What does the First Republic Bank collapse mean for the banking industry?

In the wake of the recent collapse of Silicon Valley Bank and Credit Suisse, concerns about the stability of the banking system have been amplified. With the potential for a domino effect to occur within the industry, experts have been closely monitoring the situation. 

Unfortunately, it seems that their fears have become a reality as the next victim of this ongoing crisis has been identified: First Republic Bank. As the situation continues to unfold, many are left wondering what the future holds for the banking industry as a whole.

High-net-worth individuals receive commercial banking and wealth management services from First Republic Bank, a significant provider in the industry. With 93 offices across 11 states, including New York, California, Massachusetts, and Florida, the bank has $166 billion in outstanding loans receivable as of December 31, 2022, mainly secured by collateral in major metro areas. 

The bank has grown through strategic acquisitions such as the Private Client Asset Management division of Bay Isle Financial and Bank of Walnut Creek. After being acquired by Merrill Lynch for $1.8 billion in 2007, First Republic Bank was sold to a group of private investors for $1 billion in 2010 and became a public company again after an initial public offering in December of that year. 

Since then, First Republic Bank has demonstrated a steady expansion and development by procuring wealth management firms like Luminous Capital and Constellation Wealth Partners. Gradifi, a two-year-old startup that assists companies in supporting their employees to pay off their student loan debts, was also acquired by the bank in December 2016. 

While there were some hurdles along the way, such as the departure of 50 client advisors associated with the Luminous acquisition, First Republic Bank has managed to maintain its prominent position in the high-net-worth banking and wealth management industry.

Despite the good track the bank was having, it hasn't been able to escape from the banking turmoil we are experiencing. On April 24th, the company reported earnings showing how in danger they were: revenues were down 13.4%, net interest income was down 19.4%, net income was down 32.9%, The diluted earnings per share saw a decline of 38.5%, while the net interest margin for the current quarter was 1.77%, a decrease from 2.45% in the previous quarter. 

In the bank's first update to investors since entering a free-fall over the past month and a half, its executives refused to answer questions about its first-quarter results. Even though its leaders did not want to talk, what is certain is that the bank appeared to be on the brink of collapse: it suffered a colossal loss of $102 billion in customer deposits, which accounts for more than half of the $176 billion it had held at the conclusion of the previous year. 

This substantial decline in deposits does not even consider the recent temporary aid of $30 billion granted by the largest banks in the country.

During this same period, the bank acquired a loan of $92 billion, primarily from the Federal Reserve and government-supported lending organisations, effectively swapping its deposits with loans. This is a hazardous strategy for any bank, as they typically rely on acquiring relatively low-cost customer deposits and providing loans to homebuyers and businesses at significantly higher interest rates. 

Despite the risky manoeuvre, First Republic is still generating some profit, reporting a quarterly gain of $269 million, a decrease of one-third from the previous year. The bank issued fewer loans compared to earlier quarters, following a general banking trend, as executives in the industry are concerned about an economic downturn, as well as a decline in home sales and prices.

In the aftermath of its earnings report, the bank's stock initially surged by more than 10%. Subsequently, it plummeted by approximately 20% during after-hours trading, exacerbated by executives' refusal to field analyst inquiries. On top of that, over the last half of a year, its share price decreased by 90%. The bank reassured investors by stating that the bulk of its deposit exodus had ceased by the end of March, with a mere 1.7% of its deposits lost between March 31 and April 21, primarily due to client tax payments. 

This decline was precipitated roughly six weeks prior when federal regulators seized Silicon Valley Bank and Signature Bank, prompting customers to withdraw billions of dollars in deposits. First Republic, situated in San Francisco, was one of the banks most markets to fail after the Silicon Valley collapse. In fact, it was particularly susceptible to a similar fate as it catered to many start-up companies, analogous to Silicon Valley Bank, and boasted numerous accounts holding over $250,000, the federal deposit insurance limit.

Moody's recent downgrade of 11 regional lenders highlights the banking industry's challenges, with First Republic also struggling due to a $25 billion hole in its balance sheet. The bank is in talks with financial advisers and government officials to develop a plan to save itself, potentially involving the sale of the bank or parts of it or raising new capital. However, each party involved has different priorities, timelines, and constraints. 

Despite the bank's suspension of dividends and loss of wealth advisers, analysts believe it may still be able to operate as a stand-alone company. However, there are many actions that still have to be taken. First Republic has started addressing its issues by cutting its workforce by up to a quarter and reducing executive compensation.

However, the future of this financial institution does not look very bright. This financial institution is struggling to find a buyer for the entire bank or sell portions of it separately. And if proper offers have not appeared already, it is hard to believe that they will appear in the future. 

The Federal Reserve cannot ease a takeover as it did in 2008. The Federal Deposit Insurance Corporation may have to fail the bank, which would require approval from multiple agencies. If the bank fails, the government must decide whether to protect its uninsured depositors, which is a difficult decision.

The fact that none of the largest banks in the US, such as J.P. Morgan Chase, Bank of America, Citi Bank, or Wells Fargo, have made a competitive offer is especially alarming. Is First Republic Bank in an unhealthy financial situation, or is it that not even the big fish in the industry can afford to take it? 

For the good of humanity, hopefully, it is not the second case. Otherwise, we can get ready for the worst. Nonetheless, if this situation continues, the most logical conclusion would be for the bank to end up in the government's hands and ensure the safety of people's money.

The recent downfall of First Republic Bank has once again brought the spotlight on the fragility of the banking system. The crisis has highlighted the importance of strong risk management practices that banks must adopt to withstand such unprecedented situations. 

It also emphasises the need for regulators to keep a close watch on the functioning of financial institutions to avoid similar instances from happening in the future. It is crucial for banks to maintain a proactive approach towards risk management, which involves identifying potential threats and taking necessary steps to mitigate them. 

Banks need to have robust mechanisms in place to monitor and assess the impact of risks and to have a contingency plan that can be implemented in case of a crisis. Regulators also play a critical role in ensuring the stability and sustainability of the financial system. They need to ensure that banks adhere to the regulations and guidelines set forth by them and take corrective actions in case of any non-compliance.

As we pointed out a month ago, there was a potential domino effect if a bank collapses, and it seems like it is currently in motion. The failure of a bank not only affects its depositors and creditors but also undermines trust and confidence in the entire banking system. The interconnectedness of banks means that when one institution borrows from another, its collapse can trigger a chain reaction, causing more banks to fail until measures are taken to prevent it. 

This situation raises concerns about banks' transparency and reliability and creates uncertainty among customers who fear experiencing a similar fate. As a result, they may opt to withdraw their funds from smaller banks and deposit them in larger, more stable institutions or even choose to keep their money at home in cash. 

Such behaviour can cause a further chain reaction, as banks rely on deposits to lend to other customers and cannot immediately fulfil all withdrawal requests. This can eventually lead to the bank's collapse, further exacerbating the harm to the integrity of the banking system.

M. Kabir Hassan is a Professor of Finance at the University of New Orleans, US

José Antonio Pérez Amuedo is a PhD doctoral Student at the University of New Orleans, US

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions and views of The Business Standard.