At Charles Schwab, Being a Big Bank Has Become a Big Problem

These days he has questions. Schwab has been buffeted by the crisis that’s engulfed US banks since the failure of Silicon Valley Bank. Its shares shed a third of their value in March, the worst monthly drop since 1987. Given all the headlines about the Westlake, Texas-based company’s woes, Thompson wondered if he should worry. “It was just scary, hearing that name more often,” he says.

That Schwab is part of the bank drama at all surprised many people. Ask what kind of business Schwab is, and you’ll almost certainly hear that it’s a stock brokerage. Or a wealth manager. Or a mutual fund company. But at the heart of the business there’s also a bank—in fact, it’s one of the nation’s largest, with deposits of more than $300 billion. The bank is a landing place for money that’s not in the market and provides checking and ATM cards, helping make the company a one-stop financial shop for its 34 million largely affluent customers.

Thompson ultimately concluded there was no reason to freak out. Securities held at Schwab—stocks and bonds, mutual funds, money-market shares and the like—are legally segregated from the company and are insulated from whatever happens in the bank. And bank accounts are protected by the Federal Deposit Insurance Corp. up to $250,000 per depositor, per bank and account type. (So couples with both single and joint accounts, for example, have even more coverage.) Schwab says 86% of its accounts are under insured limits.

Schwab’s executives like to call the company “a safe port in a storm” for its clients. But its bank unit now has Schwab itself navigating choppy waters. Like other banks, it’s seen the value of its assets fall as interest rates rise—with about $28 billion of unrealized losses sitting on its balance sheet at the end of last year. At the same time, depositors have moved their money in search of higher yields. Schwab is no SVB: Its customers aren’t concentrated in the jumpy world of tech startups, and a far greater percentage of its deposits are insured, so it’s not as vulnerable to a quick run for the exits. What Schwab faces instead is a slower-moving problem with no easy solution. Its bank could now be considered a burden, when before it was a key part of its success.

If Schwab were a store, it would be Walmart. It’s everywhere, and it’s packed with choices. Want to invest in Apple Inc. stock? Use a Schwab brokerage account. Need help saving for college? Talk to a Schwab adviser at one of its more than 400 branches. Looking for a cheap index investment? You can buy a Schwab exchange-traded fund, even if your broker is Fidelity or someone else. And you can easily buy other companies’ funds from Schwab’s site, too. Also akin to a big-box chain, it owes its success to one core principle: low costs.

Charles Schwab founded his eponymous company in the 1970s and made it a foil to Wall Street brokers. Taking advantage of the deregulation of brokerage commissions, he offered a steep discount on trading costs compared with what rivals charged and appealed to investors who wanted to pick stocks themselves rather than take advice from salespeople. As more Americans were pulled into investing by individual retirement accounts and a long stock market boom, Schwab flourished, because it recognized that even folks with money to spare don’t like to feel like they’re paying too much.

When Schwab veered a bit from that ethos in the dot-com bust and charged higher prices than competitors such as ETrade and Ameritrade, the founder himself swooped back into the business, replacing then-Chief Executive Officer David Pottruck. He set about cutting costs, and the company launched its folksy “Talk to Chuck” ads. Schwab introduced its bank in 2003. As the discount brokerage model became the way most people bought stocks, commissions across the industry kept falling. In 2019, Schwab followed the lead of upstart trading apps like Robinhood and dropped commissions to zero. That relentless drive to knock down prices is, in some ways, the root of Schwab’s present trouble.

If you ever wondered how the company makes money offering free trades, the bank is a big part of the answer. Schwab earns much of what it makes from “sweep” accounts, which hold uninvested dollars that are pushed from brokerage to bank accounts overnight. Schwab reinvests this cash, making a profit on the difference between the interest rate it pays the customer and the rate it earns.

After it began offering free trades, Schwab acquired TD Ameritrade. Then the pandemic set in, and retail trading went wild. Volumes at Schwab hit records. Deposits climbed, and the company needed to invest them. It plowed money into government bonds and US agency-backed mortgage securities. But when the Federal Reserve set out in 2022 on an aggressive campaign to curb inflation, interest rates rose sharply. Bonds fall in value when rates rise, so Schwab’s portfolio took a hit even though its credit quality was high.

Meanwhile, its depositors started shopping around. They’re the type. “Schwab has traditionally appealed to the self-directed investor—someone confident and sophisticated enough to make their own investment decisions,” says Jim Angel, a finance professor at Georgetown University. The company now pays customers 0.45% on its default cash deposit vehicles. But it’s easy to earn 10 times that in a money-market fund or a certificate of deposit. And since Schwab is a financial supermarket, you can make that switch right on the company’s website. In Wall Street jargon, when customers look for better yield on their uninvested dollars, it’s called “cash sorting,” but it’s also common sense. It’s behavior that’s typical of Schwab’s vigilant customers—in fact, the company says it encourages such reallocations.

Bank deposits at Schwab fell by $41 billion, to $325.7 billion, in the first three months of 2023—an 11% decline. Over the past year, deposits are down 30%. The company is shoring itself up by borrowing money at higher interest rates, becoming the largest borrower from the Federal Home Loan Bank of Dallas. It had borrowed a total of $45.6 billion from the FHLB by the end of March, up from $12.4 billion at yearend. Schwab had borrowed nothing from the FHLB system at the end of 2021. Wall Street worries this can’t be sustainable. Executives at Schwab say such borrowing is temporary.

Schwab is still profitable—it recently reported a 12% jump in adjusted net income from a year earlier. Executives say the customers’ cash movements already show signs of subsiding. CEO Walt Bettinger and a group of Schwab executives told investors on a call following the latest earnings report that customers tend to move cash out of sweep accounts in big, one-time chunks. They added that the assets usually stay within Schwab’s ecosystem, even when customers draw down deposits. Still, the company earns more on sweep accounts than it does on fees for money-market funds.

It’s not the first time Schwab’s treatment of customer cash got an awkward moment in the spotlight. Last year the company paid $187 million to regulators to settle allegations that its no-fee online “robo-adviser” service dragged down customer returns by allocating too much to cash. Schwab neither admitted nor denied the charges.

Schwab’s leadership has said there’s a “near-zero” chance they’d need to sell any of their hundreds of billions of dollars of debt securities before they mature. They say Schwab has plenty of cash flowing in to bolster liquidity and point to $300 billion of other funding sources, including its line of credit from the FHLB and the emergency support the Fed has offered all banks since the SVB collapse. Other sources of funding include CDs. Some $19 billion in Schwab CDs were sold via rival brokerages—inflows that buttressed its investor-services assets in the first quarter.

Where does Schwab go from here? One analyst toying with that question suggested it could offload its bank entirely as a last resort. Bettinger shot down that idea in an interview on CNBC. “It’s not something we’re going to look at in the short run,” he told the network. Schwab’s bank is almost certainly going to face a new regulatory landscape. The blowups of SVB and later Signature Bank have increased scrutiny of lenders that previously weren’t considered too big to fail. “We expect a high likelihood of regulatory change,” says Kyle Voigt, an analyst at Keefe Bruyette & Woods Inc.

Angel, the Georgetown professor, says investors holding Schwab shares will likely reassess the company’s prospects. But its customers? Angel is among their ranks, and he’s not moving his money away from Schwab. He says he’s confident knowing his deposits are FDIC-insured. “Let me put on my Schwab-customer-since-1983 hat,” Angel says. When it comes to the issues facing Schwab, “I don’t really give a bleep.”

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