March 2023 (Part II) – Charles Schwab Risk and Your Potential Exposure

Dear Investors and Friends,

Following up on yesterday’s letter that dealt with developing a better understanding of the risk of failure at a bank, we received several questions from clients regarding the relative safety of their assets custodied at a broker-dealer custody bank in general, and Charles Schwab in particular, since that is where most of our clients’ assets are custodied.  For everyone to have the benefit of the analysis, below we discuss Schwab’s recent volatility in the equity markets, its financial health, and your brokerage account’s exposure in the highly unlikely, but nonetheless possible event that Schwab, or any other broker-dealer custody bank, were to fail.

Schwab equity volatility

Charles Schwab’s shares fell as much as 23% Monday morning, following a 24% drop the previous week and closed down 12%yesterday (Monday, March 13th).  Today, as we write this, the stock is up 12%.  Why has the stock taken a hit?  Bank contagion – Schwab is not only one of the largest broker-dealers in the United States but is also one of the largest banks. 

Schwab bank fundamentals

As we highlighted in the letter we published yesterday, the scale of attempted withdrawals at Silicon Valley Bank (SVB) was so large that the bank ran out of cash, a classic run on the bank.  A failure of Schwab bank because of a bank run is highly unlikely.  Why?  More than 80% of Schwab’s total bank deposits fall within the FDIC insurance limit, compared to ~ 13% for SVB, meaning that depositors at Schwab, in aggregate, are much less likely to pull their cash out of a fear of failure since a far larger percentage of those funds are FDIC insured.  

In addition, Schwab has access to significant liquidity relative to the size of its deposit base.  Pursuant to a press release yesterday, the company disclosed that it has over $100 billion of cash on hand and $300 billion of incremental borrowing capacity with the Federal Home Loan Bank. Compare this liquidity to the $367 billion of deposits listed on the company’s 12/31/2023 balance sheet.

Considering Schwab’s fundamentals, we believe it is well-positioned to get through this tumultuous period.  That said, because no one can predict the future with absolute certainty, below we discuss your exposure to Schwab in the event of a failure. 

How exposed am I to a failure of Schwab’s bank?

Per FINRA, broker-dealer custodians like Schwab “are obligated to maintain custody of customer securities and safeguard customer cash by segregating these assets from the firm’s proprietary business activities” (Exchange Act Rule 15c3-3, also known as the Customer Protection Rule). Barring some type of fraud, which we deem as highly unlikely given that Schwab is one of the largest brokers in the country and effectively under a microscope by regulators, distress in Schwab’s other businesses should, from a regulatory perspective, have no impact on their broker-dealer custodian clients.

Is my cash any less protected than a security at Schwab?

Cash held in your account is treated the same as securities under the Consumer Protection Rule.  The Exchange Act Rule 15c3-3 not only segregates client securities but also cash.

What is the worst-case scenario?

Despite the Customer Protection Rule and other safeguards, if the broker-dealer custodian fails all assets held in the broker-dealers custody may be comingled together.  This happens irrespective of whether the assets belong to client cash accounts or client margin accounts.  In this worst-case scenario, the safeguards in place make it highly likely the custodied funds would still be delivered in full but that is not in any way guaranteed.  There are scenarios where account assets would be impaired. 

What is RCM’s current perspective on Schwab and the worst-case scenario? 

The regulatory framework for a broker-dealer custodian like Schwab requires, per FINRA, that “firms must, at all times, have and maintain net capital at specific levels to protect customers and creditors from monetary losses that can occur when firms fail” (Exchange Act Rule 15c3-1, also known as the Net Capital Rule). As of 12/31/2022, Schwab’s net payables to brokerage accounts in aggregate were $30.8 billion and their total net client assets were $7,049.8 billion.  Hence, if Schwab failed and all client accounts were aggregated and Schwab failed to pay in any of the net payables, RCM estimates that Schwab accounts in aggregate could lose 30.8/7,049.8, or 0.44%. 

Securities Investor Protection Corporation (SIPC) coverage and the worst-case scenario

Per the SIPC, “SIPC protects against the loss of cash and securities – such as stocks and bonds – held by a customer at a financially-troubled SIPC-member brokerage firm. The limit of SIPC protection is $500,000, which includes a $250,000 limit for cash.”  “Cash and securities held by the broker-dealer for customers comprise a fund of “customer property” which is shared pro rata by customers based on each customer’s “net equity.” For example, if the fund of customer property consists of 90% of what should have been held by the brokerage firm for customers, then all customers receive 90% of their “net equity” claims from this fund.”  In the unlikely event of a Schwab liquidation where “the fund of customer property is not sufficient to satisfy fully every customer’s “net equity” claim. In that case, SIPC advances its funds – up to $500,000 per customer (but not more than $250,000 for cash claims) – to make up any shortfall.”  If we are correct about a worst-case loss of 0.44%, and we assume an account completely of cash, hence the $250,000 limit for claims, any account less than $56.8 million would be made hole ($250,000 / 0.44%).

Additional protection provided by Schwab to its account holders over and above SIPC Protection

Per Schwab, “Additional brokerage insurance—in addition to SIPC protection—is provided to Charles Schwab & Co., Inc. accounts through underwriters in London. Schwab’s coverage with Lloyd's of London and other London insurers, combined with SIPC coverage, provides protection of securities and cash up to an aggregate of $600 million, and is limited to a combined return to any customer from a Trustee, SIPC, and London insurers of $150 million, including cash of up to $1,150,000. This additional protection becomes available in the event that SIPC limits are exhausted.

Given all the above, we continue to be comfortable with Schwab risk and continue to hold our own, our business and our family accounts there.

Please reach out to us with questions and comments. Thank you for trusting RCM with your capital. It is a privilege for us to serve you.

Dave and Mike