Charles Schwab(NYSE: SCHW) has been under pressure over the past couple of years as multidecade high interest rates have weighed on the business. The financial services company, which has relied heavily on low-cost deposits to fund its business, has struggled with declining bank deposits and has been forced to rethink its business model.
During its second-quarter earnings call, CEO Walt Bettinger said that the bank would reduce the size of its bank over the next several years. Here's why and what that means for the business going forward.
Charles Schwab has relied on low-cost funding
According to Bettinger, Charles Schwab would send excess deposits to third-party banks, which should help reduce the "capital intensity" of its bank. The move would also improve liquidity for the company, which has struggled with deposit outflows ever since the Federal Reserve began aggressively raising interest rates.
This move is likely the best one by Schwab. The financial services company relied heavily on low-cost deposits through the 2010s, which helped it achieve a stellar return on equity (ROE) compared to peers. Its low-cost business model was OK because interest rates stayed low for several years following the Great Recession.
However, this low-cost deposit model has struggled when interest rates rise. In 2017, the Federal Reserve began gradually raising its benchmark federal funds rate. Even though those rate hikes weren't as aggressive as the central bank's moves in recent years, Charles Schwab faced a problem with deposit outflows called "client cash sorting."
Customers decided that instead of keeping deposits in low-yielding bank accounts, they would take advantage of high-yield savings accounts, certificates of deposits, or other relatively safe assets with a decent yield.
Image source: Getty Images.
Client cash sorting accelerated during the Federal Reserve's aggressive interest rate policy
Schwab's client cash sorting problem was a blip on the radar in 2017. However, when the Federal Reserve began raising interest rates in 2022, the problem became much more extensive. In just over a year, the federal funds rate went from near zero to 5%, and suddenly, high-yield savings accounts and other interest-rate products became extremely attractive to investors.
The worst was from August 2022 through April 2023, when Schwab's average bank account deposit balances fell by $49.8 billion. From the start of the Fed's rate-hiking cycle, that represented a 33% decline. Although deposit outflows have slowed significantly, they continue to bleed out of Schwab's bank. This year alone, Schwab's bank account deposits have fallen another $10.3 billion, at $85.1 billion.
Its falling deposits forced Schwab to rely on higher-cost funding sources, like retail certificates of deposit and advances from the Federal Home Loan Bank, to ensure it had enough liquidity should customers continue moving funds from their bank accounts. As a result, these higher costs have eaten into Schwab's net interest margins, which have weighed on the business over the past few quarters.
Here's what's next for Schwab
Charles Schwab's move to shrink its bank will likely take years as it looks to execute its plan across the interest rate cycle. As a result, many analysts lowered their estimates for Schwab's earnings and net interest income over the next several years. According to The Fly, analysts at Bank of America noted the move "marks a 180-degree turn" in Schwab's bank-centric strategy.
Schwab's move will weigh on its growth and earnings over the next few years. However, I think it's the right decision for the company in the long run. There is a longer-term risk that inflation and interest rates will remain higher.
Massive structural changes have been happening for the past several years. A move away from globalization and more protectionist policies, growing fiscal obligations and government deficits, and rising geopolitical tensions could all keep upward pressure on inflation. If that happens, inflation and interest rates likely won't revisit the low levels seen during the 2010s.
Buy, sell, or hold Charles Schwab?
Charles Schwab could see more volatility and lower returns over the next few years as it remodels its business. The stock is priced right around its 10-year averages on price-to-earnings and price-to-book value, so it isn't cheap. If you're an investor, continue to hold, but I don't see a need for investors to rush in and buy shares right now.
SCHW PE Ratio data by YCharts
For Schwab, it's good that management acknowledges that what worked before may not work in the future, and it is taking much-needed actions to reduce this risk going forward. It will take time and could change some aspects of the business, which you'll want to pay close attention to over the next several quarters.
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Charles Schwab is an advertising partner of The Ascent, a Motley Fool company. Courtney Carlsen has no position in any of the stocks mentioned. The Motley Fool has positions in 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.
