What went wrong with First Republic Bank?
First Republic Bank has collapsed due to declining asset values and deposit flight. UNSW Business School's Mark Humphery-Jenner examines what happens now
The banking crisis has festered throughout 2023, and the latest victim is First Republic Bank. How did we get here, and what went wrong?
At the start of 2023, First Republic was worth over $20 billion. However, First Republic’s share price fell precipitously after SVB and Signature Bank collapsed. The stock price entered a death spiral after the Q1 earnings release.
In a dramatic turn of events, the Federal Deposit Insurance Corporation (FDIC) seized the First Republic and sold its assets to the highest bidder. That bidder was JPMorgan. JPMorgan acquired almost all of First Republic’s assets: $173 billion of loans and $30 billion of securities. They are also assuming control over $92 billion in deposits. JPMorgan ‘conservatively’ estimates that the deal will add $500 million to their annual net income.
First Republic's declining asset value
First Republic takes money from depositors. These deposits are liabilities from First Republic’s perspective: First Republic must repay the depositors if they ask. First Republic – like any bank – lends the money. They might do this by creating mortgages or by buying treasuries, which implicitly involves lending to the government. This lending is an asset from First Republic’s perspective: First Republic is now entitled to receive interest and principal on those loans.
First Republic’s assets fell in value and this created solvency concerns. When First Republic loaned money, it was at the prevailing interest rate. Unfortunately for First Republic, many of these loans were at low interest rates. However, the Federal Reserve hiked rates. This reduced the value of those loans. This is because a loan of a similar level of risk would now attract a higher interest rate, making existing loans at low rates worth less.
This asset issue impacted – and continues to impact – all banks to varying extents. First Republic feels the impact more than other banks due to a dearth of hedging and reports that it had issued relatively low interest loans in order to attract high-net-worth customers, which First Republic presumably felt would generate revenue through other activities.
The net result is that there were concerns about whether First Republic’s assets were truly sufficient to satisfy their deposit base. And this becomes a concern when depositors withdraw cash and First Republic must sell its assets – at the now diminished value – in order to return depositors’ money.
First Republic lost $100 billion in deposits
Deposits have left First Republic. In First Republic’s Q1 earnings, it reported that deposits fell by $70 billion (from around $170 billion to $100 billion). However, the situation is worse than it appears. Of the remaining $100 billion, $30 billion was a lifeline from 11 major banks and this offset outflows. Thus, First Republic lost $100 billion in deposits. First Republic had also started to rely on short-term facilities from the government. But, these are short-term facilities and still at higher interest rates than their loans. This raises several concerns:
- Will the first republic genuinely be able to satisfy additional deposit repatriations without taking a significant realised loss by selling its assets?
- How will First Republic attract capital to generate new loans and continue operating? What will the cost of that capital be?
- What happens when the First Republic must repay (or rollover) those short-term government facilities?
This situation spooked depositors. This was especially so given the collapse of SVB and Signature Bank. This is especially so for large deposits above the $250,000 FDIC insurance threshold.
Government communication and response
The government must take some responsibility for exacerbating this situation. Immediately after the SVB collapse, there was relief in the belief that the FDIC would temporarily insure all deposits in order to prevent a broader bank collapse. However, Treasury and Congress did not support this. This exacerbated the deposit flight.
Deposit insurance would not be a bailout per se. Rather, the insurance is funded via a special adjustment (i.e., levy) on other banks. The taxpayer does not insure the deposits. Further, the goal of deposit insurance is deterrence: If people know their deposits are safe, there is no reason to engage in a bank run; thus, there is less reason for a bank to collapse. And thus, there is less need for deposit insurance. The purpose of deposit insurance is to ensure that it is never needed.
The issue here appears to be with Congress. While the FDIC and Janet Yellen appear to understand this game theory, Congress seemed to believe that deposit insurance was a ‘bailout’; thus, it was politically untenable.
The poor communication and policy setting ultimately meant that the entire purpose of FDIC deposit insurance – preventing a bank run – appeared undone.
Bad company communication
First Republic’s communication has been bad. First Republic’s management team was relatively silent as their stock price fell before the Q1 earnings release. The Q1 earnings release revealed a precipitous decline in deposits. But communication made this worse.
Why is it that management did not manage communication before the Q1 earnings?
Management did not take questions at the earnings release. Why? Hiding from questions allows investors to assume the worst. And this creates a stock price death spiral. And, in turn, this encourages more deposit flight.
This is a problem. Managers have failed to reassure markets. This has very real consequences. When depositors see the stock price enter a death spiral, they naturally withdraw their money. This worsens the firm’s fundamentals. The market realises this risk, and the death spiral worsens. This negative feedback loop exacerbates the situation.
Could the collapse have been avoided?
In a perfect world, this situation could have been avoided. But this is easy to say with hindsight.
To be clear, this is not the fault of the Federal Reserve. The Federal Reserve increased interest rates in order to mitigate inflation. If they did not do so, inflation would be worse. Had they not increased rates, we would be discussing other negative – possibly worse – outcomes.
It is also not First Republic’s fault for lending money at low rates. Those were the prevailing rates at the time. However, one could argue that the First Republic should have hedged better, made fewer loans, or spaced the lending over time. Proactive risk management could have been better.
Other parties could have taken steps once the situation emerged. If the FDIC had insured all deposits – even temporarily until banks stabilised – it would have reduced deposit flight and prevented the situation. If management had better managed communication or sought to sell assets earlier – even at a slight loss – it could have mitigated problems. It might have cooled negative sentiment if management had communicated these steps to the market.
What happens now?
At this point, it does not appear that First Republic collapsing will trigger a broader crisis. First Republic is not interconnected to the same extent as systemically important banks (i.e., JPMorgan). The stock market appears sanguine at the time of writing. Such contagion was not necessarily certain when SVB collapsed either. But, other regional banks do not appear to be under such pressure, at least imminently.
Mark Humphery-Jenner is an Associate Professor in the School of Banking & Finance at UNSW Business School. He has been published in leading management journals, and his research interests include corporate finance, venture capital and law. For more information, please contact A/Prof. Humphery-Jenner directly.