The definition of cash used to simply be coins and paper currency. Then the definition of cash spread to checks, money orders, and even credit with the rise of financial institutions agreeing to hold your money for an agreed upon interest rate.
Banks and credit unions make money by making a spread on deposits. They take in your money and lend your money out at a higher rate. This is called the net interest margin, or NIM for short. The larger the spread on a larger deposit base the more money banks will make. Banking is one of the simplest businesses to understand in the world.
The main hurdle banks must overcome is that of trust. Banks need to be trusted in order to attract deposits given the definition of cash has now turned into simply numbers on a computer screen. We can all hope that banks will protect our hard earned money in good times and bad times. But when banks regularly lend out more than 5X their deposit base, sometimes bad things happen when panic strikes.
Since the financial crisis regulators have required a hike in bank’s tier 1 capital ratios, thereby lowering profitability as leverage is reduced. The side effects include lower compensation for financial services employees and much tougher lending standards for small business and homeowners.
ONE THING CASH IS NOT: CERTIFICATES OF DEPOSITS (CDs)
A couple things have made me question the ever expanding definition of cash recently.
1) Commenters on Financial Samurai and my various guest posts around the web consistently ask why I have so much cash as part of my net worth allocation even though I hardly have any cash.
2) Personal Capital, my online wealth management software categorizes all my CDs under the Cash section on my homepage dashboard. I just noticed this after going through every single line item in my net worth and updating the values and refreshing my accounts for my year end review.
At any given moment I’ve got less than $10,000 sitting in a bricks and mortar checking or savings account, which equates to one month or less of living expenses. My checking account pays 0.1% and my money market pays 0.2% with Citibank, which is why I loathe to have anything there. It’s way better to keep liquid savings in an online savings account where interest rates are higher. Your money is easily accessible and the bank is at least treating you with respect!
People are confusing cash with CDs. A certificate of deposit is not cash, but an investment in a stable value bond issued by the bank that promises to pay you a coupon every month, quarter, or year until maturity. If you hold the CD until maturity, you get 100% of your principal back. The special attribute of a CD is that $250,000 is guaranteed by the FDIC for single account holders, and $500,000 is guaranteed by the FDIC for married couples. No such principal guarantee exists for stocks or corporate bonds.
The proper comparison for a CD is a corporate bond. The main difference is that corporate bonds tend to have longer dated maturities, have trackable principal price movements, can be regularly bought and sold without penalty, and are issued by corporations, which are deemed higher risk. A bank issuing a CD is also a corporation, but it’s deemed lower risk, even though the bank is using your funds to lend your money out at a higher spread because of the FDIC guarantee. As a result, the closest comparison to a CD is a US Treasury bond.
When I was working in investment banking, I had to declare all my CD investments because I had to declare all outside interest investments. Declarations include buying rental property and investing in private companies. You don’t use cash to invest in a money market or checking account unlike using cash to invest in a CD. Hence, there was no need for me to declare transferring any cash to an online savings account.
If you want to get a higher interest rate, check out CIT Bank for some of the highest interest rates today.
LET’S STOP DILUTING THE DEFINITION OF CASH
Cash is cash, a medium of exchange with an implicit value in relation to other things. Cash does not have the ability to produce more value. If wealth management tools like Personal Capital want to categorize cash, then they should have their Cash section consist only of savings, checking, and physical currency. If they’d like to include CDs as part of the Cash section, then they should change the name to “Risk Free Investments” given the FDIC guarantee. If not, CDs should be categorized in the Investment category, where corporate bonds and Treasuries lie.
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Updated for 2020 and beyond.