With Declining Deposts, Is Schwab's Business Model at Risk?

Although mainly known as a broker, Charles Schwab’s financial products range from mutual funds to banking services. And just like Silicon Valley Bank, Schwab relies on customer deposits to earn yields. Is Schwab going to pay for this model in this hiking cycle?

Schwab Beats Low Expectations

Charles Schwab (SCHW) released its Q1 2023 earnings report on Monday. The brokerage delivered mixed results, with some concerns related to customer deposits. After all, it was the steady outflow of deposits from Silvergate that eventually finished the bank off. The outflow rapids from Silicon Valley Bank had the same outcome.

In the case of Schwab, its total bank deposits shrunk by 11%, going down from $366.7 billion in Q4 2022 to $325.7 billion in Q1 2023. This quarterly $41 billion deposit outflow is significant as a trend because Schwab’s revenue is mainly dependent on interest.

However, Schwab’s overall revenue increased this quarter by 9%, by $444 million. The bulk of the revenue comes from interest, at $4 billion out of a total $5.1 billion, aligned with market estimates. Schwab’s share in interest revenue went up significantly from 2022, at a 53.5% increase. The net interest revenue rose by 27%, from $2.18 billion to $2.77 billion.

Regarding net income, Schwab is also positive, up 14% from last year’s $1.4 billion to $1.6 billion this quarter. Overall, Schwab managed to beat market estimates in two ways:

  • Adjusted earnings per share (EPS) at 93 cents outperformed FactSet’s consensus of 90 cents.
  • Although the $41 billion deposit outflow is significant, as annualized 30% decrease, it was still less than expected.

One of Schwab’s key long-term shareholders, GQG Partners, left with $1.4 billion last month, according to the Financial Times’s report on Friday. Interestingly, the stated reason was not centered around concerns about Schwab’s weak fundamentals but around the “sentiment around banks,” according to GQG’s Mark Barker.

Is Schwab’s Business Model at Risk?

As is evident from Schwab’s revenue breakdown, the most prominent publicly-traded US brokerage relies on low-yield customer deposits, which it then deploys into sweep accounts. The primary function of these sweep accounts is to utilize idle cash by automatically transferring it into various investments, typically higher-yielding money market accounts.

In Scwab’s case, they paid 0.45% interest on sweep accounts. However, as the Fed turned monetary gears from a near-zero interest environment to nearly 5%, customers are no longer incentivized to keep their funds.

Schwab’s health then becomes more reliant on the deposit outflow acceleration rate. If it outpaces other sources of revenue, such as admin fees and trading revenue, Schwab would have to make up for the downturn with now-costlier loans. This is precisely what happened with Silvergate, as the bank had to sell securities at a loss to repay a $4.3 billion loan to the Federal Home Loan Bank (FHLB).

Presently, Schwab holds $14 billion in securities at an unrealized loss, mainly consisting of mortgage-backed securities (MBS), as the most common fixed-income investment in banks’ portfolios.  As for loans, Schwab increased borrowing from FHLB by 267.7%, from Q4 ’22’s $12.4 million to $45.6 million in Q1 2023.

Likewise, Schwab’s trading revenue decreased by 7.3% this quarter, from last year’s $963 million to $892 million. This is on top of implementing zero-fee trading in 2019 to remain competitive with other stock brokers, eventually leading to Schwab’s $22 billion acquisition of TD Ameritrade in October 2020.

With that said, Schwab did benefit from the Fed’s hiking cycle by expanding its net interest margin by 81 bps in Q1 2022, as the bank’s spread between interest income and interest expense. As noted, Schwab’s net interest revenue increased by 27%, to $2.8 billion, due to earning higher interest on their investments.

For now, Charles Schwab (SCHW) stock is neutral, at a 0.9% move over the week, staying steady at $52.19 per share. Year-to-date, Schwab shares lost 36.2% of their value.

This article originally appeared on The Tokenist

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