Regulatory scrutiny of 'cash sweeps' extends to Morgan Stanley

Regulatory pressure rose further on firms' handling of clients' uninvested cash with Morgan Stanley disclosing it is responding to SEC inquiries into its sweeps policies.

Morgan Stanley is among a handful of firms being sued in federal court over allegations that it has failed to ensure it was obtaining adequate returns on cash investors hold in advisory and brokerage accounts. On Monday, Morgan Stanley disclosed in a quarterly report that it has also been responding since April "to requests for information from the ... SEC regarding advisory account cash balances swept to affiliate bank deposit programs". 

The term "cash sweeps" refers to firms' practice of taking uninvested cash in advisory and brokerage accounts and moving it to banks where it can be lent out at relatively high rates of interest. The lawsuits faced by Morgan Stanley and other wealth managers accuse them of keeping most of the loan returns for themselves and allowing relatively little to flow back to clients.

Beyond Morgan Stanley, Bank of America used its own filing on July 30 to list "the rates paid on invested cash in investment advisory accounts that is swept into interest-paying bank deposits" as a possible regulatory risk. And Wells Fargo disclosed in October that its sweeps policies are under Securities and Exchange Commission scrutiny. Wells reported in a quarterly filing last week that it's nearing a resolution with the SEC.

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Swept up in changes
A Morgan Stanley spokesperson declined to comment on the SEC's inquiry. In an earnings call last month, Chief Financial Officer Sharon Yeshaya announced the firm was making changes to its cash sweeps policies but declined to say if those were coming in response to regulatory scrutiny. 

Instead, she attributed the modifications to "competitive dynamics." A spokesperson later confirmed reports that the firm is raising its returns to 2% for clients with $250,000 or more in certain sweeps accounts. Morgan Stanley now pays as low as 0.01% on sweeps holdings. 

Both Wells and Bank of America have also announced modifications to their sweeps policies. Wells estimated while reporting its second quarter earnings that the change will cost it $350 million this year.

Analysts are anxious to learn if other firms could see similar hits to their bottom lines, especially if they are pressured by regulators into making adjustments. Analyst Steven Chubak of Wolfe Research wrote in a report for the week of July 22 that he and his team think the changes at Wells, Morgan Stanley and Bank of America were driven at least in part by regulatory scrutiny.

Now there are concerns, Chubak said, that independent broker-dealers and registered investment advisors could come under similar pressure to raise their cash sweeps rates.  Executives at LPL, Stifel, Ameriprise and Raymond James have all recently expressed comfort with their firms' sweeps policies.

But Chubak's analysis notes that many retail brokers are more dependent than their wirehouse rivals on cash sweeps returns. In a "worst case scenario," the report estimates that pressure to raise sweeps rates could reduce these firms' earnings per share by as much as 20% to 30%.

Advisory vs. brokerage accounts
The Wolfe Research report says it's possible regulators will make a distinction between advisory accounts and brokerage accounts. Advisors tend to be under stricter scrutiny, according to the note, because of their fiduciary obligation to always put clients' interest first.

Some firms contend they're exempt from that duty. Charles Schwab, for instance, has said it has no regulatory or compliance oversight over advisors and thus no fiduciary responsibilities, according to the report.

But that's not to say brokerage accounts are entirely free of such obligations. The SEC's separate Regulation Best Interest calls on brokers to do what's best for clients while also disclosing unavoidable conflicts of interest.

"We struggle to rationalize why the SEC would target Advisory sweep balances across the entire Wealth industry (largest to smallest firms), and then repeat the same exercise for brokerage cash," according to the note. "But that doesn't necessarily mean the risk is off the table either."

Regulators have shown some willingness to crack down on firms over their cash sweeps policies. In 2022, for instance, the SEC reached a $187 million settlement with Charles Schwab over alleged misleading statements Schwab made about cash held in its robo-advisor service. And last September, the Wall Street regulator reached an $18.3 million settlement with the Concord, California-based investment technology and support firm AssetMark over charges that it hadn't been forthcoming about how it handles clients' uninvested cash.

What lower interest rates could mean
Defenders of sweeps generally argue that the accounts give investors a place to hold their cash for the short term while they decide if they want to put it into stocks, bonds or other investments. They also note that sweep accounts offer protection from the Federal Deposit Insurance Corp.

But the latest round of lawsuits over the policies make much of the fact that firms could easily secure better returns for clients simply by moving their uninvested cash into money markets and similar investment vehicles, many of which are now paying around 5%. Tim Welsh, the CEO of the industry consulting firm Nexus Strategy, said even if the Federal Reserve begins its long-awaited interest rate reductions, questions about cash sweeps policies are likely to remain common.

Many people expect the Fed to lower its main overnight lending rate for banks — now ranging between 5.25% and 5.5% — by a percentage point and a half at the most, or 150 basis points, over the next year or so. 

"And the current spread between money markets and cash sweeps for these cash-harvesting brokers is around 500 basis points, so [it's] still a huge difference in payouts," Welsh said. "Concerns will remain."

— This article has been updated to note that Bank of America has listed its cash sweeps policies as a possible regulatory risk.