Charles Schwab: Buy, Sell or Hold?

Charles Schwab (SCHW 0.19%) has been under pressure for the past two years as decades of high interest rates have hurt the business. The financial services company, which has relied heavily on low-cost deposits to fund its businesses, has struggled with declining bank deposits and had to rethink its business model.

During the second-quarter earnings call, CEO Walt Bettinger said the bank will reduce the size of its bank over the next few years. Here’s why and what this means for business going forward.

Charles Schwab relied on low-cost funds

According to Bettinger, Charles Schwab would send excess deposits to third-party banks, which should help reduce his bank’s “capital intensity.” The move would also improve the company’s liquidity, which has been struggling 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 until 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 after the Great Recession.

However, this low-cost deposit model has run into trouble 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 “customer cash sorting.”

Customers have decided that instead of keeping deposits in low-yielding bank accounts, they will take advantage of high-yielding savings accounts, certificates of deposit or other relatively safe assets with a decent yield.

Image source: Getty Images.

Sorting out customer cash accelerated amid the Federal Reserve’s aggressive interest rate policy

Schwab’s customer cash sorting problem was a problem in 2017. However, when the Federal Reserve began raising interest rates in 2022, the problem became much more widespread. In just over a year, the federal funds rate went from near zero to 5 percent, 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 Schwab’s average bank account deposit balances fell by $49.8 billion. Since the start of the Fed’s rate hike cycle, this has represented a 33% decline. Although deposit outflows have slowed significantly, they continue to flow out of Schwab’s bank. This year alone, Schwab’s bank account deposits fell another $10.3 billion to $85.1 billion.

The drop in deposits has forced Schwab to rely on higher-cost funding sources, such as retail certificates of deposit and advances from Federal Home Loan Bank, to ensure it has enough liquidity if customers continue to move funds from their bank accounts. As a result, these higher costs hurt Schwab’s net interest margins, which have hurt the business in recent quarters.

Here’s what’s next for Schwab

Charles Schwab’s move to shrink its bank will likely take years as it tries to execute its plan through the interest rate cycle. As a result, many analysts have lowered their estimates for Schwab’s earnings and net interest income over the next few years. According to The Fly, analysts at Bank of America noted that the move “marks a 180-degree turn” in Schwab’s bank-centric strategy.

Schwab’s move will hurt its growth and earnings over the next few years. However, I believe it is the right decision for the company in the long run. There is a long-term risk that inflation and interest rates will remain higher.

Massive structural changes have taken place in recent years. Moving away from globalization and more protectionist policies, rising fiscal obligations and government deficits, and rising geopolitical tensions could keep upward pressure on inflation. If this happens, inflation and interest rates may not return to the low levels seen in the 2010s.

Buying, selling or owning Charles Schwab?

Charles Schwab could see more volatility and lower returns over the next few years as it reshapes its business. The stock price is around its 10-year price-to-earnings and price-to-book average, so it’s not cheap. If you’re an investor, keep holding, but I don’t see the need for investors to rush out and buy shares right now.

SCHW PE report data by YCharts

For Schwab, it’s good that management recognizes that what worked in the past may not work in the future and is taking much-needed steps to reduce that risk in the future. It will take time and could change some aspects of the business that you will want to pay close attention to in the coming quarters.