In Depth July 16, 2009, 12:00AM EST

Should Charles R. Schwab Aim Higher?

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The other unit handles paperwork, processes trades, and delivers other services to more than 6,000 independent financial advisers. It's a so-called white-label arrangement: The outside advisers hang their own shingles, but Schwab handles the details behind the scenes.

The outside adviser unit generates half the revenues of the core brokerage business, but because it requires less manpower than the retail business it has fatter profit margins and accounts for about one-third of Schwab's total earnings. "Schwab is basically using profits from the adviser business to fund the retail business," says Timothy Welsh, a former Schwab executive who left in 2005 to become an industry consultant.

The problem is that Schwab's in-house retail advisers fish in the same client pool as the external advisers. The outside advisers don't always appreciate the competition.

Rival TD Ameritrade, in contrast, doesn't have any in-house advisers. It's competing vigorously to win new adviser business. When Michael Parikh and Jon Wakely left Merrill Lynch a year ago and formed PW Global Advisors, based in Boston, they chose TD Ameritrade. "They didn't have their own advisers," Wakely says. "If someone walks into a branch, TD will refer them to you, as opposed to having their own people competing against you like Schwab does."

Bettinger is working to improve relations with outside advisers. At a June conclave with its adviser clients, Schwab said it would reduce the trading commissions it charges the advisers' new customers. Schwab will also cut the fees it charges advisers for access to its client-management software. Will such moves help Schwab strike the right balance between the in-house advisers and outside firms? "That's their real strategic question," says Welsh.

As challenging as the past year has been for Schwab, some analysts think the firm should be even more aggressive in courting new business. It has long been criticized for lacking the killer instinct so common on Wall Street. "They've never gone hostile or big on a buyout," says Stace. "Can they roll up discount brokers now? Yes."

He has a point. Back in 2000, Schwab had such a lofty market capitalization that it could have taken out investment banking stalwart Goldman Sachs (GS). Later Schwab passed on the chance to grab CSFBdirect, Datek, Harris Direct, and numerous other online brokers put in play by the tech stock crash. More recently, Schwab stood by while BlackRock swooped in to take out San Francisco's Barclays Global Investors.

Schwab might benefit from going on the attack. Signing up new brokerage customers is a long, arduous process. Firms must advertise extensively, waive initial trading commissions, and process reams of paperwork. The payoff, however, is big: Brokerage accounts are "sticky," meaning once customers sign up they're reluctant to shift. A typical client generates thousands of dollars in commission and fee revenue over his investing lifetime. That's why the discount brokerage business has been consolidating for much of the past decade, with Ameritrade buying Datek before selling itself to TD Waterhouse Group, and E*Trade rolling up DLJdirect, CSFBdirect, Harris Direct, and TeleBank. It's far easier to buy whole swaths of customers than to pick them off one by one.

Struggling E*Trade, with its 4.5 million accounts and $100 billion in assets, seems like tantalizing buyout bait. It rushed headlong into mortgages during the credit boom and now is paying dearly. Some $1.6 billion worth of its loans are delinquent; the figure swells to as much as $2.26 billion if delinquent home equity loans are included. Schwab could snap up all of E*Trade; it has $21 billion in market value to E*Trade's $685 million.

Bettinger says that's not going to happen. "We've looked at every property," he says, "but we're not interested in taking on balance sheet challenges as the price to take on brokerage." Adds Schwab: "We wouldn't take [E*Trade Bank] and manage it out of its problems. We don't know troubled assets."

Fair enough, but why not at least go for E*Trade's jugular through advertising? TD Ameritrade, for one, has increased its ad budget by 13%, to $54 million this past year. "Dislocation drives opportunity," says Fredric J. Tomczyk, chief executive of TD Ameritrade. "We upped our marketing spend as the crisis worsened. We said, 'You know what your full service broker is going through—it's a good time for a second opinion.' " The strategy seems to be working: TD added 143,000 accounts in the quarter ending in March.

Schwab, meanwhile, has cut its ad budget by 24%, to $58 million. Since last fall it has been running somber commercials playing up its own services but not casting aspersions on rivals by name. "We believe our marketing works better than slamming the competition," says Saeger, Schwab's marketing head. "Why reinforce the belief that our category stinks?"

In this and most other matters Schwab is sticking with a strategy of peaceful coexistence. Instead of plundering everything in sight, it plans to take these next few quarters to grow into the new business it already has.

Some think it will regret that decision down the line. But Schwab is unapologetic: "Our clients love stability," he says. "Absolute stability and predictability." That mindset has kept the company in the game for 38 years, outliving the likes of EF Hutton, Lehman, and Kidder Peabody. Maybe the man is on to something.

BusinessWeek Senior Writer Farzad covers Wall Street and international finance. Palmeri is a senior correspondent in BusinessWeek's Los Angeles bureau.

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