Bank Counterparty Risk Fuels Concerns About Just How Safe Deposits Really Are

By the time the dust settles on the sudden failures of Silicon Valley Bank and Signature Bank, a number of lessons are likely to have emerged. Perhaps one of the most important is that depositing money in the bank is not necessarily a risk-free transaction for the customer. That’s because when you make a deposit, you establish a relationship with a counterparty – the bank, in this case. And where there’s a counterparty, you almost always find counterparty risk.

In simplest terms, a counterparty is the person or entity on the other side of a financial transaction. Counterparty risk exists the moment a transaction occurs. It refers to the prospect that a transaction or other financial relationship is unsuccessful because the counterparty fails to actually do the things it agreed to do.

Let’s define this counterparty risk more specifically in terms of retail banking.

When you keep cash under your mattress, there is no counterparty risk, because there is no counterparty. There’s just you and your money. In that situation, no other person or entity stands in between.

However, when you take that money and deposit it into the bank, there is now a counterparty – which means there is now counterparty risk. In this scenario, the risk is that the bank will be unable to return your money when you ask for it.

Recent bank collapses have resurrected concerns about the counterparty risk depositors face when they move their money from the mattress to the bank. It’s not something we tend to think about very often, but perhaps we should. This is particularly true of individuals or businesses that choose to keep on deposit amounts in excess of the Federal Deposit Insurance Corporation (FDIC) statutory limit of $250,000.

I’m going to talk a lot more about counterparty risk shortly. But we’re going to do more than go over the problem. We also will talk about an asset that enables those who own it to greatly reduce – even virtually eliminate – counterparty risk: physical precious metals.

Physical precious metals, such as gold and silver, can mitigate counterparty risk in two important ways. One has to do with the way metals are stored. Unlike your bank deposit, there is effectively zero chance that you will be unable to access all of your deposited metals when you go to withdraw them – no matter when or under what circumstances you ask for them. That’s huge.

But the ability of metals to greatly reduce counterparty risk isn’t limited to the storage protocols. The fact is that the nature of physical precious metals – including the way they derive their value – precludes the very existence of counterparty risk in terms of the asset itself. Unlike virtually every other popular asset, the value of precious metals is not dependent in any way on the willingness or unwillingness of people to do any job, perform any task, or honor any obligation.

We’re going to cover precious metals as a counterparty-risk “antidote” in much greater depth. But first things first: Let’s start by clarifying what counterparty risk looks like from the vantage point of the retail bank depositor.

Off we go.

Fractional-Reserve Banking Sits at the Core of Depositor Counterparty Risk

To clearly understand the counterparty risk that you must bear as a bank depositor, you first have to understand the fundamental nature of banking. That means understanding what a bank is…as well as what it isn’t.

Let’s start with what banks are not. They are not depositories for customer cash. The job of a bank is not to safeguard the money deposited there. The job of the bank is to put that money to work for the benefit of shareholders. And they do that by making loans and investing it.

Of course, banks have a giant vault inside of which a lot of cash is kept. But the amount of cash stored in those vaults isn’t anywhere close to the total amount the bank has received in deposits.

This gets to the heart of what banks are. They’re businesses that earn money by making loans and investing most of what they receive in deposits. And the mechanism that allows them to do it is called fractional-reserve banking.

Under a fractional-reserve model, banks are required to keep on hand just a “fraction” of customer deposits. Most of the rest is loaned out. By lending out these funds, banks not only increase their own profits but provide direct stimulation to the economy as a whole.

The Federal Reserve sets reserve requirements for banks, and will adjust those requirements based on prevailing economic conditions. Reserve requirements generally are adjusted from as “high” as 10%, to as little as – if you can believe it – 0%.[1] This means that, at any given time, banks can loan out 90% to even 100% of the money they have on deposit.

As a practical matter, banks do have money in reserves at all times. But the point is that they don’t keep in reserves anywhere near what they receive in deposits.

When the economy is relatively uneventful – which, thankfully, is most of the time – fractional-reserve banking works fine. When there are no crises at hand and no anxiety about the financial system, having even a “fraction” of customer deposits available provides more than enough money for banks to meet withdrawal requests.

It’s when those concerns do arise that the fractional-reserve system may not work so well. The reason, of course, is that when a (much) larger-than-expected number of depositors shows up at ABC Bank all at once to withdraw their money, there might not be enough to go around.

And in this particular game of musical chairs, you really don’t want to be the one left standing without a place to sit when the music stops playing.

That summarizes the principal counterparty risk that depositors bear when they hand over their money to the bank. But there’s more to the risk than the fact that banks keep just a fraction of deposits in ready reserves. The problem can be exacerbated by a variety of other factors. Among them: Banks faced with having to suddenly liquidate sizable portions of their securities portfolios to meet withdrawal demands may encounter even more trouble if those liquidations occur when the assets are underwater.

That’s also what happened to Silicon Valley Bank, and it’s another element of the counterparty risk faced by Silicon Valley depositors.[2] Technically, the crushing losses resulting from the bank’s forced bond sales were a function of market risk and interest-rate risk. However, for depositors, those losses added to the bank’s distress and hastened its downfall – which, in turn, exacerbated the impact of the counterparty risk.

Is There Really Counterparty Risk If My Money Is Insured by the Government?

FDIC insurance goes a long way to mitigating counterparty risk for bank depositors, but it doesn’t eliminate it. That’s especially true in cases where deposit amounts total more than the FDIC limit of $250,000 per customer, per bank, per account type.

This is by no means an insignificant point. According to recent estimates, a little more than $9 trillion of bank deposits in the U.S. were uninsured as of the end of 2022. That’s more than 40% of the total on deposit at all banks.[3]

Now, you may have heard that in the case of Silicon Valley Bank and Signature Bank, a special exception was granted so that even uninsured deposits were covered. That’s true.

By invoking something called the “systemic risk exception,” the Federal Reserve and the government – including the FDIC – can agree to extend the same sort of extraordinary protections to depositors of non-systemically important banks as they do to systemically important banks (SIBs), aka “too big to fail.” The idea is that the nation’s top financial regulators want to preserve the option of limiting the fallout from the failures of banks that may not meet the standard of “systemically important” if it’s believed that fallout could wreak outsized havoc on the financial system.[4]

That’s what was done in the case of Silicon Valley Bank and Signature Bank. Not long after the failure of each bank, the “systemic risk exception” was invoked, and all depositors at both banks were made whole.[5]

Speculation has since persisted that the decision to protect all depositors at two non-SIBs means all depositors at all banks will be covered going forward. However, Treasury Secretary Janet Yellen has said in recent weeks that such a comprehensive level of depositor protection is not under consideration.[6]

It remains to be seen, of course, whether uninsured depositors at banks that may fail in the future are protected the way those at Silicon Valley Bank and Signature Bank were covered. At this time, however, there’s no basis for assuming they will be. Which means those individuals and companies that have more than $250,000 on deposit at U.S. banks remain up to their eyeballs in counterparty risk.

Even for those who have less than the $250,000 limit on deposit, it’s not inappropriate to point out that there’s a difference between the indemnification of risk and the absence of risk. That may be a fine point, particularly when you consider that since the FDIC opened its doors in 1933, no depositor has ever lost a penny of insured funds.[7] Still, the existence of the FDIC does not magically remove the risk of “initial” deposit loss. What it does is reimburse depositors for those losses.

For those individuals who are eager to decrease their overall exposure to counterparty risk as much as possible, there is one asset that can go a long way to helping them realize that goal: physical precious metals.

Let’s talk about why.

Ownership of Precious Metals Can Significantly Reduce – and Even Eliminate – Counterparty Risk

Physical precious metals such as gold and silver offer retirement savers a couple of ways to greatly diminish the exposure they have to the kind of counterparty risk faced at a bank.

For starters, when you own physical metals in a gold IRA, you must store that gold and silver in an approved precious metals depository. These depositories exist solely to safeguard the precious metals on deposit. Remember how I mentioned earlier that banks aren’t in the business of protecting the money you deposit with them? Well, precious metals depositories are in that business. That’s what they do, and that’s all they do.

In the case of metals stored at a depository, there is fundamentally no counterparty risk even though another party is involved in the relationship between you and your assets. That’s because the best, most renowned depositories provide storage of customer metals on what’s called an allocated basis. Allocated storage means the metals are not merely credited to you by the depository in the way your bank deposit is credited to you electronically by the bank. Rather, the assets remain fully owned by you and are stored in your name at all times.

A related and extremely important component of allocated storage is that your metals stay off the depository’s balance sheet. This means your property is never comingled with the depository’s proprietary assets. So, in the highly unlikely event that the depository encounters solvency issues, your gold and silver would have zero exposure to any of the associated risks.

This is an enormously important distinction from how your money is “stored” at a bank. Customer bank deposits are not bailments. Those monies become the property of the bank.

That’s why banks can lend out your money – because while it’s on deposit, banks have legal title to it. As for your status, you go from being the legal owner of the money to becoming a creditor of the bank.

However, when you deposit precious metals in a depository that provides allocated and off-balance-sheet storage, those assets are exclusively your assets at all times.

Some might quibble with the notion that no counterparty risk exists in a customer relationship with a precious metals depository on the basis that the facility becomes another party through which you must go to physically access your metals assets. Technically speaking, that is true. However, that’s not really what is meant by counterparty risk. Genuine counterparty risk exists when the counterparty must play a material role in preserving the financial value of the asset.

A precious metals depository where customer metals are allocated and stored off the balance sheet plays no such role. Such depositories cannot and do not engage in bank-like kinds of practices such as lending out metals, lending money hypothecated by metals, or investing customers’ metals assets – or the value of those assets – in a depository-owned portfolio. If they did, those kinds of practices would give rise to fundamental counterparty risk.

Still, depositories do acknowledge their technical standing as counterparties – meaning, they recognize that they’re entities which maintain sole physical possession of the metals assets for as long as they’re on deposit at the facility. Accordingly, depositories carry enormous all-risk insurance policies to supplement the comprehensive physical security measures that always remain in place.

The vastly different relationship that gold IRA owners have with precious metals storage facilities – compared to the relationship depositors have with banks – is one important way in which metals ownership can help mitigate counterparty risk. But it isn’t the only one. In fact, merely owning physical metals, regardless of how you own them or where they are stored, can go a long way to effectively eliminating counterparty risk.

Here’s why.

As Assets, Physical Gold and Silver Have Zero Counterparty Risk

Look at any list of the most popular or most common long-term savings assets, and you’ll notice they tend to have one particular feature in common: They all are made out of paper. And assets that are made out of paper have counterparty risk.

Even if someone chooses to carry their stock certificates and bonds with them wherever they go, they still assume counterparty risk. Why? Stock certificates and bonds represent a financial interest in a company or government. And the preservation of that financial interest relies on more than just your ownership of it. It also relies on the company or government – the counterparty, in the context of this discussion – to perform and otherwise live up to its stated responsibilities to you as an investor. If they fail to do so, the value of your financial interest can be impacted significantly. It potentially could be reduced to nothing.

It is in this way that physical gold and silver have zero counterparty risk. Unlike companies and governments, there is no chance that physical metals will default on their obligations, commit fraud, or make decisions that lead to insolvency.

Precious metals are naturally occurring tangible assets recognized the world over as long-term stores of value.[8] The viability of a gold or silver coin is not dependent on the performance of a person, company or government.

When a company or government fails, its representative stock or bond becomes worthless. Even the Federal Reserve notes we call “dollars” technically carry counterparty risk because their value is not inherent but instead relies on the performance of the U.S. government.[9]

Please note that I mention the technical existence of counterparty risk in dollars merely as a dramatic illustration of the fact that “even” they have a shred of counterparty risk in a way that physical precious metals do not have any. I am absolutely NOT suggesting that you stop using U.S. currency or exchange all of yours for precious metals.

Along the same lines, it isn’t realistic, as a practical matter, to eliminate counterparty risk from your daily life. As I said earlier, practically every financial transaction in which you might engage is going to be characterized by some measure of it.

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[1] FederalReserve.gov, “Policy Tools – Reserve Requirements” (accessed 3/30/23).

[2] Stacey Vanek Smith, NPR.org, “Bank fail: How rising interest rates paved the way for Silicon Valley Bank’s collapse” (March 19, 2023, accessed 3/30/23).

[3] Hannah Lang and Pete Schroeder, Reuters.com, “Explainer: How safe is my money in a U.S. bank and what is insured?” (March 22, 2023, accessed 3/30/23).

[4] Jack Hersch, PitchBook, “SVB triggers return of FDIC’s Systemic Risk Exception” (March 15, 2023, accessed 3/30/23).

[5] Ibid.

[6] Andrew Duehren and Lindsay Wise, Wall Street Journal, “Yellen Says Treasury Isn’t Considering Guaranteeing All Bank Deposits” (March 22, 2023, accessed 3/30/23).

[7] FDIC.gov, “Understanding Deposit Insurance” (July 13, 2020, accessed 3/30/23).

[8] USGS.gov, “Gold Statistics and Information” (accessed 3/30/23).

[9] Jeff Deist, Twitter post, March 12, 2023, 12:20 p.m. (accessed 3/30/23).