreements with the minority allocation to cash. Treasury Only funds, a type of Government MMF, are credit risk free and provide more comfort for investors. Prime Funds may hold the same assets as Government MMFs with the addition of commercial paper, CDs, Corporate Notes, and other private instruments. However, Prime funds may have higher redemption and liquidity hurdles, which might direct investors away from this MMF type in favor of the others. Municipal or Tax-Exempt Funds are categorized as either national municipal or state municipal; national municipal invests over 80% of the fund in federal income tax-exempt securities and state municipal invests in over 80% of federal and state income tax-exempt securities.

Closing Thoughts.