Freed Enterprise : Unrestrained, Schwab Brokerage Sets Sights on New Products
Charles R. Schwab feels like a hostage set free after a long captivity.
When the brash young executive sold his fast-growing Charles Schwab & Co. discount stock brokerage to BankAmerica in 1983, its ability to develop and market new products was soon limited by regulatory shackles that prevent banks and their subsidiaries from entering businesses such as insurance and securities underwriting.
But now, a little over a month after he and an investor group bought the brokerage back from BankAmerica, the millionaire entrepreneur is moving to exploit his new-found freedom.
“We have a lengthy list of things we think we can do,” Schwab, chairman of the San Francisco-based brokerage, said in an interview in Los Angeles. Mutual funds, term insurance, real estate investment trusts, gold certificates, home equity loans and currency futures are among several new products under consideration, along with rapid expansion of branch offices, Schwab said.
Freed from banking regulations, said Perrin Long, brokerage analyst at Lipper Analytical Securities in New York, “they can do anything they want.”
Schwab’s ambitious plans are the latest manifestation of his obsession for growth and innovation that has thrust his firm far into the lead as the nation’s largest discount brokerage.
It also is yet another example of the burgeoning of products and services throughout the discount brokerage industry--a development that is blurring the distinctions between top discounters such as Schwab and their full-service competitors such as Merrill Lynch and Shearson Lehman Bros.
Discount brokerages gained initial popularity in the 1970s for no-frills execution of stock and bond trades, charging commissions as much as 80% lower than those of full-service brokerages because they did not offer expensive research and investment advice.
Now, although they still do not offer research and advice, they provide many of the same products and services as full-service brokers. That is the case even with discounters still owned by banking firms, such as Security Pacific Brokers, which has added a number of new services, including sales of mutual funds.
Discounters are even offering some services that their full-service rivals do not, such as systems that allow customers to place orders at home through personal computers 24 hours a day.
Out from under the banking system’s regulatory clutches, “We’re going to see Schwab evolve into something in between a discounter and a full-service brokerage,” said James R. Quandt, president and chief executive of Security Pacific Brokers, a unit of Los Angeles-based Security Pacific Corp.
“They are going to be developing and producing their own products, rather than just vending” other firms’ products, Quandt said. Bank-owned brokerages cannot develop their own securities products as easily as independent firms, he added.
Some industry experts say such product diversification eventually will be necessary for the discount brokerage industry if it is to significantly boost its 20% share of the retail brokerage market. Discounting is no longer a novelty to investors, and new products and services will be needed to wring more revenue from existing customers, analysts say.
Sought Visibility
In many ways, nobody embodies this diversification effort better than Schwab, 49. A Stanford MBA and former mutual fund manager who failed in several different investment ventures before starting Schwab & Co. with a $100,000 outlay in the early 1970s, he helped pioneer the discount brokerage field.
By the time the firm was acquired by BankAmerica in 1983 for $57 million, it was the industry leader with a product line that had already had grown beyond simple execution of stock and bond trades. It included, for example, the sale of term insurance, a product it had to drop after it was bought by the bank. The brokerage went into the deal with BankAmerica in part to give it added visibility and access to capital, Schwab said in retrospect.
The firm continued to add other new products and services while under BankAmerica ownership, and its profits and revenues continued to soar even while its parent’s fortunes sank due to losses from its massive portfolio of troubled loans.
BankAmerica allowed the brokerage to remain largely autonomous, Schwab said. But many product innovations were out of the question, thanks largely to the Glass-Steagall Act, the Depression-era law that prevents banks and their subsidiaries from underwriting securities or entering a number of other securities-related businesses. BankAmerica’s conservative legal staff discouraged the brokerage from testing the limits of Glass-Steagall, Schwab said.
Meanwhile, Schwab, who served as a BankAmerica director while continuing as chairman of the brokerage, was increasingly at odds with BankAmerica management over how to deal with the banking firm’s mounting financial woes. Schwab contended that the firm should move faster in cutting costs and reorganizing but said he met resistance from most other BankAmerica directors.
Thus, seeing the value of his BankAmerica stock plummet while feeling restricted by the banking system’s regulatory straitjacket, Schwab in 1985 began pressing BankAmerica to sell the firm back to him. After discouraging BankAmerica from weighing bids from about 50 other potential bidders, Schwab prevailed earlier this year, taking the firm private for $280 million in cash and securities in a deal that closed March 31.
In the wake of the buyback, Schwab said he is now considering the possibility of taking the company public, although such a move would be done more to raise capital for expansion rather than to pay debt incurred in reacquiring the firm.
Freedom from BankAmerica also will allow Schwab to work out joint ventures with other banks and firms, Schwab said.
Among the many new products that Schwab is most interested in offering are its own mutual funds. Like Security Pacific Brokers and some other discounters, Schwab & Co. sells, on a commission basis, nearly 300 mutual funds, a business that has been booming of late. But those funds are developed and managed by other firms, who thus also pocket the management fees.
Schwab said his company intends to develop and manage its own funds, which may take the form of “index” funds, which buy the stocks and bonds making up such market indexes as the Dow Jones average of 30 industrial stocks or the American Stock Exchange market-value index. Such funds, which by nature carry lower management fees than other funds, are gaining in popularity.
Schwab said the firm is also considering offering home equity loans, possibly through a joint venture with a banking firm. The loans could be tied to the credit card that Schwab already offers to customers.
Schwab said he probably will not offer commodity futures but may offer stock-index and currency futures to sophisticated investors.
Growth plans also include adding new offices to the firm’s current 102. There are nine offices in the Los Angeles area, and the executive said that number could double within two years. He also is considering opening branches in London, West Germany and Japan to add to the lone existing overseas office in Hong Kong.
Such growth is aimed at providing all of a customer’s investment needs, Schwab said. It also is aimed at helping the firm maintain its lead over such other major discounters as Fidelity Brokerage, Quick & Reilly and Security Pacific Brokers.
“No one has the critical mass to do the things we want to do on a national scale,” Schwab said, noting his firm’s large customer base and claiming that it leads in use of computers and other technology.
Analyst Long said, however, that Schwab will not find it easy to pull off such growth while keeping costs down and profitability up.
The firm’s commissions already are being undercut by other discount brokers and its pretax profit margins lag behind those of arch-rival Quick & Reilly, the nation’s second-largest discounter, Long said. Also, adding new offices and complicated products will boost Schwab’s administrative and sales costs, which could force the firm to raise commissions or cut profit margins, or both.
Meanwhile, competition from full-service firms may intensify. Some routinely offer discounts on commissions to larger, high-volume customers, Long said.
Some also are offering their own discount-commission programs, Long said. Merrill Lynch, for example, offers a program under which a select group of customers may trade stocks by telephone for fees as much as 55% lower than its full-service commissions. Trades are executed the day after orders are received, enabling the firm to bundle orders and pass the savings along to clients.
But Schwab said he is confident he can keep his costs--and commissions--well below those of full-service brokers while staying competitive with other discounters. With full-service firms’ expensive staffs of account executives and other sales and research personnel, “their cost structures are too different and too high,” Schwab said. “They are not structured to meet us head on.”
