Charles Schwab
嚜澧ase 15
Charles Schwab
Charles Hill
Introduction
In 1971, Charles Schwab, who was 32 at the time, set
up his own stock brokerage concern, First Commander.
Later he would change the name to Charles Schwab &
Company, Inc. In 1975, when the Securities and
?Exchange Commission abolished mandatory fixed commissions on stock trades, Schwab moved rapidly into
the discount brokerage business, offering rates that
were as much as 60% below those offered by full commission brokers. Over the next 25 years, the company
experienced strong growth, fueled by a customer centric
focus, savvy investments in information technology, and
a number of product innovations, including a bold move
into online trading in 1996.
By 2000, the company was widely regarded as one
of the great success stories of the era. Revenues had
grown to $7.1 billion and net income to $803 million,
up from $1.1 billion and $124 million respectively in
1993. Online trading had grown to account for 84% of
all stock trades made through Schwab, up from nothing
in 1995. The company*s stock price had appreciated by
more than that of Microsoft over the prior ten years.
In 1999, the market value of Schwab eclipsed that of
Merrill Lynch, the country*s largest full service broker,
despite Schwab*s revenues being more than 60% lower.
The 2000s proved to be a more difficult environment for the company. Between March 2000 and mid
2003 share prices in the U.S. tumbled, with the technology heavy NASDAQ index losing 80% of its value from
peak to trough. The volume of online trading at Schwab
slumped from an average of 204,000 trades a day in 2000
to 112,000 trades a day in 2002. In 2003 Schwab*s revenues and net income fell sharply and the stock price
tumbled from a high of $51.70 a share in 1999 to a
low of $6.30 in early 2003. During this period Schwab
?expanded through acquisition into the asset management
business for high net worth clients with the acquisition
on U.S. Trust, a move that potentially put it in competition with independent investment advisors, many of who
used Schwab accounts for their clients. Schwab also entered the investment banking business with the purchase
of Soundview Technology Bank.
In July 2004 founder and chairman Charles Schwab,
who had relinquished the CEO role to David Pottruck in
1998, fired Pottruck and returned as CEO. Before stepping down in 2008 he refocused the company back on
its discount brokering roots, selling off Soundview and
U.S. Trust. At the same time, he pushed for an expansion
of Schwab*s retail banking business, allowing individual
investors to hold investment accounts and traditional
bank accounts at Schwab. Schwab remains chairman of
the company.
In 2007每2009 a serious crisis gripped the financial
services industry. Some major financial institutions went
bankrupt, including Lehman Brothers and Washington
Mutual. The widely watched Dow Industrial Average
Index plunged from over 14,000 in October of 2007 to
6,600 in March 2007. Widespread financial collapse was
only averted when the Government stepped in to support
the sector with a $700 billion loan to troubled companies. Almost alone amongst major financial service firms,
Schwab was able to navigate through the crisis with relative ease, remaining solidly profitable and having no need
to place a call on Government funds. By 2010每2013 the
company was once again on a growth path, fueled by
School of Business, University of Washington, Seattle, WA 98105,
June 2013.
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Case 15 Charles Schwab
expanded offerings including the establishment of a market place for Exchange Traded Funds (EFTs). Schwab*s
asset base expanded at around 6% per annum during this
period. The major strategic question going forward was
how to continue to grow profitably in what remained a
challenging environment for financial service firms.
The Securities
Brokerage Industry1
A security refers to financial instruments, such as a stocks,
bonds, commodity contracts, stock option contracts, and
foreign exchange contracts. The securities brokerage industry is concerned with the issuance and trading of financial securities, as well as a number of related activities.
A broker*s clients may be individuals, corporations, or
government bodies. Brokers undertake one or more of the
following functions; assist corporations to raise capital by
offering stocks and bonds, help governments raise capital
through bond issues, give advice to businesses on their
foreign currency needs, assist corporations with mergers
and acquisitions, help individuals plan their financial future and trade financial securities, provide detailed investment research to individuals and institutions so that they
can make more informed investment decisions.
Industry Background
In 2011 there were 4,456 broker-dealers registered in the
United States, down from 9,515 in 1987. The industry is
concentrated with some 200 firms that are members of
the New York Stock Exchange (NYSE) accounting for
87% of the assets of all broker-dealers, and 80% of the
capital. The 10 largest NYSE firms accounted for almost
57.9% of the gross revenue in the industry in 2011, up
from 48% in 1998. The consolidation of the industry has
been driven in part by deregulation, which is discussed
in more detail below.
Broker-dealers make their money in a number of
ways. They earn commissions (or fees) for executing a
customer*s order to buy or sell a given security (stocks,
bonds, option contracts, etc). They earn trading income,
which is the realized and unrealized gains and losses on
securities held and traded by the brokerage firm. They
earn money from underwriting fees, which are the fees
charged to corporate and government clients for managing an issue of stocks or bonds on their behalf. They earn
84487_case-15_ptg01_hr_C210-C225.indd 211
C-211
asset management fees, which represent income from
the sale of mutual fund securities, from account supervision fees, or from investment advisory or administrative
service fees. They earn margin interest, which is the
interest that customers pay to the brokerage when they
borrow against the value of their securities to finance
purchases. They earn other securities related revenue
comes from private placement fees (i.e. fees from private equity deals) subscription fees for research services,
charges for advisory work on proposed mergers and acquisitions, fees for options done away from an exchange
and so on. Finally, many brokerages earn non-securities
revenue from other financial services, such as credit
card operations or mortgage services.
Exhibit 1 illustrates the breakdown between the various income sources for brokers in 2004, 2007 and 2011.
Of particular note is the surge in ※other securities revenue§ in 2007. This reflects the boom in private equity
deals, derivatives contracts, and associated fees that were
not executed through an exchange, and therefore were
unregulated. The high volume of derivatives, in particular, was a major factor in the 2008 turmoil in global financial markets, since many of the derivatives were tied
to mortgage-backed securities, the value of which collapsed during 2008.
Industry Groups
Brokerage firms can be segmented into five groups. First,
there are national full line firms, which are the largest full service brokers with extensive branch systems.
They provide virtually every financial service and product that a brokerage can offer to both households (retail
customers) and institutions (corporations, governments,
and other nonprofit organizations such as universities).
Examples of such firms include Merrill Lynch, Morgan
Stanley Smith Barney, and A.G. Edwards. Most of these
firms are headquartered in New York. For retail customers, national full line firms provide access to a personal
financial consultant, traditional brokerage services, securities research reports, asset management services,
financial planning advice, and a range of other services
such as margin loans, mortgage loans, and credit cards.
For institutional clients, these firms will also arrange
and underwrite the issuance of financial securities, manage their financial assets, provide advice on mergers and
acquisitions, and provide more detailed research reports
than those normally provided to retail customers, often
for a fee.
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Case 15 Charles Schwab
Exhibit 1
Brokers* Line of Business, as a Percentage of Revenues, 2004,
2007 and 2011
Item
2004 (%)
2007(%)
2011(%)
Commissions
16.5
8.2
17.4
Trading Gain
10.9
?2.9
1.0
0.9
0.0
10.5
6.6
12.4
Margin Interest
3.9
8.3
3.3
Asset Management Fees
8.8
6.1
17.4
Commodities
0.6
0.2
1.7
37.2
60.4
32.7
10
13.8
Investment Gain
Underwriting
Other Securities Revenue
Other Revenue
1.04
6.8
Source: SIFMA
Large investment banks are a second group. This
group includes Goldman Sachs. These banks have a limited branch network and focus primarily on institutional
clients, although they also may have a retail business
focused on high net worth individuals (typically individuals with more than $1 million to invest). In 2008
Lehman Brothers went bankrupt, a casualty of bad bets
on mortgage backed securities, while the large bank,
JP Morgan, acquired Bear Stearns, leaving Goldman
Sachs as the sole stand alone representative in this class.
A third group are regional brokers, which are full
service brokerage operations with a branch network in
certain regions of the country. Regional brokers typically
focus on retail customers, although some have an institutional presence.
Fourth, there are a number of New York City Based
brokers, who conduct a broad array of financial services,
including brokerage, investment banking, traditional
money management, and so on.
Finally, there are the discounters, who are primarily
involved in the discount brokerage business and focus on
executing orders to buy and sell stocks for retail customers. Commissions are their main source of business revenue. They charge lower commissions than full service
brokers, but do not offer the same infrastructure such
as personal financial consultants and detailed research
84487_case-15_ptg01_hr_C210-C225.indd 212
reports. The discounters provide trading and execution
services at deep discounts online via the Web. Many
discounters, such as Ameritrade and E* Trade, do not
maintain branch offices. Schwab, which was one of the
first discounters, and remains the largest, has a network
of brick and mortar offices, as well as a leading online
presence.
Earnings Trends
Industry revenues and earnings are volatile, being driven
by variations in the volume of trading activity (and
commissions), underwriting, and merger and acquisition activity. All of these tend to be highly correlated
with changes in the value of interest rates and the stock
market. In general, when interest rates fall, the cost of borrowing declines so corporations and governments tend
to issue more securities, which increases underwriting
income. Also, low interest rates tend to stimulate economic growth, which leads to higher corporate profits,
and thus higher stock values. When interest rates decline,
individuals typically move some of their money out of
low interest bearing cash accounts or low yielding bonds,
and into stocks, in an attempt to earn higher returns. This
drives up trading volume and hence commissions. Low
interest rates, by reducing the cost of borrowing, can also
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Case 15 Charles Schwab
increase merger and acquisition activity. Moreover, in a
rising stock market, corporations often use their stock as
currency with which to make acquisitions of other companies. This drives up drives up merger and acquisition
activity, and the fees brokerages earn from such activity.
The 1990s was characterized by one of the strongest
stock market advances in history. This boom was driven
by a favorable economic environment, including falling
interest rates, new information technology, productivity
gains in American industry, and steady economic expansion, all of which translated into growing corporate profits and rising stock prices.
Also feeding the stock market*s advance during the
1990s were favorable demographic trends. During the
1990s American baby boomers started to save for retirement, pumping significant assets into equity funds. In
1989 some 32.5% of U.S. households owned equities.
By 1999 the figure had risen to 50.1% (see Exhibit 2). In
1975, some 45% of the liquid financial assets of American
households were in financial securities, including stocks,
bonds, mutual funds, and money market funds. By 2011
this figure had increased to 72.6%. The total value of
Exhibit 2
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household liquid financial assets increased from $1.7
trillion to $25.6 trillion over the same period.
Adding fuel to the fire, by the late 1990s stock market
mania had taken hold. Stock prices rose to speculative
highs rarely seen before as ※irrationally exuberant§ retail
investors who seemed to believe that stock prices could
only go up made increasingly risky and speculative ※investments§ in richly valued equities.2 The market peaked
in late 2000 as the extent of overvaluation became apparent. It fell significantly over the next two years as the
economy struggled with a recession. This was followed
by a recovery in both the economy and the stock market,
with the S&P 500 returning to its old highs by October
of 2007. However, as the global credit crunch unfolded
in 2008, the market crashed, falling precipitously in the
second half of 2008 to return to levels not seen since the
mid 1990s. Although the market has since recovered, US
households still have less of their liquid financial assets
in stocks and mutual funds than at the peak of the 1990s
boom (see Exhibit 2).
The long stock market boom drove an expansion
of industry revenues, which for brokerages that were
Percentage of US Household Liquid Financial Assets held
in Equities and Mutual Funds 1990每2011
80
% of liquid financial assets
70
60
50
40
30
20
10
19
9
19 0
9
19 1
9
19 2
9
19 3
9
19 4
9
19 5
9
19 6
9
19 7
9
19 8
9
20 9
0
20 0
0
20 1
0
20 2
0
20 3
0
20 4
0
20 5
0
20 6
0
20 7
0
20 8
0
20 9
1
20 0
11
0
Equities
84487_case-15_ptg01_hr_C210-C225.indd 213
Mutual Funds
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Case 15 Charles Schwab
members of the NYSE, grew from $54 billion in 1990
to $245 billion in 2000. As the bubble burst and the
stock market slumped in 2001 and 2002, and brokerage
revenues plummeted to $144 billion in 2003, forcing
brokerages to cut expenses. By 2007 revenues had recovered again and were a record $352 billion. In 2008
the financial crisis hit and industry revenues contracted
$178 billion. In that year the industry lost $42.6 billion.
As of 2011 they remained depressed at $147 billion,
while industry profits were $7.7 billion.
The expense structure of the brokerage industry
is dominated by two big items: interest expenses and
compensation expenses (see Exhibit 3). Together these
account for about three quarters of industry expenses.
Interest expenses reflect the interest rate paid on cash
deposits at brokerages, and rise or fall with the size of
deposits and interest rates. As such, they are generally
not regarded as a controllable expense (since the interest rate is ultimately set by the U.S. Federal Reserve
and market forces). Compensation expenses reflect both
employee headcount and bonuses. For some brokerage firms, particularly those dealing with institutional
clients, bonuses can be enormous, with multi million
dollar bonuses being awarded to productive employees.
Compensation expenses and employee headcount tend
to grow during bull markets, only to be rapidly curtailed
once a bear market sets in.
Exhibit 3
As shown in Exhibit 4, which graphs the return
on equity in the brokerage industry between 1990 and
2011. The profitability of the industry is volatile, and
depends critically upon the overall level of stock market
activity. Profits were high during the boom years of the
1990s. The bursting of the stock market bubble in 2000每
2001 bought a period of low profitability, and although
profitability improved after 2002, it did not return to the
levels of the 1990s. The financial crisis and stock market crash of 2007每2009 clearly impacted profitability
for the industry.
Deregulation
The industry has been progressively deregulated since
May 1st, 1975, when a fixed commission structure on
securities trades was dismantled. This development
allowed for the emergence of discount brokers such
as Charles Schwab. Until the mid 1980s, however, the
financial services industry was highly segmented due to
a 1933 Act of Congress know as the Glass-Steagall Act.
This Act, which was passed in the wake of wide spread
bank failures following the stock market crash of 1929,
erected regulatory barriers between different sectors of
the financial services industry, such as commercial banking, insurance, saving and loans, and investment services
(including brokerages). Most significantly, Section 20
Expense Structure of Brokerages, 2000每2011
400,000
350,000
$ billions
300,000
250,000
200,000
150,000
100,000
50,000
Total Compensation
Interest Expense
11
20
10
20
09
20
08
20
07
20
06
20
05
20
04
20
03
02
20
20
01
20
20
00
0
Other Expenses
Source: SIFMA
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