Rising interest rates have challenged Charles Schwab's (SCHW -0.41%) business model, and the financial services company has seen a drastic fall in its bank account deposits in recent years.
Schwab's bank deposit outflows have slowed recently, and it is taking steps to make its business more resilient. Here's what you should know if you're considering buying Charles Schwab stock today.
Charles Schwab is changing its business
The higher interest rates weighed heavily on businesses that relied on low-cost deposits, like Charles Schwab. Before the Federal Reserve's aggressive interest rate hiking cycle began in 2022, Charles Schwab had more than $157 billion in bank account deposits. Over the past couple of years, Schwab's deposits have fallen 48% and now stand at $82 billion as of the end of the third quarter.
The downward trend accelerated into early 2023, and many worried that Schwab could be another financial institution in trouble. The financial services company had to rely on supplemental funding from the Federal Home Loan Bank (FHLB) to ensure it had enough liquidity in the face of falling deposit balances. These loans raised Schwab's funding costs and squeezed its net interest margin.
In its second-quarter earnings announcement, the company made a big change that will likely have an impact during the next several years. The company would begin sending its excess deposits to third-party banks to share in the economics of holding bank account deposits. Chief Executive Officer Walt Bettinger said the move will help improve the company's liquidity and "lower capital intensity."
Bank account deposits have been an important, low-cost funding source for Schwab for years. However, that has come back to bite it during times of rising interest rates. The move to shrink the size of its bank operation looks necessary, especially if we have to deal with higher interest rates than those seen throughout the 2010s decade.
Wealth and asset management are becoming more important
During its third-quarter earnings call, investors saw what could be in store for Schwab next. The company is working on paying down its higher-cost FHLB loans. During the quarter, Schwab's FHLB loans were at $22.6 billion, down $2.8 billion from Q2 and down $9.2 billion compared to last year. Paying down these borrowings has helped widen Schwab's net interest margin, from 1.94% last year to 2.08% in the third quarter.
In the quarter, Schwab's net revenue grew 5% to $4.8 billion. The growth was primarily driven by asset management fees, which increased more than 20% to $1.5 billion.
SCHW Revenue (Quarterly) data by YCharts
Asset and wealth management is becoming more important to Schwab's business. During its earnings call, Bettinger said, "We have been trying to do more in wealth, asset management, and lending to support our advisors."
More institutions have been chasing wealth and asset management because of the steady fee income that they provide. During the past year, Schwab has seen $346 billion in net new assets. The bull market in stocks has also benefited it, and its client assets have grown from $7.8 trillion to $9.9 trillion during the past year.
Buy, sell, or hold Schwab?
Schwab's move to shrink its banking business is painful but necessary, since there is a longer-term risk that inflation and interest rates will remain higher. That's because huge structural changes have taken place over the past several years.
Countries have been shifting toward more protectionist policies. That, coupled with growing fiscal obligations, government deficits, and rising geopolitical tensions, could all keep upward pressure on inflation. If that happens, inflation and interest rates could remain much higher than they were throughout the 2010s.
Today, the stock is priced at 2.8 times its book value, which is cheaper than its 10-year average of 3.5 times its book value. Current investors can continue to hold, but with a multiyear transformation under way, I think there are better stocks for investors to buy today.
