Charles Schwab wants to fix its struggling bank. Investors are skeptical.

Schwab’s playbook of making easy money on customer deposits was upended when interest rates rose rapidly and people moved their cash to chase higher yields. Now, Schwab is looking to change how it uses customer deposits, and make more money from lucrative services including loans and financial advice.

There is a lot riding on the makeover. While Schwab is the largest publicly traded U.S. brokerage, roughly half of its revenue comes from the bank. Banking helped Schwab cut trading fees over the years and eventually eliminate commissions on online stock trades.

Executives haven’t specified the timing or magnitude of potential changes, so it isn’t clear what Schwab’s bank will ultimately look like. Schwab has called 2024 a transition year, but the market is skeptical.

After a 17% pullback in 2023, Schwab’s stock is down 5.8% year to date, while the broader S&P 500 is up 17%.

“Their track record on execution over the last couple years has not been good as it relates to balance-sheet management," said Bill Katz, a research analyst at TD Cowen who downgraded his rating on Schwab after second-quarter earnings.

Schwab is in the midst of a C-suite shake-up. Chief Financial Officer Peter Crawford is retiring and is set to be succeeded on Oct. 1 by Mike Verdeschi, formerly Citigroup’s treasurer. Chief Operating Officer Joe Martinetto earlier this year became executive chairperson of Schwab Banks, and Bernie Clark, head of adviser services, moved to an advisory role.

A new plan for deposits

Banks make money off customer deposits in a variety of ways. At Schwab, the focus has largely been on investing the cash in such assets as Treasurys and mortgage-backed securities, and less so on making loans directly to consumers and businesses.

That strategy was squeezed when rates rose. The value of the longer-term bonds in Schwab’s investment portfolio declined, just as many customers moved their deposits into higher-yielding alternatives such as money-market funds. To avoid taking losses on its longer-term investments, Schwab had to turn to pricier short-term funding sources, such as borrowing from the Federal Home Loan Bank system.

Schwab is now looking to make its bank more nimble. On the company’s earnings call last month, Walt Bettinger, chief executive officer and co-chairman, said Schwab plans to put more of its investment portfolio into shorter-term assets. It might also offload more of its deposits to third-party banks.

“These various actions should lead—again, over time—to a bank that is somewhat smaller than our bank has been in recent years," Bettinger said.

By outsourcing deposits, Schwab can shrink its balance sheet and free up capital, which the company could reinvest into the business or return to shareholders by doing share buybacks.

“It provides us with greater flexibility," Crawford said in an interview.

Schwab already offloads some deposits to TD Bank, which offers a model for how such arrangements might work. TD Bank pays Schwab a monthly fee for the deposits, and Schwab pays a service fee to TD Bank.

The arrangement brought in about $153 million of revenue for Schwab in the second quarter, on average balances of $87 billion swept off its balance sheet. In comparison, Schwab made more than $2 billion of net interest revenue during the same period from a mix of assets, which were mostly funded by the bank deposits on its balance sheet.

Analysts largely believe the shift in bank strategy could benefit Schwab over time, but some question how Schwab would replace its interest-related earnings.

A Schwab spokesperson said that the company would only consider offloading more deposits if doing so was beneficial for customers and shareholders, and that such a move would take years.

Leaning into other revenue streams

Meanwhile, executives see plenty of room to use deposits for lending. Schwab only had about $40 billion of bank loans on its balance sheet in the latest quarter, compared with more than $250 billion of deposits. Those loans had an average interest rate of 4.4% in the second quarter.

Schwab’s bank loans are primarily mortgages, home equity lines of credit and pledged asset lines, which use customer portfolios as collateral. The company said it is investing in technology to streamline the loan application and approval process, and hiring experienced bankers to work on more-complex loans.

Another area Schwab wants to expand is its financial advice and wealth management services, which bring in fee-based revenue that isn’t as dependent on market conditions. Advice solutions brought in about $510 million in the second quarter, accounting for 11% of total revenue.

Schwab will be competing with such banking giants as JPMorgan Chase, Bank of America and Morgan Stanley. But Schwab thinks it has an advantage: former customers of TD Ameritrade, which the company acquired in 2020. Those customers were converted to Schwab accounts recently, and Schwab thinks it can get them to use more of its services.

Some analysts said Schwab won’t be able to shift its strategy until its balance-sheet troubles are behind it. In the second quarter, bank deposits continued to decline and Schwab was still paying off short-term borrowings.

Another headache: More than $150 billion of its balance sheet remained tied up in assets that are held to maturity, meaning they won’t be sold. Those assets earned an average yield of 1.7%, well below the Federal Reserve’s current benchmark interest rate of 5.25% to 5.5%.

“It all comes down to the bank," said Alex Blostein, an analyst at Goldman Sachs.