The First Republic Bank Crisis Unpacked: A Treasurer's View on the Way Forward

The First Republic Bank Crisis Unpacked: A Treasurer's View on the Way Forward

Background

First Republic Bank was known for its personalized service and catered to affluent clients who valued high-touch customer service over slightly higher interest rates on deposits. The bank collected deposits from these clients, paying minimal interest, and used the funds to finance mortgages, enabling more loans for Silicon Valley home renovations or Malibu vacation homes. In a world of ultra-low interest rates, this traditional banking model proved profitable. By 2021, First Republic's average interest rate charged on assets was 3.03%, while depositors received a mere 0.12% interest. In the decade leading up to 2021, the bank's annual profit quadrupled, making it one of the top 20 banks in the US.

Indicators of Distress

In 2022, First Republic pursued aggressive growth. Their total loans rose from $135 billion to $166 billion, while customer deposits increased from $156 billion to $176 billion, maintaining healthy loan deposit ratios of 90% and a net interest margin (NIM) of 2.45%. However, in the first quarter of 2023, the financials began to show signs of overheating. Loan deposit ratios reached 111% (indicating more loans than deposits), and NIM fell to 1.77%, a decline of xx%. Funding became a concern as short-term borrowing increased by xx% to $88.3 billion compared to December 2022. These figures suggest that First Republic struggled to maintain deposits to fund its loans. Unlike other banks, First Republic historically funded customer loans with customer deposits. The mounting pressure on NIM suggests that funding costs increased while loan income stagnated. This situation prompted First Republic to be acquired by JP Morgan to prevent a collapse.

What Happened?

Mismanagement, interest rate hikes, and an aggressive growth strategy were the main culprits. However, in my view, three factors contributed significantly to First Republic's downfall:

Fixed-Rate Mortgages

The sharp drop in net interest income indicates that most of First Republic's customer loans were fixed-rate mortgages. This was confirmed in the bank's 2021 advertising, where the 10-year mortgage rate was 3-4% per annum, consistent with the financial report's average interest charged from assets of 3.03%. This creates a risk during interest rate hikes, particularly when funding is short-term, as was the case with First Republic Bank.

Non-Sticky Deposits

According to First Republic's December 2022 financial report, most loans were funded by short-term customer deposits, which were unlikely to be "sticky." While most of the bank's deposit customers were wealthy and insensitive to pricing, there was a large outflow during interest rate hikes. In just three months between December 2022 and March 2023, the bank lost more than $72 billion, most of which was likely transferred to other banks offering better pricing. This created a domino effect, as existing customers became nervous about the bank's financial health and withdrew more deposits in the following months. First Republic's loan deposit ratios weakened from 90% to 111%, forcing them to borrow from other banks to close the gap. The market began to question the bank's liquidity health.

Interbank Borrowing

The freezing of interbank borrowing exacerbated First Republic Bank's liquidity problem. As concerns mounted about the bank's collapse, other banks were hesitant to lend money to First Republic. This weakened the bank's ability to fund its daily operations and forced it to increase short-term borrowing to $74 billion by March 2023 to replace the outflow of deposits that had been going on for the past three months. The situation was expected to worsen in the coming months, as fewer banks were willing to lend money due to credit risk. If this happened, First Republic would be unable to meet its obligations and would face collapse.

Could First Republic be saved? If the above was the case, regaining market and customer confidence to save the bank would be difficult. Acquisition by a much healthier bank or government bailout might be the only way to prevent collapse. Knowing that only 68% of their total deposits were insured by FDIC, acquisition with government support may be the only way to not only save First Republic but also to maintain confidence in the banking system, which is currently at its lowest.

Preventing Collapse: A Treasurer's Perspective

From a treasurer's perspective, the main role is to strike a balance between risk management and profitability. Profitability was clearly the primary objective for First Republic Bank, as it heavily relied on short-term "non-sticky" deposits to fund long-term loans and took enormous interest rate risks. A good treasurer should remind the board about the risks the company is taking, reflect actual market pricing into the company's balance sheet to prevent mispricing, and manage the bank's financial resources to ensure adequate liquidity and meet financial obligations. This is not an easy task, but the treasurer's job is to keep reminding the board of their role and responsibility, because if something goes wrong with liquidity, the treasurer will be the first to be blamed.Background