Deposit Insurance

A depositor asks which body stands behind the balance in her checking account at an insured commercial bank. The correct answer is:

1. A.The Federal Reserve, because it regulates member banks and holds their reserve balances.Wrong. The Fed conducts monetary policy and supervises banks, but it does not insure the deposits themselves.
2. B.The Securities Investor Protection Corporation, because a bank is a financial institution.Wrong. That body covers customer securities and cash held at a failed broker-dealer, not deposits at a bank.
3. C.The Federal Deposit Insurance Corporation, which insures deposits at its member banks.Correct. Deposit insurance at member banks is the FDIC's function, subject to the applicable coverage limits.
4. D.The Treasury, because insured bank deposits are direct obligations of the federal government.Wrong. A deposit is an obligation of the bank, and the government's role runs through the insurance program instead.

Why: The federal financial agencies each own a distinct function, and confusing them is a reliable source of wrong answers. Deposit insurance is administered by the FDIC, which pays insured depositors when a member bank fails. The Federal Reserve conducts monetary policy and supervises banks but insures nothing. The securities-side counterpart is a separate corporation covering assets held at a failed broker-dealer, and neither program protects against investment losses.

A customer keeps a savings account at a commercial bank and a brokerage account holding stocks and a cash balance at an unaffiliated broker-dealer. Which protection covers which account if each institution fails?

1. A.Deposit insurance covers both accounts, since both institutions hold the customer's money.Wrong. Deposit insurance is tied to deposits at an insured bank and does not follow money into a brokerage account.
2. B.Deposit insurance covers the bank savings account; SIPC covers the securities and cash at the broker-dealer.Correct. Each scheme responds to the failure of its own type of institution and to nothing else.
3. C.SIPC covers both, because it protects individual investors wherever their assets are held.Wrong. Its coverage is defined by membership of the failed broker-dealer, not by the investor's identity.
4. D.Neither covers the cash balance at the broker-dealer, since only securities positions are protected there.Wrong. Cash held for the purpose of purchasing securities is covered, subject to its own separate sublimit.

Why: The two schemes cover different institutions and different kinds of failure. Deposit insurance from the FDIC applies to deposits at an insured bank, so the savings balance is covered there. SIPC applies to customers of a failed broker-dealer, covering securities and cash held in the brokerage account up to the statutory limits, with the cash portion subject to its own separate sublimit. Neither scheme covers the other's institution, and neither covers investment losses, so a customer whose stocks fall in value has no claim under either. The practical consequence is that a customer with both relationships must look at which institution failed before asking which scheme responds.

All of the following are securities EXCEPT:

1. A.A depositary receipt representing ownership of shares in a foreign issuer.Wrong choice for an exception. A depositary receipt evidences an interest in shares and is itself a security.
2. B.A share of a real estate investment trust that owns and leases office buildings.Wrong choice for an exception. A REIT share is equity in a company that happens to own property, and the holder is wholly passive.
3. C.A variable life policy whose cash value tracks subaccounts the owner selects.Wrong choice for an exception. Subaccount performance passing through to the owner makes this insurance contract a security.
4. D.A demand deposit account at a commercial bank that pays a stated rate of interest.Correct. A deposit is a claim on the bank itself, governed by banking law and deposit insurance rather than the securities laws.

Why: Three of these place the holder's return at the mercy of a portfolio or a business run by someone else, which is the thread running through the whole definition. A depositary receipt, a REIT share and a variable life policy each deliver investment performance to a passive holder. A bank demand deposit does not, because the bank owes the balance whatever its own investments do, and the depositor's protection comes from supervision and deposit insurance instead. Restructure the account so the balance rose and fell with the bank's loan portfolio and it would cease to be a deposit at all.

Two customers each commit money at Fenwick Savings. One buys a certificate of deposit issued by the bank at a fixed rate. The other buys from a broker-dealer a participation in a pool of loans Fenwick originated, with returns depending on how those loans perform. Which statement is correct?

1. A.Both are securities, because in each case the customer commits money to Fenwick for a return.Wrong. Committing money for a return also describes a savings account, and deposit relationships are governed by banking law.
2. B.Neither is a security, because a federally supervised bank stands behind both arrangements.Wrong. Bank supervision protects the bank's depositors and does nothing for an investor whose return rides on loan performance.
3. C.The pool participation is a security; the bank-issued certificate of deposit is not.Correct. A fixed-rate insured deposit obligation is a banking product, while a performance-dependent participation is an investment.
4. D.The certificate of deposit is a security; the pool participation is a banking product.Wrong. This reverses the two, treating the insured fixed-rate instrument as the one carrying portfolio exposure.

Why: A conventional bank certificate of deposit is treated as a banking product rather than a security: the rate is fixed, the bank owes the money whatever its loans do, and deposit insurance and bank supervision already protect the holder. A participation in a pool of loans is different, because the buyer's return rises and falls with the credit performance of the underlying assets and no deposit relationship exists. That performance exposure, combined with reliance on the originator to service the pool, is what makes it a security. If Fenwick instead owed the participation's return out of its own general funds as an insured deposit, the analysis would move back to the banking side.