22 Aug Case 15 Charles Schwab Charles Hill IntroductIon In 1971, Charles Schwab, who was 32 at th
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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