Charles Schwab (SW 0.19%) has been under pressure in recent years as decades of high interest rates have weighed on its business. The financial services company, which relied heavily on low-interest deposits to finance its business, has struggled with falling bank deposits and has been forced to rethink its business model.
During the second-quarter earnings call, CEO Walt Bettinger said the bank will reduce its size over the next few years. Here’s why and what that means for the business going forward.
Charles Schwab focuses on low-cost financing
Bettinger said Charles Schwab would transfer excess deposits to third-party banks, which should help reduce the bank’s “capital intensity.” The move would also improve liquidity at the company, which has struggled with deposit outflows since the Federal Reserve began aggressively raising interest rates.
This move is probably Schwab’s best. The financial services company relied heavily on low-cost deposits in the 2010s, which helped it generate excellent returns on equity compared to peers. Its low-cost business model was fine because interest rates remained low for several years after the Great Recession.
However, this low-cost deposit model falters when interest rates rise. In 2017, the Federal Reserve began gradually raising its benchmark federal funds rate. While these rate hikes were not as aggressive as the central bank’s actions in recent years, Charles Schwab has had a problem with deposit outflows, known as “client cash sorting.”
Customers chose not to keep their deposits in low-interest bank accounts, but rather in high-interest savings accounts, certificates of deposit, or other relatively safe investments with a reasonable rate of return.
Image source: Getty Images.
The sorting of customer funds accelerated during the Federal Reserve’s aggressive interest rate policy
Schwab’s problem with sorting client funds was just a minor blip in 2017. But when the Federal Reserve started raising rates in 2022, the problem became much more comprehensive. In just over a year, the federal funds rate went from nearly zero to 5%, and suddenly high-yield savings accounts and other interest-bearing products became extremely attractive to investors.
The worst was from August 2022 to April 2023, when average deposits in Schwab’s bank accounts fell by $49.8 billion. That represents a 33% decline since the Fed’s rate hike cycle began. Although deposit outflows have slowed significantly, they continue to flow out of Schwab’s bank. This year alone, deposits in Schwab’s bank accounts have fallen another $10.3 billion to $85.1 billion.
As deposits declined, Schwab was forced to turn to more expensive funding sources, such as certificates of deposit and loans from the Federal Home Loan Bank, to ensure it had sufficient liquidity in case customers continued to withdraw money from their bank accounts. As a result, these higher costs have eroded Schwab’s net interest margins, which has weighed on the business in recent quarters.
This is what’s next for Schwab
Charles Schwab’s plan to downsize its bank will likely take years to complete, as the company plans to implement its plan throughout the interest rate cycle. As a result, many analysts have lowered their estimates for Schwab’s profit and net interest income over the next few years. According to The Fly, analysts at Bank of America He noted that the move marks “a 180-degree turn” in Schwab’s bank-centric strategy.
Schwab’s move will weigh on the company’s growth and earnings for years to come. However, I think it is the right decision for the company in the long run. Longer term, the risk is that inflation and interest rates will remain higher.
Massive structural changes have taken place in recent years. A move away from globalization and more protectionist policies, growing fiscal commitments and deficits, and increasing geopolitical tensions could maintain upward pressure on inflation. If this happens, inflation and interest rates are unlikely to return to the low levels of the 2010s.
Buy, sell or keep Charles Schwab?
Charles Schwab could see more volatility and lower returns over the next few years as it restructures its business. The stock price is around its 10-year average price-to-earnings and price-to-book ratios, so it’s not cheap. If you’re an investor, hold on, but I don’t see any reason for investors to rush into shares right now.
SCHW PE ratio data from YCharts
It’s good for Schwab that management recognizes that what worked in the past may not work in the future, and it’s taking much-needed steps to mitigate that risk going forward. This will take some time and could change some aspects of the business that you should pay close attention to in the coming quarters.
Charles Schwab is an affiliate of The Ascent, a Motley Fool company. Courtney Carlsen does not own any of the stocks mentioned. The Motley Fool owns and recommends Charles Schwab. The Motley Fool recommends the following options: short September 2024 $77.50 calls on Charles Schwab. The Motley Fool has a disclosure policy.
