Update on Schwab - Market Analysis for Jul 23rd, 2024

Written in conjunction with Renaissance Research.

Charles Schwab (SCHW) has recently reported its 2Q24 numbers and held a conference call. On the call, the company’s management announced several important strategic initiatives that should improve SCHW’s balance sheet and organic capital generation. The share price has fallen by more than 15% since then. In this article, we would like to take a closer look at what has happened and if there are any risks to SCHW’s long-term financial stability.

First and foremost, we would like to note that we are going to discuss SCHW’s long-term financial metrics rather than its near-term stock price performance. Those are completely different stories, and, in our view, SCHW’s share price is likely to remain under pressure in the coming months due to lower capital returns, near-term uncertainty around the company’s EPS, a premium valuation multiple, and rather negative investor sentiment. As we said, we will discuss how the initiatives announced by the management will affect the company’s long-term financial stability.

First, SCHW said it would modestly shorten its investment portfolio duration. Such a repositioning is likely to lead to some losses in the near term and will increase earnings volatility. However, this is a clear long-term positive, as it would make the company less sensitive to changes in interest rates and would reduce the maturity mismatch risk, which is still a major issue for larger U.S. banks. Importantly, this repositioning should reduce the volatility of capital levels, which are more important from a longer-term perspective than short-term earnings volatility.

The second initiative is to shrink the balance sheet of the corporation’s bank by optimizing excess deposits at third-party banks. As of the end of the first quarter, the loan-to-deposit ratio of the bank was 17%, much lower than that of the peer group, which was 63%. While we like banks with a lower loan-to-deposit ratio, most banks cannot efficiently operate with a loan-to-deposit ratio of less than 35–40%. Schwab Bank’s metric is too low, suggesting that it has a lot of excess deposits. This makes its balance sheet structure not optimal, which affects the bank’s NIM and eventually its profitability levels. For the first quarter of the year, Schwab Bank’s NIM was 66 bps, much lower than that of its peers, which was 257 bps. The ROE for 1Q24 was 4.1%, compared to 9.8% for the peers. The ROA for 1Q24 was 22 bps, compared to 92 bps for the peers.

As such, the group’s initiative to shrink the bank’s balance sheet is also a long-term positive, as it should improve the NIM and organic capital generation.

One might say that these placements at third-party banks create liquidity risk — i.e., if a bank that is being used for placing excess deposits has a liquidity issue, then this issue can result in contagion and lead to liquidity issues at Schwab itself. While this is a valid point, we note that brokerages do not disclose data on banks they are working with, and, at least, Schwab is transparent here, saying that they will work with TD Bank. In addition, Schwab will place only a portion of deposits at third-party banks, and, as we understand, Schwab Bank will still be used for sweeping money overnight.

The third initiative, which was likely the main reason for this sell-off in shares, was the group’s plan to utilize some of the liquidity it would otherwise use for share buybacks to reduce the bank’s supplemental borrowing. Here is what the group’s CFO said:

Now to the extent that we have capital in excess of what is needed to do that, we have throughout our history taken steps to return that to stockholders. That can be through increasing our dividend, which generally rises alongside earnings. That can be by redeeming outstanding preferreds to create additional dry powder for the future, especially preferreds that might be or might become relatively expensive, and that can also be, of course, through stock buybacks, which we do opportunistically. There is one additional consideration right now, which is to the extent that we have outstanding supplemental borrowing, we may choose to utilize some of the liquidity we'd otherwise use for buybacks to reduce some of that bank level debt. Now doing that reduces our reliance on non-business as usual funding sources, and given the relatively higher cost of the supplemental borrowing, it's likely more accretive to earnings in the near term, while preserving the capacity, the ability to implement stock repurchases at a later date. So by doing that, we can kind of have our cake and eat it too.

Source: Company data

Clearly, lower share buybacks mean lower EPS due to the so-called denominator effect, and it is a short-term negative for the share price. With that being said, from a longer-term perspective, this is a positive. This supplemental funding is expensive and is negative for the company’s NIM. As of the end of the second quarter, Schwab had $73B of supplemental funding, and, according to the company, a $5B decline in supplemental funding would increase the NIM by 6 bps. As such, that would eventually be positive for the profitability levels.

Bottom Line

We wrote a detailed report on Schwab, as well as on other large brokerages, and assessed the company using 20 different metrics. We do think that the proposed initiatives are accretive for the NIM and are positive for the group’s earnings generation from a longer-term perspective. Overall, we view Schwab as a good brokerage and a decent bank. From a relative standpoint, it's one of the better brokerages.

It is unlikely that Schwab will face any major issues due to these initiatives. With that being said, there is a reason why Schwab Bank did not make it into our Top-15 banks. As such, if you keep all your savings at Schwab, it would be good to do some diversification and look at safer banks. We also note that although TD Bank has a better balance sheet than some of the Top-10 U.S. banks, it still has quite a lot of issues.

At the end of the day, we're speaking of protecting your hard-earned money. Therefore, it behooves you to engage in due diligence regarding the banks which currently house your money.

You have a responsibility to yourself and your family to make sure your money resides in only the safest of institutions. And if you're relying on the FDIC, I suggest you read our prior articles which outline why such reliance will not be as prudent as you may believe in the coming years. 

It's time for you to do a deep dive on the banks that house your hard-earned money in order to determine whether your bank is truly solid or not. Details are in our due diligence methodology, outlined here.