The stock of massive brokerage firm and bank Charles Schwab (SCHW 0.46%) has come under intense selling pressure from the market this year, and is down more than 36%, which is worse than broader bank indexes.
Investors' concerns stem from the fact that Schwab has a large number of unrealized bond losses on its balance sheet and is seeing intense deposit pressure, as clients seek higher-yielding alternatives amid high interest rates.
Although I think Schwab can navigate this difficult environment, I also think that earnings could struggle this year and that there are uncertainties I would like to see abate. So I don't see a need for investors to rush into the stock despite the sell-off.
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Funding headwinds
Schwab's business model relies heavily on taking client cash amounts that are not being invested in the firm's brokerage accounts and sweeping them into bank accounts. This has typically generated low-cost deposits.
However, as interest rates have risen, clients are moving these excess cash balances into products that can earn 4% to 5% in the short term. As a result, Schwab has to replace these deposits with higher-cost funding.
In the first quarter of the year, Schwab saw bank deposits decline from more than $366 billion to around $326 billion. Year over year, bank deposits are down nearly $140 billion.
Schwab has simply let some deposits roll off, but it has also had to increase its borrowings from the Federal Home Loan Bank to more than $45 billion at quarter end, which is up from just about $12.5 billion at the end of 2022. It has to pay somewhere around 5% for those, whereas bank deposits from "sweep" accounts were only costing the bank an average interest rate of 0.73% in the first quarter.
These higher funding costs have started to cut into the money that Schwab makes from investing the bank deposits into loans and securities, which is its largest revenue source.
It has also seen greatly reduced fees from bank-deposit accounts that Schwab earned from moving sweep deposits into third-party banks. Overall, first-quarter revenue fell by 7% from the sequential quarter, and profits were down 16%.
What happens next
Management has seen some encouraging trends that the "cash sorting" to higher-yielding assets has slowed. Transactional cash per account, which largely consists of cash in sweep bank accounts and money market funds, hit a nearly 20-year low at just 4%, and that's through multiple rate-hiking cycles. And management said daily Schwab cash movement has declined in recent months, a trend that has continued in April.
That's good news, to be sure, but I do continue to wonder how sensitive sweep deposits will be to interest rates this year, given the Fed's pace of interest rate hikes. While all banks are experiencing deposit pressure, many traditional banks combine a retail consumer deposit base with smaller balances with larger commercial clients that use banks for multiple products such as cash and treasury management, and not solely for deposits. That makes those larger commercial clients more likely to stick with their traditional banks even if they could get somewhat higher rates from other financial institutions. Because most clients are primarily using Schwab for its investment capabilities, there's not the same level of stickiness.
Schwab might need to keep raising the interest it pays on bank deposits in its sweep accounts. Its 0.73% rate might not be enough to entice people if bond yields stay above 3%, so funding costs could keep rising, although Schwab will also eventually be able to reprice its securities portfolio and earn more interest to help offset higher interest paid on sweep accounts.
But the trajectory of interest rates and bond yields still could end up being higher than many believe, and the Fed might not end up cutting interest rates this year, either. The trajectory of the market is also uncertain, and many experts see a correction coming. If this happens and market sentiment gets worse, investing activity could slow due to fatigue and frustration.
Wait for clarity
While I do believe that Schwab has enough liquidity and capital to get through this difficulty, near-term earnings are likely to continue to struggle, and I view the environment as too uncertain to want to invest in the stock right now.
The banking industry is also still operating in the unknown when it comes to deposit costs. It's possible that these sweep accounts end up acting differently than they have over the past 20 years.
I see better opportunities in the banking sector to buy the dip right now, and I don't see the need for investors to rush into Schwab until the cash sorting stops for sure. If it happens soon, then great. But I think it's prudent to wait and see.
