Charles Schwab & Co. hosted its "2022 Fall Business Update" last week where the main topic was "cash sorting," or the shifting of cash from lower-yielding sweep bank deposits into higher-yielding money market mutual funds. CFO Peter Crawford comments, "Bank deposits were down 10% sequentially due to client cash allocation decisions that were broadly consistent with our expectations, given the dramatic increase in rates.... Assuming the Fed funds rate exits 2022 at 4 1/2%, we'd expect to produce another 11 to 13% year over year increase in revenue consistent with the scenario we shared earlier. That reflects continued expansion of our net interest margin ... in Q4, a roughly 10 to 12% decline in average interest earning assets from December 2021 to December 2022, and net interest revenue higher than Q3, despite continued client cash allocation decisions and some limited and temporary borrowing from the FHB to fund some of those outflows."

He explains, "Looking ahead to 2023, we continue to see no reason that the magnitude of client cash sorting will be dramatically different than the last rising rate environment, suggesting balances trough at some point next year. We have ample sources of liquidity to support our clients and anticipate growth in both net interest margin and net interest revenue from Q4 of this year to Q4 of next year and beyond. And of course, you can expect that the higher pace of capital return we started in Q3 will continue. There's obviously been a lot of commentary, perhaps too much, on the topic of client cash sorting, and we continue to receive a lot of questions. I emphasize that this is a dynamic which we view as very much temporary, quite manageable, and not a factor in our long-term performance."

Crawford says, "I want to reiterate a few high-level observations regarding our current beliefs around sorting.... We've broken these into two categories regarding the pace of sorting and the ultimate magnitude of sorting. First, we have extensive data that suggests that the rate we pay on transactional cash has little or no impact on the pace or magnitude.... You're not going to see us change our sweep deposit pricing philosophy to catch up or to influence client behavior. We've also seen from experience and it's consistent with intuition that the pace of client cash reallocation decreases once the Fed stops hiking rates."

He continues, "Third, we have seen over time that clients seek to maintain a minimum level of transactional or sweep cash in their account, and as we reach that point any remaining client cash sorting is offset by organic cash inflows to both new and existing accounts.... Higher cash balance accounts tend to move earliest, and we've already seen them decrease their activity. And fifth, our client base today has a higher mix of clients who tend to maintain higher relative levels of transactional cash. Put all that together and we are confident that the activity we're seeing will abate, as we said in our recent CFO commentary, we believe we're now in the middle innings of this process."

Crawford adds, "There's also been a lot of speculation about what actions we may need to take to support these client cash allocation decisions. So we thought it'd be helpful to share a few facts. First, we have access to roughly $100 to $150 billion of readily available cash over the next 15 months, roughly half of that from excess cash on hand or that the investment portfolio will generate, and the other half from cash that comes in through our net new assets. Second, we also have access to a very large amount of funding from the FHLB, from retail CDs we're looking to offer and various forms of supplemental funding.... It's really important to recognize that even after we reach peak rates in this cycle, we have the ability to continue expanding our net interest margin over the following years as our fixed investment portfolio rolls over. And the NIM expansion would be additive to the through the cycle financial formula that we have delivered over the years, and I expect to continue moving forward."

On their Q3'22 earnings release, CFO Crawford notes, "Schwab's diversified financial model and a significant benefit from higher rates helped us convert ongoing success with clients into record total revenues of $5.5 billion, up 20% on a year-over-year basis. Net interest revenue increased by 44% to $2.9 billion, as rising rates helped our net interest margin to expand sequentially by 35 basis points to 1.97%. This movement more than offset the 6% contraction in interest-earning assets driven by clients' cash sorting behavior and their continued market engagement. Asset management and administration fees decreased 5% to $1.0 billion as the challenging equity markets weighed on client asset balances. Trading revenue also declined slightly to $930 million primarily due to a mix shift within client trading activity."

In a Schwab CFO Commentary, he tells us, "By now, you've had a chance to digest our recent earnings release, which discussed our strong business and financial performance in Q3. In our conversations following the release, we heard positive feedback on those results -- but also lingering questions around client cash sorting and the implications for our net interest margin and net interest revenue. In light of these questions, we wanted to reinforce a few points. The main takeaway is that we believe we're in a position to grow both our net interest margin and net interest revenue from Q3 2022 to Q4 2022 and on through Q4 2023, assuming that rates follow the current forward curve."

Crawford comments, "Why is that? Several reasons: We believe we're in the middle innings of client cash sorting, which we're tracing from May forward (remember April outflows were driven by tax season). While sorting activity has occurred faster than we expected at the beginning of the year, that is because the Fed increased rates much faster. That faster pace of sorting in 2022, however, does not change our view that the magnitude of sorting (relative to uninvested client cash) is unlikely to exceed our experience through the last rising rate cycle. And contrary to some perceptions, the net reduction in client cash on our balance sheet was actually less in September than we saw in August."

He states, "Our deposit betas (i.e., changes in our Bank Sweep rates versus changes in the Fed funds target rate) continue to be lower than the last cycle, and we see no reason for that to change. Clients at Schwab have access to a broad range of cash solutions (e.g., off balance sheet purchased money funds) that offer very attractive rates for their investment cash. For everyday cash, our Bank Sweep solution provides a rate that is currently far superior to the level offered within checking accounts at the big banks. What we have seen historically is that client interest in utilizing investment cash solutions is driven by the rate offered on those solutions and their own particular cash management priorities, rather than the specific rate offered on Bank Sweep. So while we expect to see marginal betas rise somewhat along with short-term rates, we do not anticipate a need to play 'catch up'."

The CFO also says, "Approximately 40% of our interest-earning assets are tied to shorter-term interest rates, and extension risk within our fixed securities portfolio is quite limited. Despite the dramatic increase in rates over the last three months, the duration of our overall investment portfolio remains at approximately 4 years -- with our AFS portfolio under 3.5 years. This reflects our focus on buying securities with less likelihood of slower paydowns in a rising rate environment. We expect to cover the vast majority of potential client cash sorting through cash on hand, cash generated from our investment portfolio, and organic cash brought to the firm as we attract new assets."

Finally, he adds, "We have ample access to additional sources of liquidity, including FHLB advances and potential retail CD issuance. We have used these in the past for temporary funding, and we'd expect to do so again. But our expectation is that any temporary usage won't account for more than a mid-single digit percentage of our interest-earning assets while in place, thereby limiting upward pressure on aggregate liability beta. Putting all this together, we expect to continue benefitting from rising rates in coming quarters -- delivering on growth and capital return as our financial formula helps build stockholder value through the cycle. We look forward to sharing our current perspectives with you at our Business Update on October 27."

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