Charles Schwab: the biggest US bank you have never heard of

Charles Schwab is best known as a discount brokerage firm and a pioneer of low-cost investing. But over the years it has quietly transformed itself into one of America’s largest banks by deposits.

Schwab’s latest results underscored the importance of this shift. The pandemic-era retail trading boom is over. Small investors are not trading as much these days. But the Texas-based firm is still making plenty of cash — as a banker.

The sharp rise in interest rates last year helped generate $10.7bn in net interest revenue at Schwab in 2022, a 33 per cent jump from the prior year. Net interest revenue accounted for more than half of total net revenue last year. Trading by contrast generated less than a fifth.

Schwab therefore raises the same questions over peaking net interest income as Main Street lenders. Free trading and slick services give clients incentives to park cash with Schwab. The worry is they will now chase higher returns.

At Schwab, these come in the form of something called “cash sorting”. This is when clients move their assets into higher-yielding cash and fixed-income alternatives. Some $279bn was parked in money-market funds offered by Schwab as of end of December. That is a 90 per cent jump from a year ago and is more than twice the $126.6bn in Schwab bank deposit accounts.

A year ago, deposits stood at $158bn, while money-market funds had just $146.5bn. While Schwab earns fees from money-market funds, it earns less than it would by putting clients’ idle cash to work itself.

Worries over its deposit base dragged Schwab shares down more than 3 per cent on Wednesday, cutting its market valuation to $150bn. But the stock remains up nearly a third over the past six months, compared with the 1 per cent gain for the KBW Bank index. Delivering an 18 per cent return on common equity helps.

Investors should take the long view on Schwab. It has an attractive, diversified business model that also embraces custody and wealth management. Overall, it looks like a winner.