Broadly speaking, higher interest rates are supposed to be beneficial to the financial sector. A handful of big banks reported sizable increases in last quarter's net interest income, for instance, thanks to the wider profit margins on loans made at elevated interest rates. However, brokerage firm Charles Schwab (SCHW 0.13%) hasn't been able to cash in on this trend. Its net interest income tumbled 23.5% year over year during the three-month stretch ending in September, dragging earnings down with it.
What gives?
The culprit is a quirk that's unique to the brokerage business. It's an important enough quirk, however, that investors would be wise to take a closer look at what just happened to Schwab, and how. It could happen again, and in the meantime, it likely is happening to competitors.
Not all brokerage firms' profit centers are equally profitable
For its recently ended fiscal third quarter, Charles Schwab turned $4.6 billion worth of revenue into a per-share operating profit of $0.77. Revenue was roughly in line with estimates, although down from the year-ago comparison of $5.5 billion. Profits were down from $1.10 per share a year earlier, yet Schwab shares rallied after the company topped analysts' estimates of $0.74 per share.
Still, what went so wrong, so fast?
Schwab's CFO Peter Crawford explains it as "cash realignment activity." Said more completely, the brokerage firm's customers are taking money out of lower-yielding cash equivalents that are more lucrative for Charles Schwab, and then putting that money into near-cash holdings that are less profitable for Schwab ... even if they're higher-yielding for the client.
The explanation, however, arguably lacks details investors want -- and need. The table below tells the rest of the story.
But first things first.
Believe it or not, trading commissions aren't the brokerage industry's big breadwinner any longer -- many firms offer commission-free trading these days. It's not mutual funds, either. While brokers do collect a quarterly payment for their client assets invested in a particular fund company's mutual fund, these payments are modest. A handful of brokerage outfits like Schwab and Fidelity also generate fee-based income by managing corporate retirement plans or serving the investment advisory market. Again, though, this isn't either company's biggest business.
Rather, most brokerages' biggest moneymaker is clients' cash balances.
Surprised? It would be a bit unusual if you weren't. The interest payments you collect on cash held at your bank or brokerage firm is minimal, after all, almost to the point of being pointless.
Brokerage houses are doing far better than you are with this money. That's because the idle cash you typically hold in what's often referred to as a "sweep" account produces oddly high returns for the broker serving as the custodian of your assets. If you want the higher-yielding options for your otherwise idle cash -- an option with much lower returns for your brokerage firm -- you must specifically purchase a "money market" mutual fund.
The only drawback to this arrangement? If you need this almost-cash to become liquid (say, to pay for a stock trade), you must also instruct your brokerage firm to sell some of this same money market fund.
This is trouble a large swath of Schwab's customers are now willing to go to, now that interest rates are high enough to matter. As the table below illustrates, Schwab's clients have been taking money out of their Schwab One and bank-like deposit balances, and putting that money to work in a true money market mutual fund. The company's bank deposits were down 30% year over year as of the end of Q3, while money market balances grew from $211 billion then to $436 billion now.
Image source: Charles Schwab Corporation's Q3 2023 10K filing.
Note that margin loans are also down, sapping a small piece of Charles Schwab's net interest income. In a similar vein, notice that the firm's clients' total fixed income holds (bonds, CDs, Treasuries, etc.) are also well up from year-ago levels. These are assets that likely won't be liquidated for a while, yielding Schwab nothing in the meantime.
Mostly, though, it's the shift from banking deposits to money market funds that's eating into Schwab's net interest income.
What investors need to do now
The good news is that this migration from more lucrative to less lucrative (for Schwab) assets is slowing. Crawford commented in conjunction with the company's Q3 report that "cash realignment activity decelerated further during the quarter -- even with the brief uptick in August and an increase in long-term interest rates."
Data source: Charles Schwab Corp. Chart by author. Figures are in billions of dollars.
Take the optimism with a grain of salt, of course; a company's executives tend to put their employer's best foot forward. There's still more than $450 billion worth of cash in near-cash sweep accounts that could easily be converted into money market holdings.
There's a much bigger takeaway for investors, though -- two of them, actually. First, other brokerages that don't manage an in-house lending business or operate their own bank are likely facing the same headwind. Second, if you've got a brokerage account with a large stash of uninvested cash, you might want to make sure you're getting the best possible return on this money. Your brokerage firm probably won't suggest an option that crimps its own bottom line. That doesn't mean they don't offer true money market funds, however.
In the meantime, Schwab stock is arguably more of a buy than not, despite the lingering risk of more of its clients redirecting money from bank and bank-like deposits into money market funds. Crawford's optimism is justified in this light, even if the shift is merely slowing rather than reversing.
