Charles Schwab 2014 Annual Report Download - page 66

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THE CHARLES SCHWAB CORPORATION
- 48 -
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Market risk is 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.
The Company is exposed to interest rate risk primarily from changes in market interest rates on its interest-earning assets
relative to changes in the costs of its funding sources that finance these assets. The majority of the Company’s interest-
earning assets and interest-bearing liabilities are sensitive to changes in short-term interest rates. To a lesser degree, the
Company is sensitive to changes in long-term interest rates through some of its investment portfolios. To manage the
Company’s market risk related to interest rates, management utilizes simulation models, which include the net interest
revenue sensitivity analysis described below.
Net interest revenue is affected by various factors, such as the distribution and composition of interest-earning assets and
interest-bearing liabilities, the spread between yields earned on interest-earning assets and rates paid on interest-bearing
liabilities, which may reprice at different times or by different amounts, and the spread between short and long-term interest
rates. Interest-earning assets include residential real estate loans and mortgage-backed securities. These assets are sensitive to
changes in interest rates and to changes to prepayment levels that tend to increase in a declining rate environment and
decrease in a rising rate environment. Because the Company establishes the rates paid on certain brokerage client cash
balances and deposits from banking clients and the rates charged on margin loans and loans to banking clients, and controls
the composition of its investment securities, it has some ability to manage its net interest spread, depending on competitive
factors and market conditions.
To mitigate the risk of loss, the Company has established policies and procedures which include setting guidelines on the
amount of net interest revenue at risk, and monitoring the net interest margin and average maturity of its interest-earning
assets and funding sources. To remain within these guidelines, the Company manages the maturity, repricing, and cash flow
characteristics of the investment portfolios.
The Company is also subject to market risk as a result of fluctuations in option and equity prices. The Company’s direct
holdings of option and equity securities and its associated exposure to option and equity prices are not material. The
Company is indirectly exposed to option, futures, and equity market fluctuations in connection with client option and futures
accounts, securities collateralizing margin loans to brokerage customers, and customer securities loaned out as part of the
Company’s securities lending activities. Equity market valuations may also affect the level of brokerage client trading
activity, margin borrowing, and overall client engagement with the Company. Additionally, the Company earns mutual fund
service fees and asset management fees based upon daily balances of certain client assets. Fluctuations in these client asset
balances caused by changes in equity valuations directly impact the amount of fee revenue earned by the Company.
Financial instruments held by the Company are also subject to liquidity risk – that is, the risk that valuations will be
negatively affected by changes in demand and the underlying market for a financial instrument. Current conditions in the
credit markets have significantly reduced market liquidity in a wide range of financial instruments, including the types of
instruments held by the Company, and fair value can differ significantly from the value implied by the credit quality and
actual performance of the instrument’s underlying cash flows.
For discussion of the impact of current market conditions on asset management and administration fees and net interest
revenue, see “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Current
Market and Regulatory Environment and Other Developments.”
The Company’s market risk related to financial instruments held for trading is not material.
Net Interest Revenue Simulation
For the Company’s net interest revenue sensitivity analysis, the Company uses net interest revenue simulation modeling
techniques to evaluate and manage the effect of changing interest rates. The simulation includes all interest-sensitive assets
and liabilities. Key variables in the simulation include the repricing of financial instruments, prepayment, reinvestment, and