Charles Schwab touts new Fed stress test that shows its bank can weather a downturn, but it still remains vulnerable to upturn, analysts say
Morningstar calls Schwab's capital ratio increase from 2022 'great,' but test doesn't account for factors that sank Schwab stock during 2023 collapse of Silicon Valley and First Republic banks
6 min read- Schwab passed a Fed stress test simulating recession, aiming to reassure investors after 2023's banking turmoil.
- Analysts warn Schwab remains vulnerable if interest rates rise amid continued economic strength.
- Schwab plans to alter its banking strategy, relying more on third-party banks.
- Shares tumbled after net-interest income and bank deposits missed expectations.
Brooke's Note: I had partially forgotten the extraordinary events of March 2023 that took down Silicon Valley Bank and First Republic Bank and gave Schwab a major headache. Schwab had waved off concerns of lasting effects for over a year. See: Charles Schwab Corp. goes back on offense in banking -- promising to pump out discount loans with RIA help -- after rapid Fed rate hikes exposed extreme vulnerability in bank's asset base So I did a double-take when Schwab communicated not once but twice at the end of June about the passing of a routine stress test of its bank. I wondered if it was still a hot issue and began to contact sources about what to take away from these tests. They gave interesting answers about what the tests are not. Then today the Schwab earnings call centered on how Schwab is fundamentally changing how its banking business will be delivered going forward. I realized my double-take may well have been warranted.
The Charles Schwab Corp. scored high on a Federal Reserve “stress test,” measuring whether its bank can withstand weak economic conditions, but today's booming economy is the problem.
The Westlake, Texas, company, with $9.4 trillion of assets administered, put out a bylined article and a press release on June 28 about its capital buffer and how it withstood a simulated recession.
Schwab may have sought to reassure investors and clients about Schwab's bank, despite the crisis it faced in March 2023, when it was forced to write down assets. Shares plummeted to near $52 at the time.
Schwab shares tumbled more than 10% to close at $67.42 in today's (July 16) trading – and much of the bad news was bank-related.
Second quarter [ended June 30] net-interest income and bank deposits failed to meet expectations and the company may defer share buybacks “to reduce some of that bank-level debt,” the company reported.
CEO Walt Bettinger also broke the news on today's “Summer update” that Schwab intends to alter its banking strategy. Going forward, it will rely more upon third party banks, bettering the balance sheet but leading to a smaller in-house bank.
Experts also cautioned that Schwab could still be vulnerable to higher interest rates, if the economy continues on its current course, or picks up even more steam.
Risks remain
Charles Schwab Bank proved vulnerable in March a year ago, after the Fed hiked rates nine times in 12 months. Schwab, like other banks, "loaned" money largely by buying bonds, which triggered massive paper losses as rates rose. The practice remains in place. See: Charles Schwab Corp. gets over 'hump' after furious bond rally takes bite out Schwab Bank's $19.6 billion in unrealized losses, though debt overhang could still take a decade to erase
The latest economic indicators – stronger-than-expected June retail sales, a decline in year-over-year inflation to 3%, and moderating June employment growth (up 206,000 jobs) – continue to point to economic strength and sent the Dow Jones Industrial Average to a record high today (July 16).
Charles Schwab Corp. goes back on offense in banking -- promising to pump out discount loans with RIA help -- after rapid Fed rate hikes exposed extreme vulnerability in bank's asset base
"The [Federal Reserve] severe scenario imagines a major recession, which would include rate cuts," says Jonathan D. Holtoway, president of Ategra Capital Management.
"However, if Jamie Dimon’s scenario came true with even higher rates, that would severely challenge Schwab’s balance sheet.
“It’s like testing water and saying you didn’t find arsenic, and, therefore, the water is clean,” he said.
Holtaway is citing JPMorgan CEO Jamie Dimon's publicized scenario where high rates skyrocket even under depressed economic conditions.
“While market valuations and credit spreads seem to reflect a rather benign economic outlook, we continue to be vigilant about potential tail risks,” Dimon said in a statement.
Those tail risks include infrastructure spending, global crises and fiscal deficits, he added.
“Therefore, inflation and interest rates may stay higher than the market expects."
Story Timeline
Restrained view
To be clear, Schwab's CFO was restrained about what investors should take away from Q2 results of its stress test and hinted that the process of ‘enhancing’ capital levels was not over.
“Looking ahead, the firm’s priorities for managing capital remain unchanged: supporting profitable growth through the cycle, while also bolstering long-term stockholder value via our common dividend target and the opportunistic return of excess capital over time,” said Schwab Chief Financial Officer Peter Crawford.
Charles Schwab Corp. gets over 'hump' after furious bond rally takes bite out Schwab Bank's $19.6 billion in unrealized losses, though debt overhang could still take a decade to erase
“As we await the finalization of anticipated rule changes, we remain focused on continuing to enhance our strong capital levels," said Crawford, who announced his retirement in May, effective later in 2024.
Strong showing
Should the economy turn south leading to a recession, Schwab’s calculated stress capital buffer (SCB) remains well below the 2.5% minimum, according to the company.
These results included the Federal Reserve’s estimate of Schwab’s minimum capital ratios under the supervisory severely adverse scenario for the nine-quarter horizon beginning Dec. 31, 2023 and ending March 31, 2026, Schwab explained in a June 28 press release and a published byline article.
Michael Wong, an analyst at Morningstar applauded Schwab's strength in a research note. “Similar to the 2022 stress test, Charles Schwab did exceptionally well….
"In the severely adverse scenario, Schwab is modeled to incur $1.4 billion of loan losses, which is small when compared with the $27 billion of common shareholders’ equity the company had at the end of the first quarter of 2023," he wrote.
Remaining cautious
Jeffery Young, CEO of DeepMacro and former head of Japan market analysis for Salomon Brothers/Nikko Citigroup, declined to comment on Schwab specifically but cautions that contemporary “stress tests were designed to fight the last war.”
"In the Great Financial Crisis, the economy crashed, the stock market tanked, all sorts of credit instruments blew up and interest rates collapsed. We saw a mini-version of that in COVID.
"The problems that inflation caused for the banks in the 1970s --such as interest rate mismatch -- were long in the historical past.”
"If the bank holds a large amount of low-yielding government bonds -- partially because they almost have to meet 'high quality liquid asset' requirements -- they are exposed to interest rate risk.
“But the authorities generally believe that the issue this creates for banks is more about liquidity than solvency. These stress tests are designed to test for solvency (capital adequacy), whereas there are other tests for liquidity.”
Wong believes Schwab will remain cautious despite receiving the Fed's blessing for its bank.
“While Schwab is well capitalized according to the Fed’s stress test, we don’t expect the company to materially increase its dividend or share repurchase activity,” he writes.
“The company will likely retain capital until market scrutiny of unrealized losses on securities portfolios has gone away.”
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