I have recently leased an apartment with a friend, and we've subletted out a room to another girl and collected her security deposit. I want to store it in a savings account without touching it, but my co-lessee wants to invest it or otherwise use it as liquid cash until the subtenant moves out. The rationale is that it's such a low amount that it would be easy to make up by the time the lease is over, but I feel this is risky and improper. While banks use fractional-reserve and do not actually hold all of their deposits, we are not a bank. What is the correct way to handle this?
According to the New York Attorney General's Tenants' Rights Guide:
Landlords, regardless of the number of units in the building, must treat the deposits as trust funds belonging to their tenants and they may not co-mingle deposits with their own money. Landlords of buildings with six or more apartments must put all security deposits in New York bank accounts earning interest at the prevailing rate. Each tenant must be informed in writing of the bank’s name and address and the amount of the deposit.
So you have to keep it separate, you can't spend it, and if you own more than six units, you have to put it in a bank account. (The guide goes on to explain that the interest should be paid to the tenant.)
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Your tags say you are in New York. New York security deposit law requires that you store the security deposit in a banking institution. Additionally, the deposit must be stored in a separate account, not your own personal account. If the lease is for six months or more, the money must be stored in an interest-bearing account, though this is apparently not necessary if the property has fewer than six units.
Investing the money in e.g. a mutual fund would probably be illegal, and would be a bad idea anyway. If your investment turns out not to be profitable, you'd have to make up the difference. Security deposits are meant to be deposits, not investments. Besides, you have to pay interest on the deposit to your tenant; any interest over 1% must be given back to the tenant.