Watching the latest round of argument around whether Charles Schwab is too big to fail in an environment of highly mobile bank deposits, I think the critics are chasing the wrong threat.
Sure, Schwab is not primarily a bank. Management made that extremely clear in their February activity report when they noted that this isn't the kind of institution that anchors loans against checking accounts.
The "pundits" Schwab management want to discredit have argued that significant paper losses on the company's bond portfolio make it vulnerable to the kind of deposit flight that took out Silicon Valley Bank. As CFO Peter Crawford put it, that argument doesn't add up.
Schwab doesn't need to actualize those losses to cover deposits because its lending activities revolve around margin accounts. Almost everything that matters is collateralized.
If those loans blow up, Schwab recoups the money from the brokerage account and the problem goes away. Meanwhile, the company is cheerfully collecting 11-13% annualized interest on the margin.
That business may dry up if investor sentiment finally craters. But so far, it's doing fine. There's no existential crisis here.
However, it's gotten a lot harder for the bank side to justify paying 0.4% on cash when Treasury bills deliver more than 4%. The cash sweep spread needs to come up to keep those assets from straying.
And we're talking about a lot of assets that have done a lot of straying. Schwab has seen its interest-bearing assets drop 20% over the last 12 months.
On one hand, the outflows are slowing. But they haven't stopped . . . and when there's about $600 billion at stake, even a little drag hits large scale fast.
Schwab has become a prisoner of its scale on the sweep side. I don't think absorbing TDA helped on that front. Two big players on the cash sweep became one much bigger entity more reliant on the spread than ever.
There isn't a lot of wiggle room. The bond portfolio pays 1.74% until maturity. Every basis point Schwab pays out narrows the spread and sucks net interest income off the earnings report.
That revenue is crucial to the whole operation. It's true of other banks as well, but at least Schwab has other levers to pull in order to fill the hole.
Margin activity is down closer to 30% over the past year. It's a relatively small piece of the overall operation and extremely reliant on client sentiment and assets. No immediate help there.
Management touts the existence of internal high-yield products on the platform as a way to curb deposit outflows. I'd love to hear more about how their internal fee flows are structured and how profitable they are.
Any time I hear about high-yield or "enhanced" retail income products I have flashbacks to the post-2008 death of Securities America when little issuers like Provident Royalties and Medical Capital blew out. Undoubtedly Schwab's shelf is better built . . . but I want to know how.
Because if these products are too good for clients, all they do is boost cash retention and preserve that narrow but crucial sweep spread. That's not a fate I wish on any company.
And the alternative is in plain sight. Schwab did more than just about any other company to eliminate commission drag as a real disincentive against active trading. What if management takes a hard look at the market and a deep breath . . . and raises commissions a little?
Institutional commissions and what advisors pay can stay where they are. But retail traders can pay a little more. After all, Schwab already rules that world. They won. What would happen if they cashed in on that victory?
That's a real position of confidence. It takes the pressure off the banking side while those bonds mature. It buys time and gives wounded rivals a chance to follow suit.
Think of interest rates. Moving up from zero to 0.25% wasn't huge in terms of absolute numbers, but it felt like an earthquake. Moving the commission flow could have a similar impact.
Only this time, the brokerage firms are the ones making the money. Until Schwab comes up with something like this, I think they'll stay under the cloud.
