Diane Wondolowski is the chief financial officer of the Santa Barbara Museum of Natural History. She has provided stellar service there since 1999.
She has served on boards, finance committees, audit committees, and investment committees of a number of nonprofits over the years. She tries to support those who are working for the greater good by coaching them on complicated business issues that arise while working to achieve their mission.
Wondolowski compiled this very helpful information together immediately following the fiasco at Silicon Valley Bank. “I want to help the nonprofits I am involved with to think about cash proactively, not reactively,” she said.
What follows is the excellent information Wondolowski put together for the benefit of her organization and other nonprofits with whom she works.
There are several types of risk an organization needs to consider when managing its liquid assets. The risk of loss of an uninsured bank account is much lower than the risk of losing purchasing power. The various risks need to be analyzed, and a liquidity portfolio structured. The goal is to balance risk and return — cash needs with the appropriate assets.
Background information regarding cash
Nonprofits regularly hold cash — cash in bank accounts, money market accounts, savings accounts, CDs and in other cash equivalents. It is recommended that organizations have three to six months of operating expenses available in highly accessible cash equivalents. Depending on other needs such as restricted donations, construction, contingency funds, potential facility repairs, additional short-term funds may be set aside. It is important to match the timing of when an organization needs to have cash available to how those funds are held or invested.
Your uninsured account risk
The recent closure of two banks by regulators bring to the forefront one risk with holding cash — the risk that the balance will not be covered by FDIC insurance. In general, FDIC insurance covers the first $250,000 that each entity has in account(s) at a given bank. The insurance is at the entity level, not the account level. (Essentially, each EIN or SSN).
So, should an entity keep only $250,000 at each bank, and open accounts at another bank each time its liquid assets breach another multiple of $250,000?
There is also SIPC insurance which guarantees $500,000 per investment brokerage account with a limit of $250,000 in cash in the case of a brokerage failure. For the purpose of SIPC, a money market account is not considered cash.
There are many other types of risk with holding cash, cash equivalents and investments that should be weighed in determining the best liquid asset strategy for any organization. These include interest rate risk or inflation risk, liquidity risk, investment risk, and fraud risk.
And, inherent, is public relations risk.
Inflation risk can be a concern
Inflation Risk is the risk that the dollar an organization has in the bank account today is worth less tomorrow.
In the past year, inflation has run higher, such that $100 left in a non-interest-bearing account for the past year would only buy $94 worth of goods as prices increased 6 percent.
To avoid inflation risk, an entity would want a portion of its liquid assets in appropriate cash equivalents or investments that return more than inflation.
I am using “appropriate cash equivalents or investments” to mean assets whose liquidity and volatility match the time horizon of the entities needs for those assets. An entity may use a variety of savings accounts, money markets, CDs, treasuries, government and corporate bonds and investments that match up with their expected expenditures of those funds.
So, keeping all of one’s cash in the mattress or in a non-interest-bearing account brings with it inflation risk.
Consider your liquidity risk
Liquidity risk is the risk an entity will need access to cash at a time that is not optimal. If an entity has most of its funds in a US Treasury that matures in six months, but needs those funds now, that is a mismatch in timing and having to access those funds by selling the treasury could result in a loss. That is essentially (in a very simplified way) what happened to Silicon Valley Bank.
To avoid liquidity risk, an entity would want cash needed in the very short term in cash, checking, money market, or savings accounts. Cash needed in the near future could be in slightly longer-term assets such as CDs.
Cash that the organization definitely knows it won’t need until a certain time could be in US Treasuries. Funds that the organization is certain it won’t need for a few years could be in more volatile instruments, such as stocks, bonds.
Pay attention to your investment risk
Investment risk is the chance that an investment will lose value. f an investment loses value at the time an entity needs to use the funds locked up in that investment, the sale of that asset will result in a loss. Over the long term, investments gain in value.
Investments are appropriate for funds that are not needed for long periods of time, so they can be held through down markets, allowing the funds to go back in value during the full market cycle. The long-term average annual return on the stock market is 10 percent, but the year-to-year returns can vary significantly.
Money market accounts are are not quite “low risk.” On rare occasions, a given money market fund’s net asset value, which normally stays constant at $1 has fallen below a buck. This is called “breaking the buck.”
Breaking the buck is not a frequent occurrence, with money market funds generally seen as some of the safest, most reliable investments available.
Heed the possible opportunity cost
Opportunity cost is the loss of potential gain when an asset class with a lower rate of return is chosen over a higher rate of return.
There is always the risk of fraud
Fraud risk is the possibility of an unexpected loss due to fraudulent activity by an internal or external actor and can include theft and embezzlement.
Beware of the public relations risk
The risk that something “bad” happens and taints public perception of an organization and its brand reputation is public relations risk. Decisions that lead to an unexpected bad outcome may in hindsight be deemed irresponsible by the general public who was not privy to the facts that were considered at the time of the decision.
The assets and the risks all work together
All nonprofits with any cash are subject to many of the risks listed above. To have too much money in a non-interest-bearing bank account leaves the organization open to inflation risk and opportunity risk. If the balance is over $250,000 it can lead to uninsured account risk.
Having more accounts across multiple banks leads to higher costs for staff to administer and move the funds around as needed. Without the proper internal controls, an organization that has several rarely-used bank accounts can increase fraud risk.
Money market accounts held in investment brokerage accounts are also subject to uninsured account risk if the total amount invested is over $500,000 with any given brokerage. In equally rare instances, they can be subject to investment risk. When interest rates are low, they are subject to inflation risk.
Having too much of your funds locked up in longer term assets brings with it liquidity risk. This can include CDs, Treasuries, and Government and Corporate Bonds.
These assets, if held to maturity, will result in the full amount of the investment being returned. But if the organization needs to access the funds earlier, they may either be subject to a penalty or have to be sold at the current market price, which may result in either investment gain or investment loss.
Longer term assets can also include stocks and other marketable investments whose price fluctuates daily. These are subject to investment risk, so the organization should invest funds where the principal won’t need to be accessed for a number of years.
Losing funds due to a bank run, due to investment losses, or due to theft may create bad public relations if it appears the organization took undue risks. Losses that are the result of following standard practices in a period where most of the organization’s contemporaries incurred similar losses will probably not result in the same bad public relations.
The goal is to balance risk and return, cash needs with the appropriate assets.
SIPC insurance has rarely been used for brokerage firm failures, most notably in 2008 for Bernie Madoff and Lehman Brothers. It is not unusual for at least a few U.S. banks to fail in any given year. However, before this month, the last time a bank backed by the FDIC failed was Oct. 23, 2020.
There are more than 4,500 FDIC-insured commercial banks in the U.S. (This is a loss rate of about 0.022 percent.) So, I assert the chance of incurring an uninsured account loss is low.
For a multi-year period, interest rates were very low and stable. Currently, we are in an inflationary period with an increasing interest rate market. That means that cash in savings and checking accounts are subject to inflation risk and opportunity risk.
It is an everyday occurrence for stocks and bonds to gain and lose value.
So, what is an organization to do?
1. Determine when various amounts of cash will be needed. How much is needed in the next three months, six months, one year, two years, and longer than five years?
2. Review your internal controls over cash and investments to ensure the checks and balances exist to catch a theft in a timely manner.
3. Determine how much the organization disburses each month. At least this amount must be at the organization’s main operating bank. This may be more than the FDIC-insured account limit.
4. Educate the finance committee and board on the various types of risks, and the chances and circumstances under which those risks will occur.
5. Determine how to manage cash needed for the next three to six months and weigh the extremely low risks of money market accounts (FIDC and SIPC insurance limits, breaking the buck) versus the interest to be earned and the staff time to administer the cash solution.
a. Look at options for where the organization can put the short-term cash. There are now products that some banks offer such as an Insured Cash Sweep Service or CDARS that spread your bank balance seamlessly across multiple FDIC-insured financial institutions for you.
6. Determine how to manage the assets needed greater than one year understanding investment risk, liquidity risk, and inflation risk.
7. Step back and review the plan. Consider how the organization’s balance sheet will appear to a funder, to a foundation, or to a reporter.