Past CFO Commentary

Today we released our November Monthly Activity Report.  While we produced another month of solid client metrics, we have no illusions about another press release stealing the show later this week.  As you know, the Federal Reserve is widely anticipated to begin raising interest rates on December 16th.  We have seen economic and employment reports meet expectations, FOMC minutes evolve, and member speeches show increasing conviction.  While it's impossible to be certain about what will be announced on the 16th or how Fed actions will unfold, we thought it might be a good time to review our comments on the revenue impact of rising interest rates, and specifically to discuss how we would expect the effects of an initial rate hike in December to unfold.
 

There are two main areas where the rate environment has a revenue impact – our money market mutual funds, and the interest-bearing assets and liabilities on our balance sheet.  Let's begin with our money market funds.  As rates rise, the fee waivers we are currently granting clients will decrease; waivers totaled $166 million last quarter, or $664 million annualized.  The average management fee across our $160 billion in money funds (as of Q3) was 59 basis points versus an average yield of 18 basis points, and the weighted average maturity of investments is currently 43 days.  Given that the money funds will have investments pricing or repricing daily, we anticipate that portfolio yields will improve as soon as short term rates react to any Fed move. We should note that short term rates have already been rising in anticipation of an approaching rate hike, which means that some of the rate hike benefit is already being realized.
 

There obviously wouldn't be much room for a significant impact on fourth quarter results, but the relatively short duration of these portfolios means that we'd be capturing the vast majority of a December rate hike as the first quarter progressed. As we've been saying, we expect the industry, including Schwab, to retain any incremental yield improvement until the waivers are eliminated.  While most of our money funds carry fees that are at least 25 basis points higher than current yields, a few carry lower fees that will be met within the first 25 basis points of rate increase; a majority will cap out if we see a second 25 basis point increase.
 

Turning to the potential balance sheet impact, the "coiled spring" we've been talking about for most of my tenure as CFO remains very much in place, growing over the years in keeping with the growth in our business.  As you'll remember, we have shared that, assuming a parallel shift in the yield curve, we expect to see 60 basis points of Net Interest Margin ("NIM") improvement on our interest-bearing assets for every 100 basis points of Fed Funds rate increase, and that the same goes for the next 100 basis points.  For reference, our third quarter 2015 NIM was 1.57%.  To the extent rate increases occur in smaller doses, say 25 basis points at a time, we'd expect the NIM improvement to be roughly proportionate to that 60-per-100 rule of thumb.
 

This sensitivity comes from the way we have deliberately engineered our balance sheet so that the majority of our interest-bearing assets and liabilities are tied to the shorter end of the yield curve.  The only places on the asset side of our balance sheet where we allow average duration beyond approximately 90 days are Schwab Bank's investment portfolio, where about half of the total is invested in longer-dated assets, and the mortgages in the Bank's loan book – altogether about 35-40% of the company's interest-bearing assets.  You'll also remember that we manage the rate we pay on the vast majority of our interest-bearing liabilities, with the most notable exception being the modest amount of fixed-rate debt employed in our capital base.  The net result is that the yield on interest-bearing assets will rise faster than the cost of supporting balances as market rates rise.  As with the money funds, we have assets pricing or repricing daily, so the NIM improvement is starting already and will continue as floating-rate assets reprice and short-term assets mature and are reinvested.  It will take a quarter or two for the majority of the rate hike effect to be felt, and well over a year before the full effect shows up.
 

Finally, while this may not be an issue for a while, I should repeat that once short term rates get to 2% or so, we anticipate that market forces will lead to lower incremental NIM on further rate increases, as we expect competitive pressures to mount for deposits, causing their rates to move up more quickly in response to market movements.
 

So that's the revenue side.  We know that you're also interested in how we'll approach expense management once rates start to rise, but we'll need to wait until the Winter Business Update in early February to discuss our thinking more fully.  For now, I've already shared our broad brush thinking about 2016 expense growth in a no-rate-hike scenario – somewhere above our 2015 growth rate but south of double digits.  Where our 2016 spending plan goes from there will depend on multiple factors, including the Fed's December decision and our best read on the expected timing and pace of future Fed actions.  We continue to maintain a prioritized list of areas where we can increase investment to drive stronger long-term growth and build stockholder value; at the same time we continue to expect to deliver a substantial portion of rate-hike related revenue growth to pre-tax profit as the process of raising rates begins.
 

After all these years and multiple head fakes, we've become well versed in talking to you about hypothetical rate increases and their impact.  Here's hoping that the "uncoiling" of the spring soon becomes a reality.  We look forward to updating you on our evolving financial picture at the Winter Business Update.

Forward-looking statements

This commentary contains forward-looking statements relating to a December 2015 interest rate increase by the Federal Reserve; expectations regarding the effects of a December 2015 and other interest rate increases, including the impact and timing of impact on money market fund fee waivers and portfolio yields and net interest margin improvement; the retention of incremental yield improvement; the yield on interest-bearing assets rising faster than the cost of supporting balances; 2016 expense growth; and delivering rate-hike related revenue growth to pre-tax profit.
 

Important factors that may cause such differences include, but are not limited to, general market conditions, including the level of interest rates; competitive pressures on rates and fees; client sensitivity to interest rates; the volume of prepayments in the company's mortgage-backed securities portfolio; the company's ability to manage expenses; and other factors set forth in the company's most recent reports on Form 10-K and Form 10-Q.