Charles Schwab - Earnings Call - Q1 2022

Transcript

Richard Fowler (MD & Head of Investor Relations)

And we're live. Good morning, everyone. Welcome to Schwab's Spring 2022 Business Update. This is Rich Fowler, Head of Investor Relations. And first off, we want to thank you for spending some time with us today.

And as always, we hope everyone on the call and your families remain safe as the pandemic continues on its knock wood downward path. We do have a full program today, including our President, Rick Worster's inaugural interim update participation. So let's do a quick administrative review and get right into it. As the holding slides indicated, Walt, Rick and Peter are the presenters today. The program remains at 60 minutes with Q and A following prepared remarks.

Jeff Edwards will once again moderate the Q and A session. We'll take questions from the dial in and the webcast console, And we ask that you stick with the 1 plus follow on approach so that we can cover as much ground as possible in a limited time that we have today. Also as before, we will post the slides on the IR site as Peter begins his remarks. And finally, please make note of the forward looking statement language as always. And with that, Walt, will you start us off?

Walter Bettinger (CEO & Co-Chairman)

Thanks, Rich. Good morning, everyone. Thanks for joining us this morning. Consistency, it's a word that I spend a lot of time on and it's a word that is critical at Schwab. It means that we're committed to a consistent business strategy, a Consistent commitment to feeding the virtuous cycle and innovating on behalf of investors, a consistent Financial reporting cadence, a consistent commitment to our employees and the communities that we live and work in and a consistent long term approach.

It's focused not just on the current year, but on years to come. But when I talk about consistency, I also want to emphasize that It doesn't mean that we have to be slow or stodgy or unwilling to be disruptive. Frankly, I don't think I've ever heard anyone refer to Schwab as unwilling To be disruptive, but it does mean that clients can count on us through good times, for investing as We enjoyed much of last year as well as more difficult times. It means that they know we work hard to improve on our shortcomings and that we will continue to innovate, enhance and Keep their best interest at the forefront of our firm. I think as all of you know who followed our company taking a long term client centric approach, It's not always easy, but after almost 14 years as CEO, I'm as committed as ever to my belief that it is really the only path to rewarding long term stockholders.

And in the Q1 of this year, we executed on that exact approach, despite it being a tough quarter for investors. And clients continue to reward us with their business over a 1,000,000 new brokerage accounts, over $120,000,000,000 in net new assets. We're just going to continue investing to Better serve them and innovate on their behalf. Importantly, we're also going to remain consistent in our strategic approach through client's eyes and that is our North Star. So let's take a look at Some of the details from the Q1 and the implications for our long term emphasis.

It was, I guess you could say a fairly brutal quarter for investors, whether they were conservative, aggressive or anywhere in between. So we had 4 decade high inflation and the resulting anticipated increase in interest rates really punished fixed income investors. And of course, the equity market declined rather sharply before we saw a modest comeback a bit late in that Q1. But despite it being a difficult quarter, again, clients continued to trust us. They continued to bring their Hard earned investment dollars to Schwab and open new accounts with us.

We maintained an organic growth rate in terms of core net new assets at Same consistent level we've been able to deliver for over a decade. We've done that in good times. We've done it in more difficult times. And of course, we've done it even as we've grown larger, had a much larger base and therefore, presumably, more challenging. Taking a look at the next slide, investor sentiment fell pretty hard during the quarter.

It turned quite a bit negative, then we had a small recovery in the market late again in the quarter, created a little bit of a lift off the floor from where we were in sentiment. But we saw the sentiment manifest itself throughout the quarter, Things like margin loan balances falling about $6,000,000,000 from year end. And although trading activity It was relatively robust overall. I think as Peter is going to discuss in his section, the mix of those trades changed and reflected much more of what we might consider a risk off viewpoint by investors. But again, with our commitment to consistency, it means we don't slam on the gas or slam on the brakes, depending on Environmental factors that are going on around us, instead we're our strategic efforts are designed to enhance services to clients for years to come, deliver financial benefits to stockholders over the years.

So as you would expect, we will continue making Investments for the long term consistent with the 3 key strategic initiatives that we've shared with you multiple times. And Rick, maybe I can turn it over to you and you can spend a bit of time discussing some of those efforts.

Richard Wurster (President)

Thank you, Walt, and hello, everyone. I'm thrilled to be here today to share an update on the progress we have made this year to advance our key strategic initiatives. Walt talked about consistency, Our actions continue to be guided by our through client size strategy. With that as our North Star, we're focused on the three actions that you see on this page: Achieving even more scale and efficiency, pursuing win win monetization and meeting the segmented needs of our clients. In this quarter, we've made progress on all fronts, and I'd like to start by sharing some of the updates on scale and efficiency.

In the Q1, the key measure of our scale and efficiency, our expense on client assets or EOKA was 15 basis points or 13 basis points on an adjusted basis. Although that's up slightly from recent levels due to seasonal expenses and the market decline, We continue to believe that this lower cost to serve provides us with a competitive edge. To illustrate the power of the investments we've made in digital and technology capabilities, I think it is remarkable that we have bolstered our trading system capacity By more than 5 times over the last 5 years. To put that in perspective, this means that we have the ability within a handful of minutes As we think about the future for us in scale and efficiency, our top priority remains consistent, the integration of Ameritrade. And we made consistent and more progress on this front in the Q1 of this year, including dually licensing Ameritrade Financial Consultants.

Moving retention and win win monetization. Speaking of win win monetization, I spoke in January about 3 areas where we see the opportunity to help more clients and to drive growth. And those areas are asset On the proprietary asset management side, I am thrilled to share that last week we launched Schwab personalized indexing. Our proprietary launch provides tax benefits to investors. It brings the minimum on our platform for direct indexing down to $100,000 from the 250,000 level that it was at for the 3rd party product that has been on our platform.

Yet that $100,000 minimum is still at a level where we think Meaningful tax benefits can be provided to clients. And finally, we launched at 40 basis points for retail clients and 25 basis points for advisors, which are very competitive fee points. You can expect us to continually innovate in this area, and stay tuned for more as it relates to personalization and a digital experience within our personalized indexing offer. In February, we launched our new strategic relationship with This launch has a number of client benefits, including providing RIAs with no transaction fee access to TROW Price's lowest cost institutional share class funds. Turning now to lending.

I've talked previously about the potential upside to enhancing our lending offer for both IS and AS clients. Most importantly, I think this would be a win for clients. Clients are asking to do their borrowing through Schwab and we know they can access our industry leading low rates here. We've made a progress on this front this year. We've cut our pledged asset line or PAL cycle times down significantly.

We've created a new lending experience for our ultra high net worth clients. And we've worked with Rocket Mortgage to make it easier for our $5,000,000 plus clients to get a mortgage. All of this has resulted in our client promoter scores for lending Being at 77 in the Q1, which is near all time highs, suggesting clients are seeing the value from this offer. Let me wrap up with sharing a bit more on our efforts to meet the specific needs of our client segments. As I mentioned earlier, seeing through client size is our North Star and we made progress this quarter to meet the needs and preferences of a range of investors and I want to share an update on that.

For trading oriented and newer clients, we launched thematic stock list in March. This is an innovative new tool that will help trading oriented and newer clients identify themes that may be of interest to them and help them identify investment and trading opportunities. We have over 45 themes available for clients today, including a number of ESG related themes. You can expect from us additional advancements as it relates to this capability and the way we deliver it to clients over time. Turning now to our high net worth client segment.

This client segment grew at 5 times the rate of retail households year over year And we continue to enhance our advice, our service and our offers like lending to make sure that they meet the specific needs of our high net worth clients. More broadly, we continue to make progress to build out our relationship support model. We've added financial consultants, wealth strategists and other professionals to make sure that investors at Charles Schwab feel supported. For our trader clients, we've established 1st ever Ameritrade Active Trader FC branch. For our ESG investors, we've recently launched MSCI ESG ratings on individual stocks that our clients can use to evaluate the investment decisions they're making alongside other criteria that they like to look at.

This new resource on ESG adds The other enhancements that we've made in the past year for ESG investors, including the launch of the Schwab Ariel ESG ETF, The Wazmer Schroeder positive impact strategy launched last year, ESG related themes that can be found in the thematic stock list and access to an ESG index as part of our recent Schwab personalized indexing launch. And finally, we also have an RIA client segmentation strategy. Our AS model is designed to serve clients of all sizes from clients just starting their businesses to large multifamily offices and everywhere in between. Late last year, we segmented our client base into 3 sub segments to tailor support to the needs and priorities of our different advisors. Early results show this specialization or segmentation has been immensely successful with client satisfaction up and improved service.

As we look ahead, you will continue to see the consistency of our strategy. With through client size as our North Star, We will continue to put our clients first as we make progress on these important initiatives. And with that, I will turn it back to Walt.

Walter Bettinger (CEO & Co-Chairman)

Thanks, Rick. It's a wonderful summary of several of the efforts going on across the firm to better serve our clients and build Someone asked me in a meeting Tuesday morning, they said, Walt, what are you going to do about The decline in SCHW that happened on Monday. And it probably shouldn't surprise any of you what my answer was. I said, it's pretty simple. We're going to keep focusing on our clients and our prospects.

We're going to keep executing on the Virtuous cycle. We're only scratching the surface Of the available domestic market with about 12% penetration. And when we do those things well, I'm confident in our future prospects. We never panic. We never try to pull rabbits out of the hat.

We're never going to try and make short term results by deviating from an approach that has worked for 50 years. So just to wrap things up in my segment, yes, it's a tough environment for investors. But our all weather financial model performed quite strongly during a period of market turbulence. And When I look out through the course of 2022, I am very optimistic about our earnings potential. More on that will come from Peter.

But no matter how the year unfolds, you can count on the fact that we will remain consistent in the areas that matter most. A strategy based on seeing the world through client size, a set of competitive advantages that we continue to enhance, A commitment to the virtuous cycle that continually rewards our clients, our employees and our long term stockholders. We'll keep making progress on our key strategic initiatives that Rick referenced and we'll keep making progress on the integration of TD Ameritrade. And we'll do it all in a consistent manner with a winning strategy through client size. So Peter, I know a lot of folks are anxious to hear from you.

So let me turn it over to you for a look at our financials.

Peter Crawford (Executive VP, CFO & MD)

Excellent. Well, thank you very much, Walt. So you all heard Walt and Rick The progress we're making in bringing new solutions to our clients and advancing our strategic priorities. And finally, about the huge opportunity we have to broaden our moat and continue to drive strong organic growth. In my time today, I'm going to talk about how our all weather business model helped us produce results that were off last year's record level, but still quite strong considering the various headwinds we face.

I'll discuss our evolving management thinking and how we're positioned to benefit significantly if the Fed hikes rates as expected. And finally, I'll provide an update on our capital management approach moving forward. The message you should hear is that regardless of how someone might have viewed our recent quarter's financial results, our through client size strategy is working and our business model is working, Producing strong financial performance with the potential for an acceleration of revenue growth in the quarters ahead should the Fed follow through on their tightening cycle. So let's talk about some of the crosscurrents that influenced our financial performance in the Q1. At At our winter business update a few months ago, we highlighted some of the questions that would shape our operating and financial performance in 2022. As Walt talked about, the quarter was a challenging one for our clients and investors in general. As we look at the quarter from the context of our business model, some of the developments have been helpful. The decline in COVID cases clearly, the rise in long term interest rates and continued robust trading activity, while others have presented challenges, Specifically rapidly rising inflation, a fed funds rate, which of course is expected to rise dramatically over the next several quarters, but which remain near 0 for most of the quarter, A decline in equity markets that Walt referenced and a less exuberant attitude among investors in general and our clients in particular.

Now despite some of those challenging dynamics, we were able to deliver financial performance that was a bit below last year's record level, but still quite solid. As we said previously, with the acquisition of Ameritrade, we are more exposed to dynamics that can fluctuate in less predictable ways, trading behavior, margin utilization and securities lending to name a few. In Q1, the risk off sentiment among clients impacted all these drivers and weighed on our results, resulting in revenue that was down 1% from the unprecedented Q1 of 2021. Now we limited Growth in adjusted expenses to 4% year over year, which produced an adjusted pre tax margin close to 45%, 26% return on tangible common equity and $0.77 of adjusted EPS. Comparing conditions to the financial scenario we shared in January, the equity market decline has obviously been a negative, while the As we'll discuss in a moment, as Walt previewed, the mix of trades was different than what we saw last year, which produced lower revenue per trade.

The scenario assumed consistent securities lending revenue and margin utilization, but both were down from the 4th quarter 20% in the case of Sec lending, which Of course, adversely impacted our net interest margin and revenue. And balance sheet growth tracked a little higher than contemplated in this scenario, given Asset gathering and somewhat lower net purchase activity by clients. It's always a little tricky comparing results for a single quarter with That covers the full year, especially given the assumption in the January scenario for 2 more rate hikes in 2022, which Should increase revenue growth and pre tax margins in subsequent quarters. But our financial results thus far have been pretty close to what the scenario anticipated for the Q1. And on the expense side, our results were very much consistent with our financial plan, Meaning that we're sticking with our expectation for full year adjusted expense growth of 6% to 7%, excluding of course any variation based on our bonus funding.

I mentioned earlier that even as overall trading activity has remained quite robust, We have seen some changes in the types of trades being made, which on balance have reduced the revenue per trade versus the Q4 as we previewed in the commentary attached to our February Smart Report. Our RIA clients are being relatively more active. And while derivatives continue to account for 23% of total trades, we're seeing an increase in futures trades as well as options activity on indices relative to individual equities. We also saw a decline in the size of the average options trade. So all these factors taken together combined to lower revenue per trade by roughly 10% versus the Q4 of 2021.

It's too early, of course, to know whether this mix shift is an anomaly or a trend, but we're certainly Our platform can meet a broad and sometimes varying range of needs across retail and RIA clients, equities, futures and options, small Turning our attention to the balance sheet. Our balance sheet grew another 2 sequentially driven by more than $20,000,000,000 increase in bank deposits due to strong asset gathering and our migration of $12,000,000,000 or $13,000,000,000 in cash out of the IDA. Within our interest earning assets, the decline in equity markets Prompted a decline in margin utilization. While we're continuing to be very successful in increasing adoption of our compelling bank lending solutions, With balances up another $2,500,000,000 in the quarter and 46% over the last 12 months. We're active on the financing front, issuing $3,000,000,000 of debt to supplement parent liquidity and $700,000,000 in referred to support the balance sheet growth we've experienced.

Now stockholders' equity declined due to mark to market unrealized losses on our AFS or available This is a good moment to remind you all that we moved approximately $111,000,000,000 of securities From AFS to held to maturity at the end of January, insulating from AOCI Further changes in their unrealized gainloss. And the loss at the time of that transition was $2,400,000,000 which will amortize as those securities mature. And that negative AOCI does not impact regulatory capital. So our consolidated Tier 1 leverage ratio remained just north of 6%. As I mentioned earlier, our financial performance was helped only modestly this quarter by the increase in interest rates to start the year.

But going forward, that should change with Schwab poised to see tremendous lift should the Fed pursue what is expected to be a dramatic increase in rates. The path of our net interest margin will always depend on how rates ultimately trend, as well as how our clients manage their cash, how we manage our investment portfolio and of course the level of the securities lending revenue and margin utilization. Now as you In our earnings release, our net interest margin decreased 6 basis points sequentially from the Q4 of 2021 to the Q1 of 2022. That decrease was entirely due to a lower contribution from securities lending and margin utilization, as well as an increased allocation of cash, which More than offset a 7 basis point sequential improvement in the yield on our investment portfolio. Looking forward, If the Fed hikes rates to a range of 2.25 percent to 2.5% by the end of the year as the market currently expects, We could see our net interest margin climb to the mid-180s in Q4.

So while our NIM decline in Q1, the upside to higher rates Still very much exists. So now let's talk about some of the factors that influence our NIM trajectory. The most important factor of course is what ultimately happens with rates. We talk a lot, both Rick and Walt referenced our through client size strategy. We talked about it in the context of our business priorities and approach, but we also adopted a similar lens in our investment approach.

And what I mean by that We don't change our investment strategy based off our own in house view of what is going to happen with rates in the future. Instead, we take market expectations as an input and then adjust our investment strategy based on how we think clients might respond, which ultimately influence our liability duration, our liquidity planning to support the client behavior and deposit pricing. Over time, the amount of cash our clients hold tends to grow with the growth in accounts and the growth in total client assets. And how much of that cash sits on our balance sheet, primarily in our bank sweep and broker dealer free credit products, well, that varies based off the level of primarily short term interest rates. When the Fed funds rate increases, solutions like purchase money funds and CDs are able to offer more meaningful yields.

So clients tend to move more of their so called investment cash off our balance sheet Into these higher yielding alternatives is what we've called client cash sorting. Now in 2015 to 2019, the client cash sorting produced Roughly 20% reduction in uninvested or sweep cash balances over a 3 year period once the Fed started tightening, until those balances resume growing again. Now assuming the Fed follows through as expected, we would expect that process to return. The 2015 to 2019 period is a reasonable reference point for our expectations this cycle, but there are a number of different dynamics this time around that could influence that behavior. At the same time, we'd expect to see continued growth in bank lending, As Rick discussed, as we improve the Powell process, make our lending solutions available to legacy Ameritrade clients and Continue to increase awareness of our very competitive mortgage rates.

And given the way the LCR or liquidity coverage ratio calculation works, We need to maintain stable or even growing free credit balances within the broker dealers to support our margin book. So any sorting that happens there needs to be replaced by transferring balances out of BankSuite. Now with higher rates, we'd also expect pay downs to slow. Now we have plenty of liquid assets and borrowing capacity to support outflows, But we'd rather not sell assets potentially at a loss or have to rely on higher cost FHLB borrowing on a long term basis. So we need to ensure we have enough liquidity at the banks to enable these client cash allocation changes without selling securities or borrowing from the FHLB.

Our investment portfolio in aggregate looks pretty similar to how it looked 1 year ago with a fixed Allocation of 90.10 and a duration around 4.7. But those numbers are higher than in 2015, which means that the upside from higher rates is very much still there, So the benefit will accrue to us over a longer period of time than the last rising rate cycle. We are however carrying more cash on the portfolio, 15% or 16% versus our typical 5% to 7% level. This decision to hold more cash wasn't about market timing, though In hindsight, it was good. We didn't deploy the cash earlier in the quarter when rates were much lower than where they are now.

But it does Give us more flexibility and increases our upside to higher rates. We're also repositioning the portfolio and targeting our investments ensure we have a lot of maturities in the next 2 to 3 years. While the yield curve is quite flat, we are sacrificing some amount Current net interest revenue to maintain this higher level of liquidity, but I emphasize current because this is just a timing difference. If the Fed follows through as planned that the yield trade off will decrease steadily and this approach obviously increases our asset sensitivity and upside to higher rates. As we look to the future, we would expect deposit betas to be no higher than they were during the last rising rate cycle.

And that is a function of our cash strategy through which we offer our clients access to higher yielding cash alternatives within their brokerage accounts for their investment cash, Allowing us in our flagship bank suite product, which is the repository of what we call transaction cash or cash awaiting investment to offer a yield that is somewhat lower, but still quite compelling relative to the checking account rates offered by the big banks. And finally, a word or 2 on capital. With the continued growth on our balance sheet, our consolidated Tier 1 leverage ratio declined slightly to 6.1 percent below our operating objective, but well above the regulatory minimum. Now I've read some commentary on our negative And a potential impact that could have on our regulatory capital. Now as a reminder for some of you who may be less familiar with the issues involved, Mark to market gains and losses in our AFS portfolio do not flow through the P and L, but do impact the stockholders' equity through a line item called accumulated other comprehensive income or AOCI.

Now as a Category 3 below $700,000,000,000 in assets, we have the option, which we have taken, to exclude AOCI from our regulatory capital ratios. As of threethirty one, AOCI was negative $11,000,000,000 but again, that doesn't impact our regulatory capital. It will only do so if and when we cross $700,000,000,000 in assets and stay there for 4 consecutive quarters. And while we are close to that level today, the client cash sorting that should accompany higher rates will mean a slowing or even reversal of balance sheet growth, which means we may not hit that trigger for some time, at which point that AOCI mark will have amortized down somewhat. So what that means is higher rates mean that the $700,000,000,000 threshold gets pushed out, while lower rates mean that The negative AOCI gets reduced.

Either way, we see this as something that is quite manageable. Let me close with a few thoughts. It's obviously been a turbulent week for the stock as Walt referenced Frankly, a turbulent start to the year, and we're cognizant of the impact that has on all of you, our owners. At the same time, we continue to focus on the things that we can control. And the measures that we look at as indicators of the value of the business have stayed remarkably consistent.

Our organic growth, whether measured by net new assets or new accounts, our net promoter score or what we call client promoter scores, which have reached new highs Despite the market turbulence, our TOA ratio and the wins we see from competitors and the progress we're making on our strategic agenda, Those are the most important barometers regarding the health of the business and are all giving us confidence that we're on the right track. With that, Jeff, let me turn over to you to facilitate our Q and A. Thanks.

Jeff Edwards (MD & Head of Investor Relations)

Great. Thank you very much, Peter. Let's go ahead and turn to the phone lines. Operator, first question, please.

Operator (participant)

Thank you. And our first question today is from Ken Worthington from JPMorgan.

Kenneth Worthington (Financial Analyst)

Hi, good morning. Thanks for taking the question. So you mentioned that you're building cash on the balance sheet In part as a function to prepare, I think, for cash shorting is how I interpreted it. And there is a benefit of being able to invest for higher rates How much cash do you want to or feel you need to have on hand in coming quarters to meet these needs? And is this 15% level that we saw in the Q1 the right level that you would expect to be at in future quarters?

Or should it go higher before it starts to go lower?

Peter Crawford (Executive VP, CFO & MD)

Yes. Thanks, Ken, for the question. So I would expect that level of cash, it's not like we're holding the cash because we think that sorting is going to happen this quarter or next quarter. It's really looking out over the next Several years and thinking about how do we want to make sure we position the portfolio, such that we have ample liquidity, to be able to support A range of possible outcomes around this client cash sorting. I would expect that That level of cash will come down over time through some of the purchase activity that we outlined in one of those pages there.

For example, we were considering deploying some of it into kind of a treasury ladder, for example, that would give it be an alternative to that cash would lock in some of the forward rates, protect us from some of the downside in case rates don't climb as expected. But I would still expect even that, I would expect that our cash levels will still remain higher than that 5% to 7% typical level that we target.

Kenneth Worthington (Financial Analyst)

Okay. And then can you help us think about the timing of investing some of the cash as it goes in? So you built up cash. At what point do you start to invest and maybe further take advantage of the better rate environment? I know you said it wasn't your goal to time the market, but you built up cash.

Do we start to see more deployment of this cash In the next 1 to 2 quarters or does it make more sense given the shape of the curve to maybe sit on cash not just for sorting purposes, But for the fact that if you hold cash now and wait 2 or 3 quarters in the future, you can get an even better yield And therefore, NIM would be much better off by waiting.

Peter Crawford (Executive VP, CFO & MD)

Yes. Well, as you said, we don't we definitely don't try to time the market. So it really is Function of what we see with that client what we see with the rate environment, what we see with that client activity. I do expect that we'll deploy some of that cash over the next couple of quarters, But we'll likely be deploying that in or continue to deploy that in securities that have a relatively short maturity. So we have a lot of pay downs and maturities in the next 2 or 3 years. In terms of the timing to go out Further on the curve to be buying some of the traditional mortgage backed securities that we have traditionally bought, That's really going to be more of a function of what we see with client activity, and to see how that evolves over time.

Kenneth Worthington (Financial Analyst)

Okay, great. Thank you very much.

Operator (participant)

Thank you. And our next question is from Craig Siegenthaler from Bank of America.

Craig Siegenthaler (Managing Director)

Hey, good morning, everyone.

Peter Crawford (Executive VP, CFO & MD)

Good morning, Craig.

Craig Siegenthaler (Managing Director)

Peter, I appreciate your updated commentary on But it looks like you're going to cross $700,000,000,000 over the next few quarters. You're only about 3% away now. However, it seems like you disagree with this just given your expectation for cash shorting. So I was just wondering if you could elaborate on the comment you made in the prepared remarks.

Peter Crawford (Executive VP, CFO & MD)

Sure. So I guess the short answer, Craig, is it depends. I think that it's certainly conceivable that we could Within the next couple of quarters, it's also conceivable that if the client cash sorting evolves in a manner consistent with what we saw in 2015 through 2019, that It could slow the balance sheet growth or potentially even reverse some of that balance sheet growth and push that date further back. I guess either way, I would say we feel like it's a manageable issue for us to navigate. By virtue of We're certainly cognizant of the implications on our regulatory capital, but sitting here as CFO and thinking about the profile of the business and how much capital do we need to support It's not like an accounting convention changes the fundamental profile of the company.

When we think about how we manage our capital And the level of capital that we want to maintain to support the business, when we think about our stress test, the most stressful scenario for us is interest rates go down and cash flows onto the balance sheet. Well, scenario like that, that negative AOCI goes away and basically goes back to 0 with decline in interest rates. So it's sort of an example where, again, we think this is a very manageable situation in a Scenario where rates are continuing to be high, that's also a scenario where we're likely generating a lot of organic capital and probably utilizing less of that organic capital to support the balance sheet growth. So we're generating a lot of excess capital in that scenario. Again, we think this is a very manageable situation.

Craig Siegenthaler (Managing Director)

And then Peter, for my follow-up, Once you do, if you do cross $700,000,000,000 and you exist there for 4 quarters, how do you expect to manage the capital Through this process, and I'm thinking like what additional levers do you have to avoid a large impact to excess capital? And I know you migrated some securities in January from AFS to HTM. Can you do more? And also, your business model looked different 5, 10 years ago, but are you able to move Client cash sweep deposit liabilities back into money market funds, like if that we have if it ever was an issue with capital.

Peter Crawford (Executive VP, CFO & MD)

Well, I mean, again, our capital levels, we have buffers on top of buffers on top of buffers. So we've got we feel like we're sitting A lot of capital even sitting where we are today at 6.1 percent Tier 1 leverage. And we certainly won't want to do anything that sacrifices long term growth of the business. So the idea of saying let's somehow cap our growth below $700,000,000,000 I wouldn't necessarily see that as a path that we want to Pursue, we did as you mentioned, we did migrate those $111,000,000,000 of securities out of available for sale to held to maturity Really before we saw a dramatic rise in rates, so that certainly has been helpful. And to the extent we were buying new securities On the margin, we would be likely to put those into to held to maturity assuming it was an appropriate fit with the security.

So those are all actions that certainly we'll continue to look at. And a lot of the purchasing we're doing by targeting securities with a duration or maturity less 3 years, those don't generate much AOCI volatility. So that helps us. And some of this AOCI, of course, amortizes down over time. So again, that's all makes the point, I think, or help support, I guess, why we feel like this is a very manageable situation.

Craig Siegenthaler (Managing Director)

Thank you, Peter.

Operator (participant)

Thank you. Our next question is from Devin Ryan from JPM Securities.

Devin Ryan (Director of Financial Technology Research)

Hey, thanks. Good morning, everyone. So I guess another question here just on the balance sheet. So on the NIM Commentary for 4Q by kind of mid-180s. What is your expectation at that point for prepay amortization?

What's the assumption there? How much drag? I guess it's left. I think you have about 50 basis points today. So what's embedded?

And then in terms of just The mix and thinking about kind of the loan book, obviously, you've had some good traction on mortgage lending and refinance activity as you guys talked about. It seems like that might Slow here just in the rising rate environment. So maybe talk a little bit about kind of the outlook for growing the loan book and are there other products that could offset that and even would Do an acquisition to kind of accelerate other areas of loan growth.

Peter Crawford (Executive VP, CFO & MD)

Sure. So on the prepayment amortization, we saw about a 7 or 8 basis point reduction in premium amortization between Q4 and Q1. And embedded within that NEM outlook that we shared It's our expectation that again assuming rates continue as they have, that we could see another similar size reduction between Q1 and Q2 and probably between Q1 and Q4, somewhere around the order of 10 basis points plus or minus improvement in the level of premium amortization. In terms of loan growth, we do despite the rising rate environment, we do think there's a lot of opportunity for growth. Clearly, the refinancing wave has largely passed, and we're entering on the mortgage side a new purchase, It's more of a new purchase market.

But our rates are very, very compelling and the still despite the success we've had with Growing our lending solutions. There's still a lot of clients out there who don't yet turn to us for their lending needs, who would be better off turning to us for their lending needs. It's good for them and it's good for us both financially and strategically. So we still think there's a big opportunity there with both the Schwab clients as well as with the now with the legacy Ameritrade clients to increase the awareness of the Schwab Bank capabilities, pricing, etcetera. And then with pledged asset line, Rick referenced the improvement in cycle times.

That's a I think that continues to be a big opportunity. We are Very much underpenetrated in that product relative to other wealth management firms. And so we're working hard to Again, increase the awareness, improve the process there to make that more accessible to both retail clients as well as the RIA clients. The RIA clients have a lot of interest in pledged asset. And so we think there's a big opportunity there.

So we think there's a lot of opportunity on the lending side without a doubt.

Devin Ryan (Director of Financial Technology Research)

Yes, great. Okay. Quick follow-up, obviously, I think enthusiasm around the personalized indexing and the direct indexing opportunity. Is there any way to frame out kind of the trajectory and opportunity there, kind of how you think about the impact of Schwab or the size of the market over time as that continues to scale.

Richard Wurster (President)

Absolutely. I'll share a few thoughts on that. First, one of the things that's exciting to us about this launch is that it's an advice product that appeals to a broad range of investor types, Including those self directed clients at Schwab, who maybe haven't previously been interested in advice here at Schwab. So we're excited about the fact that it opens up Opens us up to a broader set of clients that may be interested in it. In terms of thinking through the scale and how it may grow, There's I think around $14,000,000,000,000 that sits in active mutual funds today.

I believe last quarter something like 140,000,000,000 Came out of active mutual funds and ETFs grew by about $200,000,000,000 So there's a lot of money sitting there that may be interested in something Like this. And I think there's 2 primary reasons why some of that money may move over time. 1 clearly is taxes. I think if you go back and study this, there can be somewhere around a 2% return improvement through harvesting taxes. So for the taxable investor, the opportunity to participate in that return stream and pay a 40 basis point fee Looks like an attractive option relative to even a low cost ETF and perhaps against some active strategy.

So I do think there will be some appeal to mutual fund and ETF investors. But I also believe that this is a product that if you walk down the street and ask someone, hey, do you want a direct indexing or when people come into our offices, they've never heard of the product before. When people come into our offices, they've never heard of the product before by and large. And so one of the real powers, I think, that Schwab brings to the As it relates to personalized indexing is, I think success is going to take 3 things. 1, it's going to take strong indexing skills.

2, it's going to take digital capabilities and importantly number 3, it's going to take distribution because in the near term this product is going to have to be sold, it's going to have to be explained. The benefits are going to have to be shared with clients as to why that's helpful. And so I really think we're in a unique position And we're excited for the growth. I do think next 5 or 10 years, as Walt has put it before, I think a freight train of money will move into this area. And I believe we're perfectly positioned to play a big role.

Devin Ryan (Director of Financial Technology Research)

Okay, terrific. Thank you.

Operator (participant)

Thank you. Our next question is from Rich Repetto from Piper Sandler.

Richard Repetto (Managing Director)

Yes. Hi, Walt and Rick and Peter. I guess my question first is on the impact of incremental Fed fund rate hikes. It helps Peter that you gave us the exit NIM for what you expected the Fed access as sort of the curve is projecting. But I guess my question is, you don't have in the sensitivity, the impact of the next Fed funds rate hike.

And these rate hikes are certainly going to have spillover effects in 2023. So I think we can back into this, but you might be able to help us. What is the incremental impact you see of Fed on rate increases beyond the first 2 or 3 when we recover the waivers, the money market fund fee waivers.

Peter Crawford (Executive VP, CFO & MD)

Well, thank you, Rich, for the question. I do think that's something we're likely to include when we have our July update as we get further into this cycle. As you point out, the next couple of Fed funds increases will get the benefit From the increase itself plus the impact on the money fund fee waivers, those money fund fee waivers should all be gone After the next certainly one or potentially 2 Fed increases, I think probably the next one, they're pretty much all gone at that point. The next couple after that, Certainly, you've got the very quick benefit on the roughly 40% to 45% of our balance sheet or interest earning assets that are in floating rate securities today. So that benefit kicks in relatively quickly and you can do the math in terms of that.

The deposit betas, as you may recall from the last rising rate cycle, they started off on the lower end and then they start They do edge up over time after we get above sort of 100 basis points, 125 basis points. But they never I don't think they ever got above, I want to say 25% or 30% even at sort of a 2% fed funds or 2.25 percent, 2.5% fed funds rate. So that the incremental benefit of the 8th Fed Inc, 25 basis point Fed increases is slightly less than the benefit of the 7th. But there's still certainly significant upside as you start to stack some of these Fed funds increases on top of each other.

Richard Repetto (Managing Director)

Got it. That's helpful, Peter. And then one follow-up and back to this client cash sorting. So we see that the slide you put up, I think it's 24. At least it feels like you've been Conservative when you say that the balance sheet, you could see some contraction.

And you have a low of the 11.4% is low Looks like historically from Slide 24, but when we looked at it last time, The purchase money market funds as a percentage of overall client cash, it got right now it's about 13%, it got a lot higher Last cycle like multiple times. So I guess the question is, is that sort of what you're sort of implying When you talk about balance sheet, like that would be a big balance sheet contraction, I suspect. Is that a good metric to sort Judge where client cast sorting can go.

Peter Crawford (Executive VP, CFO & MD)

Well, we use that we mentioned that, Rich, as a reference Not as a prediction. There are a number of different dynamics this time, this go around, right? We're not going through the bulk transfer. We're not executing the bulk transfers As we did last time when those boat transfers were a catalyst for some clients to take action with regard to their cash. We have the Ameritrade clients now and their accounts, which tend to be smaller and more trading oriented.

So And they didn't have access to necessarily or certainly to the same access to purchase money funds in the last rising rate cycle. So we don't necessarily have great The information in terms of how they'll behave. We have a lot of new accounts that we picked up in the last year and a half that oftentimes are smaller and more trading oriented. So how will they behave as well? And so given all of that, we feel like it's Bria, to make sure we are planning for different scenarios in terms of how this could unfold and maintaining and that's Really the key word is maintaining that flexibility so that we don't box ourselves in and we can respond under depending on how things evolve.

Richard Repetto (Managing Director)

Okay. Very helpful, Peter. Thank you.

Operator (participant)

Thank you. Our next question is from Brennan Hawken from UBS.

Brennan Hawken (Senior Analyst - Equity Research)

Hey, thanks for taking my question. Good morning. Actually Sort of a follow-up on the Rich's questions. When we think about the BDA And you think about sweep as a percent of your client cash as you laid out, would you include the BDA when you Think about a comparable set? I'd think that you wouldn't, but just want to clarify.

And then, The BDA that you pulled into the balance sheet here this quarter, is that all we should expect for 2022 or is there more optionality? I know there are Some wrinkles in that agreement, which could allow for some additional transfers.

Peter Crawford (Executive VP, CFO & MD)

Thanks. So let me take the second question First, hard to say, we certainly have the option to take additional balances over the course of the year. At this point, I'm not sure I would expect A lot more additional migrations out of the BDA or the IDA onto our balance sheet in 2022. In terms of the upside on the BDA or IDA, you're absolutely right. It is very much there.

About 20% of those balances are in floating rate and those are tied to the Fed funds rate. So as the Fed increases, you get the on 20 percent of $140,000,000,000 pretty quickly. And we are executing new fixed investments About 90 basis points higher than the roll off rate on those fixed maturities or those tenors that are maturing over the next 12 months. So a lot of upside in terms of the fixed portion of the IDA as well.

Brennan Hawken (Senior Analyst - Equity Research)

Great. Thanks for that color, Peter. Appreciate it. And then it seems like the NIM trajectory you provided has securities Lending at a similar level to the Q1. So that makes sense.

But when we think about The change we've seen in securities lending revenue, sorry, how much of that is Due to less specials or hard to borrow versus lower balances or spreads and how much could Spread improving spreads with higher rates help that line going forward.

Peter Crawford (Executive VP, CFO & MD)

Yes, it's a really interesting question. So our securities lending operation tends to focus more on the hard to borrow stocks. And so we're lending out stocks that oftentimes have a 99% rate annualized rate. So it's certainly very these are very high spread. Security is very much in demand.

They can generate a lot of certainly a lot of revenue. And the and so when you look over time, the interest in those hard to borrow stocks tends to correlate with sentiment in the market and so and the availability as well of those hard to borrow stocks varies with the sentiment in the market. In other words, when Clients have higher margin balances that tends to correlate to an extent with more securities lending revenue. Now in a higher rate environment, so for those of you who don't know as much about securities lending, when we lend out the stock, we do get cash as collateral From the counterparty, we have to lock up that cash in the reserve portfolio and it earns What the reserve portfolio earns in a higher rate environment, of course, the cash that we receive, we can earn a higher yield on that cash. Oftentimes though that does when the counterparties are thinking about the rebate rates, they do factor that in to the rebate that they're willing to give us.

So in other words, if you talk about a stock that might be they might be willing to pay, let's say 10% per year for In an environment where the cash that we're receiving doesn't earn much, if we're earning 2% on that cash, maybe they're only willing to pay 8% in rebate. And so if you're looking forward, if you're looking at the reported securities lending revenue, you might see the direct securities lending revenue being lower, but it's being made up Or by earning more on the cash, which sits in another place on the income statement.

Brennan Hawken (Senior Analyst - Equity Research)

Thanks for that thorough answer, Peter.

Jeff Edwards (MD & Head of Investor Relations)

Peter, a question from the web console from Dan Fannon at Jefferies. I know you mentioned that you'd be revisiting We'll say a more formal update to the scenario later in the year as things continue to unfold, but maybe you could spend a little bit of time talking about some of the potential upside that we might see or that could be available due to additional late hikes if they were to manifest.

Peter Crawford (Executive VP, CFO & MD)

Sure. So I mean there's a number of different, certainly a number of different dynamics at play there. So then again, the next couple of rate hikes, The $54,000,000 in money fund fee waivers, we'd expect those to be completely eliminated by assuming the Fed follows through, be completely eliminated by the end of the So going into the Q3, we've got the full fees that we're capturing there. We have, I think most recently, I think we've got 43% of the balance of the interest earning assets are in floating rate securities. Those tend to reprice very, very quickly.

And so you take 43 percent times, dollars 600 plus 1,000,000,000 interest earning assets, and you get that benefit on that Very quickly with each Fed increase. The other To the extent that we're the rates are continuing to follow the forward curve and continue to climb, then that gives us more opportunity as we are doing executing new purchases to be picking up yield. That will play out over time given the duration of our investment portfolio. We do get That pay down activity and those maturities on that investment portfolio and that creates new fuel to be able to reinvest in those higher rates. And then as I had mentioned, With the IDA, you've got the 20% in floating roughly, that re prices relatively quickly or very quickly.

And then we have The roll on versus roll off rate in the IDA, we're picking up that 90 basis points. Again, that's more of a function of long term rates, but certainly with those being where they are today, That creates certainly some nice wind in our backs on the IDAs as well.

Jeff Edwards (MD & Head of Investor Relations)

Operator, I believe we have time for one last question. Thank you.

Operator (participant)

All right. Our final question today is from Brian Bedell from Deutsche Bank.

Brian Bedell (Director)

Great. Hi, folks. Thanks for squeezing me in here. Just back to the balance sheet strategies, size, Peter, and thanks All of the color that you've given on this. Maybe just some thoughts on how you would manage that given the flexibility That you've been gearing up for, if we think about client cash that's coming in with net new asset growth, maybe some commentary on What percentage of that cash what percentage of NNA typically comes in?

And I know it takes a while to reinvest, so you've got that. And then Would you try to be flexible on that balance sheet size and maybe would that influence your decision to bring more BDA Yes, it's on if you let's say you wanted to stay in the upper 600s, as opposed to if there was more cash flowing that brought that balance sheet down?

Peter Crawford (Executive VP, CFO & MD)

Sure. So, let's see, let me again take the second part of the question first. Executing on The transfers on the IDA, as I mentioned, I wouldn't expect that we're going to do we already took the $12,000,000,000 $13,000,000,000 thus far this year, and I wouldn't expect Do a lot more on the IADA migrations this year. We'll have to see kind of where we are next year as we get into our planning and how we think about that. In terms of investing in new or new cash flows, that is absolutely part of our consideration as we see those cash flows We do make a decision, but it's part of the overall mosaic, if you will, around how we think about our investment strategy.

It's not like we think about new cash than we do, the cash that's generated from pay downs and maturities and so forth. We're looking at I'm doing multiple forecasts over several years to sort of think about how conditions could evolve over time and making sure we are adjusting our asset duration, maturity schedule, liquidity positioning to be able to respond to a range of possible scenarios for that.

Brian Bedell (Director)

Great. Thanks, Yuna. My last question is for Rick actually. Given the high net worth expansion strategy and I guess Thinking also about Advisor Services in the IRA business, can you talk about making alternatives available on your platform, obviously with The theme of democratization of alternative investments and still some 1% to 2% types of allocations and clamoring for that. Are you seeing demand from Your clients, your advisors as well and are there plans to add a lot more capabilities for alternatives onto your platform?

Richard Wurster (President)

Thanks for the question. I'd say 2 things. First, we have a tremendous amount of resources available for clients today in the alternative space. On both Advisor Services and Investor Services, we are working So that's number point number 1. Point number 2, there is growing and greater demand for alternatives.

And we know that there are some enhancements we can make, Particularly on the retail side. And so you can expect to see from us in coming periods more Development on that front, we have a nice range of alternative related options available for retail clients today, but we also believe we can go to the next level in terms of the types So, you can expect more development from us on that front off what we think is already a strong base of appealing options that both our advisor clients and investor services clients can take advantage of today.

Peter Crawford (Executive VP, CFO & MD)

All right. Well, that brings us to the top of the hour. I just I want to thank you all for your questions. Walt Paul used the word consistency in his opening remarks. I think that's a very apt word to describe our business strategy as well as our ALM and investing strategy.

I'd also use the word humility, in that, humility to understand there's a lot happening, right now in the environment, that we don't We can't completely predict. We can't necessarily completely predict what investor sentiment is going to do, what the Fed is going to do, what's going to happen with interest rates. And Given that humility, we also want to make sure we maintain a lot of flexibility. That is the overarching Word, I guess, that there were the sentiment that characterizes our investing strategy and how we're positioning The company, the balance sheet, etcetera moving forward. But we're very excited, very confident for what the future will bring both financially and strategically. We'll look forward to giving you another update in July. Thanks everyone.