How Safe Are Institutional Assets in a Custodial Bank’s Insolvency?

83 Min Read By: Edward H. Klees


It is a widely held belief among institutional investors that custody accounts are protected against a bank’s insolvency in the United States. This assumption undergirds trillions of dollars of assets held in custody in U.S. banks. However, despite the 2008 financial crisis, little if any attention has been paid to analyzing whether this belief is, indeed, valid. This article argues that while the FDIC, as receiver of almost all failed banks in the United States, will likely protect custodied assets to the extent permitted by law, clients bear several significant legal and operational risks that could limit recovery of their custodied assets. While investors can protect against some risks, others may be outside their control. The article outlines these risks and proposes ameliorative steps for institutional investors.

It is an article of faith among institutional investors that assets held in custody are protected against a bank’s insolvency in the United States. It is such commonly accepted wisdom that there has been little, if any, analysis of the topic since the 2008 financial meltdown. This seems surprising when contrasted with the sudden, widespread focus on the risks of prime brokerage after the collapse of Bear Stearns and Lehman Brothers. This disparity would seem to confirm the accepted view among institutions that a custody account is the “safest place” for their assets.1

This article of faith undergirds the U.S. banking system. There are trillions of dollars of institutional investment assets held in United States custody accounts,2 and undoubtedly the assumption of most institutional investors is that if the bank fails, assets would remain theirs and beyond the reach of the bank’s creditors and general depositors. If this assumption were wrong, then the assets could be reduced—perhaps significantly—to satisfy the claims of those other parties. Loss of these assets could be cataclysmic for mutual funds, pension plans, hedge funds, endowments, and other depositor institutions,3 and needless to say, their clients and beneficiaries.

Along with this assumption is the notion that custodied assets will become available almost immediately for repossession by the investor, as contrasted with claim resolution in a bank’s insolvency proceedings, which might take years.

The attributes of custody are so widely recognized that since 2008 many hedge funds have moved their “net long” positions from prime brokerage to bank custody accounts,4 and similarly, since passage of the Dodd-Frank Act (“Dodd-Frank”),5 swap dealers and traders have explored holding margin or collateral in a custody account.6 Dodd-Frank itself imposes new custody requirements for investment advisory assets and futures collateral.7

Investors have good reason to trust bank custody. The Office of the Comptroller of the Currency (“OCC”) advises that “[a]ssets held by banks in a custodial capacity do not become assets or liabilities of the bank. . . . They are not subject to the claims of the bank’s creditors.”8 In addition, the American Bankers Association assures that “a failure of a bank will have no adverse effect on trust, fiduciary or custodial accounts: they remain the property of the account owner(s).”9

Thus, it is with good reason that bank custody is seen as best practice, and directors and officers of institutional investors may feel with confidence that they are properly discharging their fiduciary duties by entrusting assets with a bank custodian. If the financial community regards the sanctity of custody accounts as a truism, it is worth asking whether this assumption is, in a word, true. This is what this article sets out to do.

After surprisingly lengthy research, the answer is not simple. The challenges in understanding U….

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By: Edward H. Klees

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