UNITED STATES

SECURITIES  AND  EXCHANGE  COMMISSION

Washington, D.C.  20549



FORM 10-Q



QUARTERLY  REPORT  PURSUANT  TO  SECTION  13  OR  15(d)
OF  THE  SECURITIES  EXCHANGE  ACT  OF  1934



For the quarterly period ended September 30, 2016



Commission File Number: 1-9700



THE  CHARLES  SCHWAB  CORPORATION

(Exact name of registrant as specified in its charter)





211 Main Street, San Francisco, CA  94105

(Address of principal executive offices and zip code)



Registrant’s telephone number, including area code:  (415) 667-7000



Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes ⌧  No ☐



Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes ⌧   No ☐



Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.





Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ☐ No ⌧



Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.



 1,325,672,135 shares of $.01 par value Common Stock

Outstanding on October 26, 2016





 

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Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A)





INTRODUCTION



The Charles Schwab Corporation (CSC) is a savings and loan holding company engaged, through its subsidiaries, in wealth management, securities brokerage, banking, money management, custody, and financial advisory services. Charles Schwab & Co., Inc. (Schwab) is a securities broker-dealer with over 330 domestic branch offices in 46 states, as well as a branch in each of the Commonwealth of Puerto Rico and London, England. In addition, Schwab serves clients in Hong Kong through one of CSC’s subsidiaries. Other subsidiaries include Charles Schwab Bank (Schwab Bank), a federal savings bank, and Charles Schwab Investment Management, Inc. (CSIM), the investment advisor for Schwab’s proprietary mutual funds, which are referred to as the Schwab Funds®, and for Schwab’s exchange-traded funds (ETFs), which are referred to as the Schwab ETFs™.



CSC and its subsidiaries (collectively, referred to as the Company) operate through two reportable segments – Investor Services and Advisor Services. The Investor Services segment provides retail brokerage and banking services, retirement plan services, and other corporate brokerage services. The Advisor Services segment provides custodial, trading, and support services as well as retirement business services.



This quarterly report on Form 10-Q should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2015 (2015 Form 10-K).





Forward-Looking Statements



In addition to historical information, this Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are identified by words such as “believe,” “anticipate,” “expect,” “intend,” “plan,” “will,” “may,” “estimate,” “appear,” “aim,” “target,” “could,” “would,” “continue,” and other similar expressions. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances are forward-looking statements.



These forward-looking statements, which reflect management’s beliefs, objectives, and expectations as of the date hereof, are necessarily estimates based on the best judgment of the Company’s senior management. These statements relate to, among other things:



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Achievement of the expressed beliefs, objectives, and expectations described in these statements is subject to certain risks and uncertainties that could cause actual results to differ materially from the expressed beliefs, objectives, and expectations. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this Quarterly Report on Form 10-Q or, in the case of documents incorporated by reference, as of the date of those documents.



Important factors that may cause actual results to differ include, but are not limited to:



Certain of these factors, as well as general risk factors affecting the Company, are discussed in greater detail in “Part I –Item 1A – Risk Factors” in the 2015 Form 10-K, and “Part II – Other Information – Item 1A – Risk Factors.”



 

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GLOSSARY OF TERMS



Active brokerage accounts: Brokerage accounts with activity within the preceding eight months.



Asset-backed securities: Debt securities backed by financial assets such as loans or receivables.



Assets receiving ongoing advisory services: Client relationships under the guidance of independent advisors and assets enrolled in one of the Company’s retail or other advisory solutions.



Average client assets: The daily average client asset balance for the period.



Basel III: Global regulatory standards on bank capital adequacy and liquidity issued by the Basel Committee on Banking Supervision.



Basis point: One basis point equals 1/100th of 1%, or 0.01%.



Cash and investments segregated and on deposit for regulatory purposes: Client cash or qualified securities balances not used for margin lending are segregated into investment accounts maintained for the exclusive benefit of clients, pursuant to Rule 15c3-3 of the Securities Exchange Act of 1934, by the Company’s broker-dealer subsidiaries.



Client assets: The market value of all client assets custodied at the Company, which includes both cash and securities, at a point in time.  



Client cash as a percentage of client assets: Calculated as money market fund balances, bank deposits, Schwab One® balances, and certain cash equivalents as a percentage of client assets.



Clients’ daily average trades: Includes daily average revenue trades by clients, trades by clients in asset-based pricing relationships, and all commission-free trades.



Commitments to extend credit: Legally binding agreements to extend credit for unused home equity loans and lines of credit (HELOCs), Pledged Asset Lines® (PALs) and other lines of credit.



Common Equity Tier 1 (CET1) Capital: The sum of common stock and related surplus net of treasury stock, retained earnings, accumulated other comprehensive income (AOCI) and qualifying minority interests, less applicable regulatory adjustments and deductions.



Common Equity Tier 1 Risk-Based Capital Ratio: The ratio of CET1 Capital to total risk-weighted assets.



Concentration risk: The potential for loss resulting from holding large positions in financial instruments collateralized by assets with similar economic characteristics or in securities of a single issuer or particular industry or geographical area.



Core net new client assets: Net new client assets before significant one-time inflows or outflows, such as acquisitions/divestitures or extraordinary (generally, greater than $10 billion) mutual fund clearing transfers.



Credit risk: The potential for loss due to a borrower, counterparty, or issuer failing to perform its contractual obligations.



Customer Protection Rule: Refers to Rule 15c3-3 of the Securities Exchange Act of 1934.



Daily average revenue trades: Total revenue trades during a certain period, divided by the number of trading days in that period. Revenue trades include all client trades that generate trading revenue (i.e., commission revenue or principal transaction revenue).



Debt to total capital ratio: Calculated as long-term debt divided by stockholders’ equity and long-term debt.



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Delinquency roll rates: The rates at which loans transition through delinquency stages, ultimately resulting in a loss. The Company considers a loan to be delinquent if it is 30 days or more past due.



Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank): Regulatory reform legislation signed into federal law in 2010 containing numerous provisions which expanded prudential regulation of large financial services companies.



Final Regulatory Capital Rules: Refers to the regulatory capital rules issued by U.S. banking agencies in July 2013 that implemented Basel III and relevant provisions of Dodd-Frank, which apply to savings and loan holding companies, as well as federal savings banks. Implementation began on January 1, 2015.



First Mortgages: Refers to first lien residential real estate mortgage loans, which include two loan classes: first mortgages and purchased first mortgages.



Full-time equivalent employees: Represents the total number of hours worked divided by a 40-hour work week for the following categories: full-time, part-time, and temporary employees and persons employed on a contract basis.



Interest rate risk: The potential for variability in net interest revenue or the fluctuation in the valuation of assets arising from changes in interest rates.



Interest-bearing liabilities: Includes bank deposits, payables to brokerage clients, short-term borrowings, and long-term debt on which the Company pays interest.



Interest-earning assets: Includes cash and cash equivalents, cash and investments segregated, broker-related receivables, receivables from brokerage clients, securities available for sale, securities held to maturity, and bank loans on which the Company earns interest.



Investment grade: Defined as a rating equivalent to a Moody’s Investors Service (Moody’s) rating of “Baa” or higher, or a Standard & Poor’s Ratings Group (Standard & Poor’s) or Fitch Ratings, Ltd (Fitch) rating of “BBB-” or higher.



Liquidity risk: The potential that the Company will be unable to sell assets or meet cash flow obligations when they come due without incurring unacceptable losses.



Loan-to-value ratio: Calculated as the principal amount of a loan divided by the value of the collateral securing the loan.



Margin loans: Advances made to brokerage clients on a secured basis to purchase securities reflected in receivables from brokerage clients on the Company’s balance sheets.



Market risk: The potential for changes in earnings or the value of financial instruments held by the Company as a result of fluctuations in interest rates, equity prices or market conditions.



Master netting arrangement: An agreement between two counterparties that have multiple contracts with each other that provides for net settlement of all contracts through a single cash payment in the event of default or termination of any one contract.



Mortgage-backed security: A type of asset-backed security that is secured by a mortgage or group of mortgages.



Net interest margin: Net interest revenue divided by average interest-earning assets.



Net new client assets: Total inflows of client cash and securities to the Company less client outflows.



New brokerage accounts: All brokerage accounts opened during the period, as well as any accounts added via acquisition.



Nonperforming assets: The total of nonaccrual loans and other real estate owned.



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Operational risk: The risk, including litigation, of inadequate or failed internal processes, people, systems or from external events and relationships impacting the Company and/or any of its key business partners and third parties.



Order flow revenue: Net compensation received from markets and firms to which Schwab and optionsXpress, Inc. send equity and options orders. Reflects rebates received for certain types of orders, minus fees paid for types of orders for which exchange fees or other charges apply.



Pledged Asset Line: A non-purpose revolving line of credit from Schwab Bank secured by eligible assets held in a separate pledged asset account maintained at Schwab.



Return on average common stockholders’ equity: Calculated as net income available to common stockholders annualized divided by average common stockholders’ equity.



Risk-weighted assets: Primarily computed by assigning specific risk-weightings as specified by the regulators to assets and off-balance sheet instruments for capital adequacy calculations.



Tier 1 Capital: The sum of CET1 Capital and additional Tier 1 Capital instruments and related surplus, less applicable adjustments and deductions.



Tier 1 Leverage Ratio: Tier 1 Capital divided by adjusted average total consolidated assets at the end of the quarter.



Trading days: Days in which the markets/exchanges are open for the buying and selling of securities. Early market closures are counted as half-days.



U.S. federal banking agencies: Refers to the Board of Governors of the Federal Reserve System (Federal Reserve), the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), and the Consumer Financial Protection Bureau (CFPB).



Uniform Net Capital Rule: Refers to Rule 15c3-1 under the Securities Exchange Act of 1934 which specifies minimum capital requirements that are intended to ensure the general financial soundness and liquidity of broker-dealers.





 

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OVERVIEW



Management of the Company focuses on several client activity and financial metrics in evaluating the Company’s financial position and operating performance. Management believes that net revenue growth, pre-tax profit margin, earnings per common share (EPS), and return on average common stockholders’ equity provide broad indicators of the Company’s overall financial health, operating efficiency, and ability to generate acceptable returns. Expenses excluding interest as a percentage of average client assets are considered by management to be a measure of operating efficiency. Results for the third quarters and first nine months of 2016 and 2015 are:







During the third quarter of 2016, the Company’s range of full-service investment capabilities continued to attract a broad spectrum of investors. Core net new assets totaled $30.0 billion and $88.6 billion for the third quarter and nine months ended September 30, 2016, respectively, sustaining a 5% annualized organic growth rate over year-end 2015 client assets. The Company ended the quarter serving 10.0 million active brokerage accounts, 1.1 million banking accounts and 1.6 million retirement plan participants, up 4%, 6%, and 5%, respectively, from the same period in 2015. Total client assets reached $2.73 trillion at September 30, 2016, up 13% year-over-year, as investors continued to engage with the Company throughout the summer quarter. During the third quarter of 2016, the Company’s financial consultants held planning conversations with 34,000 clients, up 17% from the same quarter in 2015. For the nine months ended September 30, 2016, 101,000 clients have participated in such conversations, up 22% from September 30, 2015. Assets enrolled in some form of ongoing advisory service totaled $1.37 trillion at quarter-end, up 14% from a year ago.

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Net revenues increased 20% and 17% in the third quarter and first nine months of 2016, respectively, compared to the same periods in 2015 primarily due to growth in client assets and higher short-term interest rates.



Expenses increased 10% and 9% in the third quarter and first nine months of 2016, respectively, compared to the same periods in 2015 consistent with management’s expectations for spending to support current and future growth in the business.



The pre-tax profit margin for the third quarter and first nine months of 2016 was 41.5% and 39.4%, respectively, compared to 36.5% and 34.9% for the same periods in 2015. Net income grew by 34% and 33%, respectively, for the third quarter and first nine months 2016 compared to the same periods in 2015.



Subsequent Event



On October 31, 2016, the Company issued and sold 600,000 depositary shares, each representing a 1/100th ownership interest in a share of fixed-to-floating rate non-cumulative perpetual preferred stock, Series E, $0.01 par value, with a liquidation preference of $100,000 per share (equivalent to $1,000 per depositary share) (Series E Preferred Stock). The Series E Preferred Stock has a fixed dividend rate of 4.625% through February 28, 2022, payable semi-annually, and thereafter at a floating rate of three-month LIBOR plus a fixed spread of 3.315%, payable quarterly. Net proceeds received from the sale were $591 million and are being used to support balance sheet growth, including the migration of certain client balances from sweep money market funds into Schwab Bank.



Current Regulatory Environment and Other Developments



In September 2016, the OCC issued final guidelines for recovery planning by national banks and federal savings banks with total consolidated assets of $50 billion or more. The guidelines establish enforceable standards requiring each bank to develop and maintain a recovery plan that describes how the bank will restore itself to financial health and viability in response to a wide range of external and internal financial and operational stress scenarios. The guidelines go into effect on January 1, 2017, and Schwab Bank will have until the end of 2017 to develop and prepare a recovery plan.



Effective July 1, 2016, the FDIC began imposing a surcharge on insured depository institutions with total consolidated assets of $10 billion or more at the same time that a scheduled reduction in the regular FDIC insurance assessment also went into effect. As a result, the Company is now subject to a 3 basis point regular assessment on its total assessment base (down from 5 basis points) and a new 4.5 basis point surcharge on the amount of its assessment base in excess of $10 billion. For the third quarter of 2016, the Company’s combined FDIC assessment rate, measured against its total assessment base, rose by a net of 2.2 basis points.



In May 2016, the Federal Reserve, the OCC and the FDIC jointly issued a notice of proposed rulemaking that would impose a minimum net stable funding ratio (NSFR) on certain banking organizations, including CSC. The NSFR is intended to measure an organization’s “available” amount of stable funding relative to its “required” amount of stable funding over a one-year time horizon. The effective date of the rule would be January 1, 2018. The comment period for the proposed rule ended on August 5, 2016 and the impact to the Company cannot be assessed until the final rule is released.



In April 2016, the Department of Labor published a final rule that significantly broadens the definition of “fiduciary” under the Employee Retirement Income Security Act of 1974. Among other things, the new rule subjects broker-dealers who provide non-discretionary investment advice to retirement plans and accounts to a “best interest” standard, as well as other conditions and requirements. Based on the Company’s evaluation of the final rule to date, the Company does not expect the rule to have a material impact on the Company’s business, financial condition or results of operations.



In October 2015, the Federal Reserve issued a notice of proposed rulemaking that, among other things, would require certain financial institutions that are subject to the Federal Reserve’s capital rules to apply a regulatory capital deduction treatment to their investments in unsecured debt issued by U.S. bank holding companies identified as global systemically important banking organizations. The comment period for the rule proposal ended on February 19, 2016 and the rule proposal is subject to further modification. The proposed effective date of the rule would be January 1, 2019. The Company continues to monitor developments in order to assess the impact of the proposed rule, but does not expect it to have a material impact on the Company’s business, financial condition and results of operations.



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Results of Operations



The following discussion presents an analysis of the Company’s results of operations for the third quarter and first nine months of 2016 compared to the same periods in 2015.



Net Revenues









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Asset Management and Administration Fees



Asset management and administration fees include mutual fund and ETF service fees and fees for other asset-based financial services provided to individual and institutional clients. The Company earns mutual fund and ETF service fees for shareholder services, administration, and investment management provided to its proprietary funds, and recordkeeping and shareholder services provided to third-party funds. These fees are based upon the daily balances of client assets invested in these funds. Asset management and administration fees do not include securities lending revenues earned by proprietary mutual funds and ETFs as those amounts, net of program fees, are credited to the fund shareholders.



The Company also earns asset management fees for advice solutions, which include managed portfolios, specialized strategies and customized investment advice.  



The fair values of client assets included in proprietary and third-party mutual funds and ETFs are based on quoted market prices and other observable market data.



Other asset management and administration fees include various asset-based fees, such as trust fees, 401(k) recordkeeping fees, mutual fund clearing fees, collective trust fund fees, and non-balance based service and transaction fees.



Asset management and administration fees vary with changes in the balances of client assets due to market fluctuations and client activity.



The following tables present a roll forward of client assets for the Schwab money market funds, Schwab equity and bond funds and ETFs, and Mutual Fund OneSource®:









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The following tables present asset management and administration fees, average client assets, and average fee yields:









Note: Certain changes have been made to the above categorizations. Prior period information has been recast to reflect these changes.



Asset management and administration fees increased by $135 million, or 20%, and $277 million, or 14%, in the third quarter and first nine months of 2016 compared to the same periods in 2015. The increase is primarily due to higher net yields on money market fund assets as short-term interest rates have risen in 2016, partially offset by a reduction in average client assets in Mutual Fund OneSource.



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Net Interest Revenue



Net interest revenue is the difference between interest earned on interest-earning assets and interest paid on funding sources. The Company’s interest-earning assets are primarily funded through bank deposits and client brokerage account balances.



Interest-earning assets primarily include cash and cash equivalents, segregated cash and investments, margin loans included in receivables from brokerage clients, investment securities and bank loans on which the Company earns interest. Revenue on interest-earning assets is affected by various factors such as the distribution and composition of assets, prevailing interest rates when purchased, and changes in prepayment levels. Fees earned on securities borrowing and lending activities conducted by the Company’s broker-dealer subsidiaries on assets held in client brokerage accounts are included in other interest revenue and expense. The rates on the majority of the Company’s investment securities and loans re-price or reset based on short-term interest rates and the remainder is invested in fixed-rate loans and securities.



The Company’s interest-bearing liabilities include bank deposits, payables to brokerage clients, short-term borrowings and long-term debt. Interest-bearing liabilities are primarily sensitive to short-term interest rates and the Company establishes the rates paid on most of these liabilities. The Company expects that the rate paid on these liabilities will generally adjust at some fraction of the movement in short-term interest rates.



The Company expects that net interest revenue will increase as short-term interest rates increase and decline should rates fall below current levels. When interest rates fall, the Company may attempt to mitigate some of this negative impact by lowering rates paid to clients on interest-bearing liabilities. The current low interest rate environment limits the extent to which the Company can reduce interest expense on funding sources. The Company may also alter the amount and type of fixed rate loans and securities that are added to the portfolio. Generally, modest increases in the percentage of fixed-rate assets will reduce the rate at which net interest revenue changes if rates move.



Non-interest-bearing funding sources include certain cash balances, stockholders’ equity and other miscellaneous assets and liabilities.



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The following tables present net interest revenue information corresponding to interest-earning assets and funding sources on the condensed consolidated balance sheets: