Although the “disrupter” label is conventionally applied to big-tech platforms, Charles Schwab’s brokerage has been redefining this sector since its namesake first created discount brokerage in 1975. Now, its merger with TD Ameritrade is also transformational, marking the first major retail-finance takeover that recognizes the strategic reality of lower-for-longer under post-crisis capital, liquidity, and brokered-deposit regulation. Whether this transaction is good for shareholders or viable under antitrust consideration is for other analyses; here, I focus on one financial institution that saw change coming and beat it to the punch. In a highly-regulated sector, this is a vital strategic advantage as all too many learn the all too hard way.
Different though they are from banks, retail securities and asset-management companies face strategic challenge even greater than that of banks watching net interest margin fade into a zero profitability lower bound. For them, it means that fee-based revenue on actively-managed funds is a thing of the past. Passive investments now dominate retail holdings other than direct stock or bond purchases. Commissions sustained broker profitability during periods of market volatility when stock markets seem to rise ever higher, but stock-market stability leads to reduced trading and, far worse, stock dives lead to equity-investor retrenchment. All this makes commissions highly-cyclical. They have also shrunk under fierce competitive pressure siphoning off higher-balance accounts into fee-based products and leaving small investors to fend for themselves.
Bowing to the inevitable – indeed, advantaging itself well ahead of time – Schwab has already gone commission-free. As we recently noted, this is a big boost to small investors and, in concert with new fractional-share options, an impressive effort to encourage equity investing that reduces inequality, at least a little. However, zero-commissions also proved a big boost to Schwab, redefining retail brokerage as a business in which what were once ancillary services – not day-in, day-out trading revenue – boost profitability. TD Ameritrade apparently heard the church bells ring and decided to make a deal.
As with much else in modern finance, the ancillary businesses that are Schwab’s new rocket fuel are volume-dependent. Under the new tailoring rule, Schwab as a savings-and-loan holding company (SLHC) came under the scope of bank-like rules never previously imposed on most SLHCs. Schwab protested the proposal and lost. It thus faced three hard choices: shrink and eventually shrivel away, try to operate under the new regulatory framework despite lower-for-longer costs, or – the choice it of course made – strike first, grow big, and prove itself the retail broker that survives and even thrives in the new financial-policy construct.
Following the path we think successful non-bank applicants for insured-depository charters must also tread, Schwab has also recognized that being regulated like a bank means being a bank. This isn’t all that bad if one carefully designs the holding company because being a bank means having a large insured-deposit base that can generate profitability from the potent combination of low-cost sweep accounts and low-risk assets. Low-cost funds also provide fuel for additional lending business should Schwab decide to expand its mortgage or business-lending books for additional investment or investor-service objectives. However, its basic franchise doesn’t depend on financial intermediation or payment-system access so it’s business plan isn’t caught up in costly capital rules and at immediate risk from big-tech platforms.
Another advantage of an SLHC charter is the security this gives custody-banking customers. Schwab is now the largest custodian servicing independent investment advisers, holding $1.8 trillion in a business essentially created by another regulatory event: the Madoff scandal. TD Ameritrade also holds a large share of this market. Combined, custody banking is a formidable largely counter-cyclical profit engine unless or until Schwab grows so big that it is designated a GSIB and comes under the enhanced supplementary leverage ratio that bedevils diversified GSIBs with large custody-bank operations.
Even though Schwab is governed by bank-like rules, it is anything but bank-like in its ability to see a chance and take it. Schwab could falter as it consolidates its huge new operation, face stronger macroeconomic headwinds, or come a-cropper in a newly-vigilant antitrust environment. Even so, its takeover of TD Ameritrade is a game-changer not just for retail brokers, but also for retail banks: financial policy need not also be profitability destiny.