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Case 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
Case 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 xed com- missions on stock trades, Schwab moved rapidly into the discount brokerage business, offering rates that were as much as 60% below those offered by full com- mission 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 dif cult environ- ment for the company. Between March 2000 and mid 2003 share prices in the U.S. tumbled, with the technol- ogy 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 rev- enues and net income fell sharply and the stock price tumbled from a high of $51.70 a share in 1999 to a
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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 competi- tion with independent investment advisors, many of who used Schwab accounts for their clients. Schwab also en- tered 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, red Pottruck and returned as CEO. Before step- ping 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 2007–2009 a serious crisis gripped the nancial services industry. Some major nancial 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 nancial collapse was only averted when the Government stepped in to support the sector with a $700 billion loan to troubled compa- nies. Almost alone amongst major nancial service rms, Schwab was able to navigate through the crisis with rela- tive ease, remaining solidly pro table and having no need to place a call on Government funds. By 2010–2013 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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expanded offerings including the establishment of a mar- ket 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 pro tably in what remained a challenging environment for nancial service rms.
the SecurItIeS Brokerage InduStry1
A security refers to nancial instruments, such as a stocks, bonds, commodity contracts, stock option contracts, and foreign exchange contracts. The securities brokerage in- dustry is concerned with the issuance and trading of nan- cial 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 nancial fu- ture and trade nancial securities, provide detailed invest- ment 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 rms 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 rms 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 rm. They earn money from underwriting fees, which are the fees charged to corporate and government clients for manag- ing an issue of stocks or bonds on their behalf. They earn
asset management fees, which represent income from the sale of mutual fund securities, from account supervi- sion 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 nance purchases. They earn other securities related revenue comes from private placement fees (i.e. fees from pri- vate equity deals) subscription fees for research services, charges for advisory work on proposed mergers and ac- quisitions, fees for options done away from an exchange and so on. Finally, many brokerages earn non-securities revenue from other nancial services, such as credit card operations or mortgage services.
Exhibit 1 illustrates the breakdown between the vari- ous income sources for brokers in 2004, 2007 and 2011. Of particular note is the surge in “other securities rev- enue” in 2007. This re ects 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 particu- lar, was a major factor in the 2008 turmoil in global - nancial markets, since many of the derivatives were tied to mortgage-backed securities, the value of which col- lapsed during 2008.
Industry groups
Brokerage rms can be segmented into ve groups. First, there are national full line rms, which are the larg- est full service brokers with extensive branch systems. They provide virtually every nancial service and prod- uct that a brokerage can offer to both households (retail customers) and institutions (corporations, governments, and other nonpro t organizations such as universities). Examples of such rms include Merrill Lynch, Morgan Stanley Smith Barney, and A.G. Edwards. Most of these rms are headquartered in New York. For retail custom- ers, national full line rms provide access to a personal nancial consultant, traditional brokerage services, se- curities research reports, asset management services, nancial planning advice, and a range of other services such as margin loans, mortgage loans, and credit cards. For institutional clients, these rms will also arrange and underwrite the issuance of nancial securities, man- age their nancial 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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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
Investment Gain
1.04
0.9
0.0
Underwriting
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
Other Securities Revenue
37.2
60.4
32.7
Other Revenue
6.8
10
13.8
Source: SIFMA
Large investment banks are a second group. This group includes Goldman Sachs. These banks have a lim- ited branch network and focus primarily on institutional clients, although they also may have a retail business focused on high net worth individuals (typically indi- viduals 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 insti- tutional presence.
Fourth, there are a number of New York City Based brokers, who conduct a broad array of nancial 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 custom- ers. Commissions are their main source of business rev- enue. They charge lower commissions than full service brokers, but do not offer the same infrastructure such as personal nancial consultants and detailed research
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 of ces. Schwab, which was one of the rst discounters, and remains the largest, has a network of brick and mortar of ces, 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 acquisi- tion 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 bor- rowing declines so corporations and governments tend to issue more securities, which increases underwriting income. Also, low interest rates tend to stimulate eco- nomic growth, which leads to higher corporate pro ts, 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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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 com- panies. 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 expan- sion, all of which translated into growing corporate prof- its 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 retire- ment, pumping signi cant assets into equity funds. In 1989 some 32.5% of U.S. households owned equities. By 1999 the gure had risen to 50.1% (see Exhibit 2). In 1975, some 45% of the liquid nancial assets of American households were in nancial securities, including stocks, bonds, mutual funds, and money market funds. By 2011 this gure had increased to 72.6%. The total value of
household liquid nancial assets increased from $1.7 trillion to $25.6 trillion over the same period.
Adding fuel to the re, 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 “in- vestments” in richly valued equities.2 The market peaked in late 2000 as the extent of overvaluation became ap- parent. It fell signi cantly 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 nancial 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
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Exhibit 2
Percentage of US Household Liquid Financial Assets held in Equities and Mutual Funds 1990–2011
80706050403020100
Equities
Mutual Funds
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% of liquid financial assets
1990 1991
1992 1993
1994 1995
1996 1997
1998 1999
2000 2001
2002 2003
2004 2005
2006 2007
2008 2009
2010 2011
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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 re- covered again and were a record $352 billion. In 2008 the nancial 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 pro ts 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 re ect 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 inter- est rate is ultimately set by the U.S. Federal Reserve and market forces). Compensation expenses re ect both employee headcount and bonuses. For some broker- age rms, 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.
As shown in Exhibit 4, which graphs the return on equity in the brokerage industry between 1990 and 2011. The pro tability of the industry is volatile, and depends critically upon the overall level of stock market activity. Pro ts were high during the boom years of the 1990s. The bursting of the stock market bubble in 2000– 2001 bought a period of low pro tability, and although pro tability improved after 2002, it did not return to the levels of the 1990s. The nancial crisis and stock mar- ket crash of 2007–2009 clearly impacted pro tability for the industry.
deregulation
The industry has been progressively deregulated since May 1st, 1975, when a xed 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 nancial 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 nancial services industry, such as commercial bank- ing, insurance, saving and loans, and investment services (including brokerages). Most signi cantly, Section 20
Exhibit 3
400,000 350,000 300,000 250,000 200,000 150,000 100,000
50,000 0
Source: SIFMA
Total Compensation Interest Expense
Other Expenses
Expense Structure of Brokerages, 2000–2011
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$ billions
2000 2001
2002 2003
2004 2005
2006 2007
2008 2009
2010 2011
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Exhibit 4
50 40 30 20 10
0
–10
–20
–30
–40
–50
Source: SIFMA
of the Act erected a wall between commercial banking and investment services, barring commercial banks from investing in shares of stocks, limiting them to buying and selling securities as an agent, prohibiting them from underwriting and dealing in securities, and from being af liated with any organization that did so.
In 1987, Section 20 was relaxed to allow banks to earn up to 5% of their revenue from securities underwriting. The limit was raised to 10% in 1989 and 25% in 1996. In 1999, the Gramm-Leach-Bliley (GLB) Act was past, which nalized the repeal of the Glass-Steagall Act. By removing the walls between commercial banks, broker- dealers, and insurance companies, many predicted that the GLB Act would lead to massive industry consolida- tion, with commercial banks purchasing brokers and in- surance companies. The rational was that such diversi ed nancial services rms would become one stop nancial supermarkets, cross-selling products to their expanded client base. For example, a nancial supermarket might sell insurance to brokerage customers, or brokerage services to commercial bank customers. The leader in this process
was Citigroup, which was formed in 1998 by a merger between Citicorp, a commercial bank, and Traveler’s, and insurance company. Since Traveler’s had already ac- quired Salmon Smith Barney, a major brokerage rm, the new Citigroup seemed to signal a new wave of consolida- tion in the industry. The passage of the GLB Act allowed Citigroup to start cross selling products.
However, industry reports suggest that cross selling is easier in theory than practice, in part because custom- ers were not ready for the development.3 In an apparent admission that this was the case, in 2002 Citigroup an- nounced that it would spin off Traveler’s Insurance as a separate company. At the same time, the fact remains that the GLB Act has made it easier for commercial banks to get into the brokerage business, and there have been several acquisition to this effect. Most notably, in 2008 Bank of America purchased Merrill Lynch, and JP Morgan Chase purchased Bear Stearns. Both of the acquired enterprises were suffering from serious nan- cial troubles due to their exposure to mortgage backed securities.
Return on Equity (%) Brokerage Industry, 1990–2011
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ROE (%)
1990199119921993199419951996199719981999200020012002200320042005200620072008200920102011C-216
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the growth of SchwaB
The son of an assistant district attorney in California, Charles Schwab started to exhibit an entrepreneurial streak from an early age. As a boy he picked walnuts and bagged them for $5 per 100 pound sack. He raised chicken in his backyard, sold the eggs door to door, killed and plucked the fryers for market, and peddled the manure as fertilizer. Schwab called it “my rst fully in- tegrated businesses”.4
As a child, Schwab had to struggle with a sever case of dyslexia, a disorder that makes it dif cult to process written information. To keep up with his classes, he had to resort to Cliffs Notes and Classics Illustrated comic books. Schwab believes, however, that his dyslexia was ultimately a motivator, spurring him on to overcome the disability and excel. Schwab excelled enough to gain admission to Stanford, where he received a degree in economics, which was followed by an MBA from Stan- ford Business School.
Fresh out of Stanford in the 1960s, Schwab embarked upon his rst entrepreneurial effort, an investment ad- visory newsletter, which grew to include a mutual fund with $20 million under management. However, after the stock market fell sharply in 1969, the State of Texas or- dered Schwab to stop accepting investments through the mail from its citizens because the fund was not registered to do business in the State. Schwab went to court and lost. Ultimately, he had to close his business, leaving him with $100,000 in debt and a marriage that had collapsed under the emotional strain.
the early days
Schwab soon bounced back. Capitalized by $100,000 that he borrowed from his uncle Bill, who had a success- ful industrial company of his own called Commander Corp, in 1971 Schwab started a new company, First Commander. Based in San Francisco, a world away from Wall Street, First Commander was a conventional bro- kerage that charged clients xed commissions for securi- ties trades. The name was changed to Charles Schwab the following year.
In 1974, at the suggestion of a friend, Schwab joined a pilot test of discount brokerage being conducted by the Securities and Exchange Commission. The discount brokerage idea instantly appealed to Schwab. He person- ally hated selling, particularly cold calling; the constant calling on actual or prospective customers to encourage
them to make a stock trade. Moreover, Schwab was deeply disturbed by the con ict of interest that seemed everywhere in the brokerage world, with stock brokers encouraging customers to make questionable trades in order to boost commissions. Schwab also questioned the worth of the investment advice brokers gave clients, feel- ing that it re ected the inherent con ict of interest in the brokerage business and did not empower customers.
Schwab used the pilot test to ne tune his model for a discount brokerage. When the SEC abolished mandatory xed commission the following year, Schwab quickly moved into the business. His basic thrust was to em- power investors by giving them the information and tools required to make their own decisions about securities in- vestments, while keeping Schwab’s costs low so that this service could be offered at a deep discount to the com- missions charged by full service brokers. Driving down costs meant that unlike full service brokers, Schwab did not employee nancial analysts and researchers who de- veloped proprietary investment research for the rm’s clients. Instead, Schwab focused on providing clients with third party investment research. These “reports” evolved to include a company’s nancial history, a smat- ter of comments from securities analysts at other broker- age rms that had appeared in the news and a tabulation of buy and sell recommendations from full commission brokerage houses. The reports were sold to Schwab’s customers at cost (in 1992 this was $9.50 for each report plus $4.75 for each additional report).5
A founding principle of the company was a desire to be the most useful and ethical provider of nancial services. Underpinning this move was Schwab’s own be- lief in the inherent con ict of interest between brokers at full service rms and their clients. The desire to avoid a con ict of interest caused Schwab to rethink the tradi- tional commission based pay structure. As an alternative to commission based pay, Schwab paid all of its employ- ees, including its brokers, a salary plus a bonus that was tied to attracting and satisfying customers and achieving productivity and ef ciency targets. Commissions were taken out of the compensation equation.
The chief promoter of Schwab’s approach to busi- ness, and marker of the Schwab brand, was none other than Charles Schwab himself. In 1977, Schwab started to use pictures of Charles Schwab in its advertisements, a practice it still follows today.
The customer centric focus of the company led Schwab to think of ways to make the company accessible to customers. In 1975, Schwab became the rst discount
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broker to open a branch of ce and to offer access 24 hours a day seven days a week. Interestingly, however, the de- cision to open a branch was not something that Charles Schwab initially embraced. He wanted to keep costs low and thought it would be better if everything could be managed by way of a telephone. However, Charles Schwab was forced to ask his Uncle Bill for more capi- tal to get his nascent discount brokerage off the ground. Uncle Bill agreed to invest $300,000 in the company, but on one condition, he insisted that Schwab open a branch of ce in Sacramento and employee Uncle Bill’s son in law as manager!6 Reluctantly Charles Schwab agreed to Uncle Bill’s demand for a show of nepotism, hoping that the branch would not be too much of a drain on the com- pany’s business.
What happened next was a surprise; there was an immediate and dramatic increase in activity at Schwab, most of it from Sacramento. Customer inquiries, the number of trades per day, and the number of new ac- counts, all spiked upwards. Yet there was also a puzzle here, for the increase was not linked to an increase in foot traf c in the branch. Intrigued, Schwab opened sev- eral more branches over the next year, and each time noticed the same pattern. For example, when Schwab opened its rst branch in Denver it had 300 customers. It added another 1,700 new accounts in the months fol- lowing the opening of the branch, and yet there was a big spike up in foot traf c at the Denver branch.
What Schwab began to realize is that the branches served a powerful psychological purpose—they gave customers a sense of security that Schwab was a real company. Customers were reassured by seeing a branch with people in it. In practice, many clients would rarely visit a branch. They would open an account, and exe- cute trades over the telephone (or later, via the Internet). But the branch helped them to make that rst commit- ment. Far from being a drain, Schwab realized that the branches were a marketing tool. People wanted to be “perceptually close to their money”, and the branches satis ed that deep psychological need. From 1 branch in 1975, Schwab grew to have 52 branches in 1982, 175 by 1992, and 430 in 2002. The next few years bought re- trenchment however, and Schwab’s branch fell to around 300 by 2008.
By the mid 1980s, customers could access Schwab in person at a branch during of ce hours, by phone day or night, by a telephone voice recognition quote and trad- ing service known as TeleBroker, and by an innovative proprietary online network. To encourage customers to
use TeleBroker or its online trading network, Schwab reduced commissions on transactions executed this way by 10%, but it saved much more than that because doing business via computers was cheaper. By 1995, Telebroker was handling 80 million calls and 10 million trades a year, 75% of Schwab’s annual volume. To service this system, in the mid 1980s Schwab invested $20 million in four regional customer call centers, routing all calls to them rather than branches. Today these call centers have 4,000 employees.
Schwab was the rst to establish a PC based on- line trading system in 1986, with the introduction of its Equalizer service. The system had 15,000 customers in 1987, and 30,000 by the end of 1988. The online system, which required a PC with a modem, allowed investors to check current stock prices, place orders, and check their portfolios. In addition, an “of ine” program for PCs enabled investors to do fundamental and technical analy- sis on securities. To encourage customers to start using the system, there was no additional charge for using the online system after a $99 sign up fee. In contrast, other discount brokers with PC based online systems, such as Quick and Riley’s (which had a service known as “Quick Way”), or Fidelity’s (whose service was called “Fidelity Express”) charged users between 10 cents and 44 cents a minute for online access depending on the time of day.7
Schwab’s pioneering move into online trading was in many ways just an evolution of the company’s early utilization of technology. In 1979, Schwab spent $2 mil- lion, an amount equivalent to the company’s entire net worth at the time, to purchase a used IBM System 360 computer, plus software, that was leftover from CBS’s 1976 election coverage. At the time, brokerages gener- ated and had to process massive amounts of paper to execute buy and sell orders. The computer gave Schwab a capability that no other brokerage had at the time; take a buy or sell order that came in over the phone, edit it on a computer screen, and then submit the order for process- ing without generating paper. Not only did the software provide for instant execution of orders, it also offered what were then sophisticated quality controls, checking a customer’s account to see if funds were available be- fore executing a transaction. As a result of this system Schwab’s costs plummet as it took paper out of the sys- tem. Moreover, the cancel and rebill rate—a measure of the accuracy of trade executions—dropped from an av- erage of 4 to 0.1%.8 Schwab soon found it could handle twice the transaction volume of other brokers, at less cost, and with much greater accuracy. With two years,
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every other broker in the nation had developed similar systems, but Schwab’s early investment had given it an edge and underpinned the company’s belief in the value of technology to reduce costs and empower customers.
By 1982, the technology at Schwab was well ahead of that used by most full service brokers. It was this com- mitment to technology that allowed Schwab to offer a product that was similar in conception to Merrill Lynch’s revolutionary Cash Management Account, which was introduced in 1980. The CMA account automatically sweeps idle cash into money market funds and allows customers to draw on their money by check or credit card. Schwab’s system, know as the Schwab One Account, was introduced in 1982. It went beyond Merrill’s in that it allowed brokers to execute orders instantly through Schwab’s computer link to the exchange oor.
In 1984 Schwab moved into the mutual fund business, not by offering its own mutual funds, but by launching a mutual fund marketplace, which allowed customers to in- vest in some 140 no-load mutual funds (a “no-load” fund has no sales commission). By 1990, the number of funds in the market place was 400 and the total assets involved exceeded $2 billion. For the mutual fund companies, the mutual fund marketplace offered distribution to Schwab’s growing customer base. For its part, Schwab kept a small portion of the revenue stream that owed to the fund com- panies from Schwab clients.
In 1986, Schwab made a gutsy move to eliminate the fees for managing Individual Retirement Accounts (IRAs). IRAs allow customers to deposit money in an ac- count where it accumulates tax free until withdrawal at retirement. The legislation establishing IRAs had been passed by Congress in 1982. At the time, estimates sug- gest that IRA accounts could attract as much as $50 billion in assets within ten years. In actual fact, the gure turned out to be $725 billion!
Initially Schwab followed industry practiced and col- lected a small fee for each IRA. By 1986 the fees amounted to $9 million a year, not a trivial amount for Schwab in those days. After looking at the issue, Charles Schwab him- self made the call to scrap the fee, commenting that “It’s a nuisance, and we’ll get it back.”9 He was right; Schwab’s No-Annual Fee IRA immediately exceeded the company’s most optimistic projections.
Despite technological and product innovations, by 1983 Schwab was scrapped for capital to fund ex- pansion. To raise funds, he sold the company to Bank of America for $55 million in stock and a seat on the bank’s board of directors. The marriage did not last long.
By 1987 the bank was reeling under loan losses, and the entrepreneurially minded Schwab was frustrated by banking regulations that inhibited his desire to introduce new products. Using a mix of loans, his own money, and contributions from other managers, friends and family, Schwab led a management buyout of the company for $324 million in cash and securities.
Six months later on September 22, 1987 Schwab went public with an IPO that raised some $440 million, enabling the company to pay down debt and leaving it with capital to fund an aggressive expansion. At the time, Schwab had 1.6 million customers, revenues of $308 million, and a pre tax pro t margin of 21%. Schwab announced plans to increase its branch network by 30% to around 120 of ces over the next year. Then on Monday, October 19, 1987, the United States stock market crashed, dropping over 22%, the biggest one day decline in history.
october 1987–1995
After a strong run up over the year, on Friday, October 16th the stock market dropped 4.6%. During the week- end, nervous investors jammed the call centers and branch of ces, not just at Schwab, but at many other bro- kerages, as they tried to place sell orders. At Schwab, 99% of the orders taken over the weekend for Monday morning were sell orders. As the market opened on Monday morning, it went into free fall. At Schwab, the computers were overwhelmed by 8am. The toll free number to the call centers was also totally overwhelmed. All the customers got when they called were busy signals. When the dust had settled, Schwab announced that it had lost $22 million in the fourth quarter of 1987, $15 million of which came from a single customer who had been unable to met margin calls.
The loss which amounted to 13% of the company’s capital, effectively wiped out the company’s pro t for the year. Moreover, the inability of customers to execute trades during the crash damaged Schwab’s hard earned reputation for customer service. Schwab responded by posting a two page ad in the Wall Street Journal on October 28th, 1987. On one page there was a mes- sage from Charles Schwab thanking customers for their patience, on the other an ad thanking employees for their dedication.
In the aftermath of the October 1987 crash, trading volume fell by 15% as customers, spooked by the vola- tility of the market, sat on cash balances. The slowdown
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prompted Schwab to cut back on its expansion plans. Ironically, however, Schwab added a signi cant number of new accounts in the aftermath of the crash as people looked for cheaper ways to invest.10
Beset by weak trading volume through the next 18 months, and reluctant to layoff employees, Schwab sought ways to boost activity. One strategy started out as a compliance issue within Schwab. A compliance of cer in the company noticed a disturbing pattern; a number of people had given other people limited power of attorney over their accounts. This in itself was not unusual—for example, the middle aged children of an elderly individual might have power of attorney over their account—but what the Schwab of cer noticed was that some individuals had power of attorney over dozens, if not hundreds of accounts.
Further investigation turned up the reason—Schwab had been serving an entirely unknown set of customers, independent nancial advisors who were managing the nancial assets of their clients using Schwab accounts. In early 1989 there were some 500 nancial advisors who managed assets totaling $1.5 billion at Schwab, about 8% of all assets at Schwab.
The advisors were attracted to Schwab for a number of reasons, including cost and the company’s commit- ment not to give advice—which was the business of the advisors. When Charles Schwab heard about this he immediately saw an opportunity. Financial advisors, he reasoned, represented a powerful way to acquire custom- ers. In 1989, the company rolled out a program to aggres- sively court this group. Schwab hired a marketing team and told them to focus explicitly on nancial planners, set apart a dedicated trading desk for them, and gave dis- counts of as much as 15% on commissions to nancial planners with signi cant assets under management at Schwab accounts. Schwab also established a Financial Advisors Service, which provided its clients with a list of nancial planners who were willing to work solely for a fee, and had no incentive to push the products of a par- ticular client. At the same time, the company stated that it wasn’t endorsing the planners’ advice, which would run contrary to the company’s commitment to offer no advice. Within a year, nancial advisors had some $3 billion of client’s assets under management at Schwab.
Schwab also continued to expand its branch network during this period, at a time while many brokerages, still stunned by the October 1987 debacle, were retrenching. Between 1987 and 1989 Schwab’s branch network in- creased by just ve, from 106 to 111, but in 1990 it opened up an additional 29 branches and another 28 in 1991.
By 1990s Schwab’s positioning in the industry had become clear. Although a discounter, Schwab was by no means the lowest price discount broker in the coun- try. Its average commission structure was similar to that of Fidelity, the Boston Based mutual fund company that had moved into the discount brokerage business, and Quick & Reilly, a major national competitor (see Exhibit 5). While signi cantly below that of full service brokers, the fee structure was also above that of deep discount brokers. Schwab differentiated itself from the deep discount brokers, however, by its branch network, technology, and the information (not advice) that it gave to investors.
In 1992 Schwab rolled out another strategy aimed at acquiring assets—OneSource, the rst mutual fund “supermarket”. OneSource was created to take advan- tage of America’s growing appetite for mutual funds. By the early 1990s there were more mutual funds than individual equities. On some days Fidelity, the largest mutual fund company, accounted for 10% of the trading volume on the New York Stock Exchange. As American baby boomers aged, they seemed to have an insatiable appetite for mutual funds. But the process of buying and selling mutual nds had never been easy. As Charles Schwab explained in 1996:
“In the days before the supermarkets, to buy a mutual fund you had to write or call the fund distributor. On Day Six, you’d get a prospectus. On Day Seven or Eight you call up and they say you’ve got to put your money in. If
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Exhibit 5
Commission Structure in 1990
Type of Broker
Average Commission Price on 20 trades averaging $8,975 each.
Deep Discount Brokers
$54
Average Discounters
$73
Banks
$88
Schwab, Fidelity and Quick & Reilly
$92
Full Service Brokers
$206
Source: E.C.Gottschalk, “Schwab forges ahead as other brokers hesitate”, Wall Street Journal, May 11th, 1990, page C1.
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you’re lucky, by Day Ten you’ve bought it. . . . It was even more cumbersome when you redeemed. You had to send a notarized redemption form.”11
One Source took the hassle out of owning funds. With a single visit to a branch of ce, telephone call, or PC based computer transaction, a Schwab client could buy and sell mutual funds. Schwab imposed no fee at all on investors for the service. Rather, in return for shelf space in Schwab’s distribution channel and access to the more than 2 million accounts at Schwab, Schwab charged the fund companies a fee amounting to 0.35% of the assets under management. By inserting itself between the fund managers and custom- ers, Schwab changed the balance of power in the mutual fund industry. When Schwab sold a fund through One Source, it passed along the assets to the fund managers, but not the customers’ names. Many fund managers did not like this, because it limited their ability to build a direct relationship with customers, but they had little choice if they wanted access to Schwab’s customer base.
One Source quickly propelled Schwab to the number three position in direct mutual fund distribution, behind the fund companies Fidelity and Vanguard. By 1997, Schwab customers could choose from nearly 1,400 funds offered by 200 different fund families and Schwab cus- tomers had nearly $56 billion in assets invested through One Source.
1996–2000: eSchwab
In 1994, as access to the World Wide Web began to dif- fuse rapidly throughout America, a two year old start- up run by Bill Porter, a physicist and inventor, launched its rst dedicated web site for online trading. The com- pany’s name was E*Trade. E*Trade announced a at $14.95 commission on stock trades, signi cantly below Schwab’s average commission which at the time of $65. It was clear from the outset that E* Trade and other on- line brokers, such as Ameritrade, offered a direct threat to Schwab. Not only were their commission rates consid- erably below those of Schwab, but the ease, speed, and exibility of trading stocks over the Web suddenly made Schwab’s proprietary online trading software, Street Smart seemed limited. (Street Smart was the Windows based successor to Schwab’s DOS based Equalizer pro- gram). To compound matters, talented people started to leave Schwab for E*Trade and its brethren, which they saw as the wave of the future.
At the time, deep within Schwab, William Pearson, a young software specialist who had worked on the devel- opment of Street Smart, quickly saw the transformational
power of the Web and believed that it would make pro- prietary systems like Street Smart obsolete. Pearson believed that Schwab needed to develop its own Web based software, and quickly. Try as he might, though, Pearson could not get the attention of his supervisor. He tried a number of other executives, but found sup- port hard to come by. Eventually he approached Anne Hennegar, a former Schwab manager that he knew who now worked as a consultant to the company. Hennegar suggest that Pearson meet with Tom Seip, an Executive Vice President at Schwab who was know for his ability to think outside of the box. Hennegar approached Seip on Pearson’s behalf, and Seip responded positively, asking her to set up a meeting. Hennegar and Pearson turned up expecting to meet just Seip, but to their surprise in walked Charles Schwab, his Chief Operating Of cer, David Pottruck, and the Vice Presidents in charge of stra- tegic planning and the electronic brokerage arena.
As the group watched Pearson’s demo of how a web based system would look and work, they became increasingly excited. It was clear to those in the room that a Web based system based on real time information, personalization, customization, and interactivity all ad- vanced Schwab’s commitment to empowering custom- ers. By the end of the meeting, Pearson had received a green light to start work on the project.
It soon transpired that several other groups within Schwab had been working on projects that were similar to Pearson’s. These were all pulled together under the control of Dawn Lepore, Schwab’s chief information of cer, who headed up the effort to develop the Web based service that would ultimately become eSchwab. Meanwhile, signi cant strategic issues were now beginning to preoccupy Charles Schwab and David Pottruck. They realized that Schwab’s established brokerage and a Web based brokerage business were based on very different revenue and cost models. The Web based business would probably cannibalize business from Schwab’s established brokerage operations, and that might lead people in Schwab to slow down or even derail the Web based initiative. As Pottruck later put it:
“The new enterprise was going to use a different model for making money than our traditional business, and we didn’t want the comparisons to form the basis for a measurement of success or failure. For example, eSchwab’s per trade revenue would be less than half that of the mainstream of the company, and that could be seen as a drain on resources rather than a response to what customer would be using in the future”.12
Pottruck and Schwab understood that unless eSchwab was placed in its own organization, isolated and protected
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from the established business, it might never get off the ground. They also knew that if they did not cannibalize their own business with eSchwab, someone would do it for them. Thus they decided to set up a separate organiza- tion to develop eSchwab. The unit was headed up by Beth Sawi, a highly regarded marketing manager at Schwab who had very good relations with other managers in the company. Sawi set up the development center in a unit physically separated from other Schwab facilities.
eSchwab was launched in May 1996, but without the normal publicity that accompanied most new products at Schwab. Schwab abandoned its sliding scale commis- sion for a at rate commission of $39 (which was quickly dropped to $29.95) for any stock trade up to 1,000 shares. Within two weeks 25,000 people had opened eSchwab accounts. By the end of 1997 the gure would sore to 1.2 million, bringing in assets of about $81 billion, or ten times the assets of E* Trade.
Schwab initially kept the two businesses segmented. Schwab’s traditional customers were still paying an average of $65 a trade while eSchwab customers were paying $29.95. While Schwab’s traditional customers could make toll free calls to Schwab brokers, eSchwab clients could not. Moreover, Schwab’s regular customers couldn’t access eSchwab at all. The segmentation soon gave rise to problems. Schwab’s branch employees were placed in the uncomfortable position of telling custom- ers that they couldn’t set up eSchwab accounts. Some eSchwab customers started to set up traditional Schwab accounts with small sums of money so that they could access Schwab’s brokers and Schwab’s information ser- vices, while continuing to trade via eSchwab. Clearly the segmentation was not sustainable.
Schwab began to analyze the situation. The compa- ny’s leaders realized that the cleanest way to deal with the problem would be to give every Schwab customer online access, adopt a commission of $29.95 on trad- ing across all channels, and maintain existing levels of customer service at the branch level, and on the phone. However, internal estimates suggested that the cut in commission rates would reduce revenues by $125 mil- lion, which would hit Schwab’s stock. The problem was compounded by two factors; rst, employees owned 40% of Schwab’s stock, so they would be hurt by any fall in stock price, and second, employees were worried that going to the web would result in a decline in business at the branch level, and hence a loss of jobs there.
An internal debate ranged within the company for much of 1997, a year when Schwab’s revenues surged 24% to $2.3 billion. The online trading business grew by
more than 90% during the year, with online trades ac- counting for 37% of all Schwab trades during 1997, and the trend was up throughout the year.
Looking at these gures, Pottruck, the COO, knew that Schwab had to bite the bullet and give all Schwab customers access to eSchwab (Pottruck was now run- ning the day to day operations of Schwab, leaving Charles Schwab to focus on his corporate marketing and PR role). His rst task was to enroll the support of the company’s largest shareholder, Charles Schwab. With 52 million shares, Charles Schwab would take the biggest hit from any share price decline. According to a Fortune article, the conversation between Schwab and Pottruck went something like this:13
Pottruck:
Schwab: Pottruck:
Schwab:
“We don’t know exactly what will happen. The budget is shaky. We’ll be winging it.”
“We can always adjust our costs”. “Yes, but we don’t have to do this now. The
whole year could be lousy. And the stock!” “This isn’t that hard a decision, because we really have no choice. It’s just a question of
when, and it will be harder later”.
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Having got the agreement of Schwab’s founder, Pottruck formed a task force to look at how best to imple- ment the decision. The plan that emerged was to merge all of the company’s electronic services into Schwab. com, which would then coordinate Schwab’s online and off line business. The base commission rate would be $29.95 whatever channel was used to make a trade— online, branch, or the telephone. The role of the branches would change, and they would start to focus more on customer support. This required a change in incentive systems. Branch employees had been paid bonuses on the basis of the assets they accrued to their branches, nut now they would be paid bonuses on assets they came in via the branch, or the Web. They would be rewarded for directing clients to the web.
Schwab implemented the change of strategy on January 15, 1998. Revenues dropped 3% in the rst quar- ter as the average commission declined from $63 to $57. Earnings also came in short of expectations by some $6 million. The company’s stock had lost 20% of its value by August 1998. However, over much of 1998 new money poured into Schwab. Total accounts surged, with Schwab gaining a million new customers in 1998, a 20% increase, while assets grew by 32%. As the year progressed, trading volume grew, doubling by year end. By the third quarter Schwab’s revenues and earnings were surging past ana- lysts’ expectations. The company ultimately achieved
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record revenues and earnings in 1998. Net income ended up 29% over the prior year, despite falling commission rates, aided by surging trading volume and the lower cost of executing trades over the Web. By the end of the year, 61% of all trades at Schwab were made over the Web. After its summer lows, the stock price recovered, ending the year up 130%, pushing Schwab’s market capitaliza- tion past that of Merrill Lynch.14
2000–2004: after the Boom
In 1998 Charles Schwab appointed his long time number two, David Pottruck, co-CEO. The appointment signaled the beginning of a leadership transition, with Schwab eas- ing himself out of day today operations. Soon Pottruck had to deal with some major issues. The end of the long stock market boom of the 1990s hit Schwab hard. The average number of trades made per day through Schwab fell from 300 million to 190 million between 2000 and 2002. Re ecting this, revenues slumped from $7.1 billion to $4.14 billion and net income from $803 million to $109 million. To cope with the decline, Schwab was forced to cut back on its employee headcount, which fell from a peak of nearly 26,000 employees in 2000 to just over 16,000 in late 2003.
Schwab’s strategic reaction to the sea change in market conditions was already taking form as the market implo- sion began. In January 2000, Schwab acquired U.S. Trust for $2.7 billion. U.S. Trust was a 149-year-old investment advisement business that manages money for high net worth individuals whose invested assets exceed $2 million. When acquired, U.S. Trust had 7,000 customers and assets of $84 billion, compared to 6.4 million customers and assets of $725 billion at Schwab.15
According to Pottruck, widely regarded as the archi- tect of the acquisition, Schwab made the acquisition be- cause it discovered that high net worth individuals were starting to defect from Schwab for money managers like U.S. Trust. The main reason; as Schwab’s clients got older and richer they started to need institutions that spe- cialized in services that Schwab didn’t offer—including personal trusts, estate planning, tax services, and private banking. With baby boomers starting to enter middle to late middle age, and their average net worth projected to rise, Schwab decided that it needed to get into this busi- ness or lose high net worth clients.
The decision though, started to bring Schwab into con ict with the network of 6,000 or so independent nancial advisors that the company has long fostered
through the Schwab Advisers Network, and who fun- neled customers and assets into Schwab accounts. Some advisors felt that Schwab was starting to move in on their turf, and they were not too happy about it.
In May 2002, Schwab made another move in this di- rection when it announced that it would launch a new service targeted at clients with more than $500,000 in assets. Know as Schwab Private Client, and developed with the help of U.S. Trust employees, for a fee of 0.6% of assets Private Client customers can meet face to face with a nancial consultant to work out an investment plan and return to the same consultant for further advice. Schwab stressed that the consultant would not tell clients what to buy and sell—that is still left to the client. Nor will clients get the legal, tax and estate planning advice offered by U.S. trust and independent nancial advisors. Rather, they get a nancial plan and consultation regard- ing industry and market conditions.16
To add power to this strategy, Schwab also an- nounced that it would start a new stock rating system. The stock rating system is not the result of the work of nancial analysts. Rather, it is the product of a computer model, developed at Schwab, that analyzes more than 3,000 stocks on 24 basic measures, such as free cash ow, sales growth, insider trades, and so on, and then assigns grades. The top 10% get an A, the next 20% a B, the middle 40% a C, the next 20% a D, and the lowest 10% an F. Schwab claims that the new system is “a systematic approach with nothing but objectivity, not in uenced by corporate relationships, investment banking, or any of the above”.17
Critics of this strategy were quick to point out that many of Schwab’s branch employees lacked the quali ca- tions and expertise to give nancial advice. At the time the service was announced, Schwab had some 150 quali ed nancial advisers in place, and planned to have 300 by early 2003. These elite employees required a higher salary than the traditional Schwab branch employees, who in many respects were little more than order takers and providers of prepackaged information.
The Schwab Private Client service also caused fur- ther grumbling among the private nancial advisors af l- iated with Schwab. In 2002 there were 5,900 of these. In total their clients amounted to $222 billion of Schwab’s $765 billion in client assets. Several stated that they would no longer keep clients’ money at Schwab. How- ever, Schwab stated that it would use the Private Client Service as a device for referring people who wanted more sophisticated advice than Schwab could offer to its
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network of registered nancial advisers, and particularly an inner circle of 330 advisers who have an average of $500 million in assets under management and 17 years of experience.18 According to one member of this group, “Schwab is not a threat to us. Most people realize the hand holding it takes to do that kind of work and Schwab wants us to do it. There’s just more money behind the Schwab Advisors Network. The dead wood is gone, and rm’s like ours stand to bene t from even more addi- tional leads”.19
In 2003 Charles Schwab nally stepped down as co- CEO, leaving Pottruck in charge of the business (Charles Schwab stayed on as chairman). In late 2003, Pottruck announced that Schwab would acquire Soundview Tech- nology Group for $321 million. Soundview was a boutique investment bank with a research arm that covered a couple of hundred companies and offered this research to institu- tional investors, such as mutual fund managers. Pottruck justi ed the acquisition by arguing that it would have taken Schwab years to build similar investment research capabilities internally. His plan was the have Soundview’s research bundles for Schwab’s retail investors.
2004–2008: the return
of charles Schwab
The Soundview acquisition proved to be Pottruck’s undoing. It soon became apparent that the acquisition has a huge mistake. There was little value to be had for Schwab’s retail business from Soundview. Moreover, the move had raised Schwab’s operating costs. By mid 2004, Pottruck was trying to sell Soundview. The board, which was disturbed at Pottruck’s vacillating strategic leader- ship, expressed their concerns to Charles Schwab. On July 15th, 2004, Pottruck was red, and the 66-year-old Charles Schwab returned as CEO.
Charles Schwab moved quickly to refocus the company. Soundview was sold to the investment bank UBS for $265 million. Schwab reduced the workforce by another 2,400 employees, closed underperforming branches, and removed $600 million in annual cost. This allowed him to reduce commissions on stock trades by 45%, and take market share from other discount brokers such as Ameritrade and E* Trade.
Going forward, Charles Schwab reemphasized the tradition mission of Schwab—to empower investors and provide them with ethical nancial services. He also reemphasized the importance of the relationships that Schwab had with independent investment advisors. He
noted: “Trading has become commoditized. The future is really about competing for client relationships”.20 One major new focus of Charles Schwab was the company’s retail banking business. This had been established in 2002, but it had been a low priority for Pottruck. Now Schwab wanted to make the company a single source for banking, brokerage, and credit card services—one that would give Schwab’s customers something of value: a personal relationship they could trust. The goal was to lessen Schwab’s dependence on trading income, and give it a more reliable earnings stream and a deeper rela- tionship with clients.
In mid 2007 Schwab’s reorientation back to its tradi- tional mission reached a logic conclusion when U.S. Trust was sold to Bank of America for $3.3 billion. Unlike in the past, however, Schwab was no longer earning the bulk of its money from trading commissions. As a percentage of net revenues, trading revenues (mostly commissions on stock trades) was down from 36% in 2002 to 17% in 2007. By 2007, asset management fees accounted for 47% of Schwab’s net revenue, up from 41% in 2002, while net interest revenue (difference between earned interest on as- sets such as loans and interest paid on deposits) was 33%, up from 19% in 2002.21 Schwab’s overall performance had also improved markedly. Net income in 2007 was $1.12 billion, up from a low of $396 million in 2003.
the great financial crisis and its
aftermath: 2008–2012
The great nancial crisis that hit the nancial services in- dustry in 2008–2009 had its roots in a bubble in housing prices in the United States. Financial service rms had been bundling thousands of home mortgages together into bonds, and selling them to investors worldwide. The purchasers of those bonds thought that they were buying a solid nancial asset with a guaranteed payout—but it turned out that the quality of many of the bonds was much lower than indicated by bond rating agencies such as Standard & Poor’s. Put differently, there was an unex- pectedly high rate of default on home mortgages in the United States.
At the top of the housing bubble, many people were paying more than they could afford to for homes. Banks were only to happy to lend them this money because they assumed, incorrectly as it turned out, that if the bor- rower faced default, the home could be sold for a pro t and the balance on the mortgage paid off. The aw in this reasoning was the assumption that the underlying
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asset—the house—could be sold and that home pric- ing would continue to advance. There had been massive overbuilding in the U.S. By 2007 home prices were fall- ing as it became apparent that there was too much excess inventory in the system. The net result; many suppos- edly high quality mortgage backed bonds turned out to be nothing more than junk and prices for these bonds fell precipitously. Institutions holding these bonds had to write down their value, and their balance sheets started to deteriorate rapidly. As this occurred, other nancial in- stitutions became increasingly reluctant to lend money to those institutions seen as being overexposed to the hous- ing market. Suddenly the banking system was facing a major credit crunch.
As the crisis unfolded, several major nancial insti- tutions went bankrupt, including Lehman Brothers (a major player in the market for mortgage backed securi- ties) and Washington Mutual (one of the nation’s largest mortgage originators). AIG, a major insurance company which had built a big business in the 2000s selling de- fault insurance to the holders of mortgage backed se- curities, faced massive potential claims and had to be rescued from bankruptcy by the U.S, Government. The Government took an 80% stake in AIG in return for pro- viding loans worth $182 billion. The U.S. Government also created a $700 billion fund—the Troubled Asset Relief Program—that banks could draw upon the shore up their balance sheets and meet short-term obligations. While these actions managed to arrest what was the most serious crisis to hit the global nancial system since the Great Depression of 1929, they could not stave off a sever and prolonged recession an
