Governance, Operational Resilience, Regulation & Supervision

Eight epic fails which brought down First Republic

By Ellesheva Kissin
Image: Getty Images

A US regulator’s analysis of why First Republic Bank failed pins the blame on loss of depositor confidence, interest rate failures – and huge holes in its own oversight.

The damning report, conducted by Federal Deposit Insurance Corporation chief risk officer Marshall Gentry, scrutinised the bank from 2018 up to its failure in May 2023 following one of the largest US bank runs in history. 

Most of the Californian-based bank’s assets and liabilities were later sold to JPMorgan Chase.

Putting aside the FDIC’s own shortcomings for now, what can banks learn from First Republic’s mistakes?

Losing trust: The primary trigger for the run was the market and depositors losing faith in the bank. An earnings call in April, which disclosed that First Republic lost over $100bn in deposits during the first quarter of 2023, contributed to the bank’s stock price slide and huge deposit outflows. 

First Republic was lulled into a false sense of security because its customer survey results showed a high degree of satisfaction, but depositors can flee in times of market distress.

Rapid growth and poorly managed concentrations: First Republic Bank outpaced its peers with a 21% average annual growth in total assets between 2018 and 2022. But it didn’t properly manage this growth, which was highly concentrated among certain assets.

That meant the bank’s performance was sensitive to economic headwinds. A significant portion of its portfolio was in single-family residential loans, a key part of the bank’s business model. Borrowers preferred long-term, low-rate loans during a period of low interest rates. However, rapid interest rate rises in 2022 created an asset/liability mismatch, posing a significant challenge for the bank.

Dependence on uninsured deposits: A major Achilles’ heel was First Republic’s overreliance on uninsured deposits. Depending heavily on one source of funding is risky business, which became evident when withdrawals surged during the crisis.

From 2018 to 2022, uninsured deposits ranged from 51% to 64% of the bank’s total assets. They nearly doubled from the end of 2019 to the end of 2021, as customers flocked to cash.

But uninsured depositors, although happy in good times, deserted the bank when it faced difficulties. 

Interest rate risk ignored: First Republic Bank had a lending-focused business model that worked well when rates were low.

The bank’s success depended heavily on its ability to attract stable, low-cost deposits and issue low-rate loans. However, when interest rates started rising in 2022, that business model came under pressure. 

Customers shifted from non-interest-bearing accounts to interest-bearing time deposits, increasing the bank’s funding costs. The bank also took a hit from unrealised fair value losses on loans and securities due to rising rates.

First Republic failed to mitigate interest rate risk. It could have adjusted loan pricing, raised more capital, engaged in hedging activities, or sold loans before rates increased. 

Contagion effect: The failure of other mid-sized banks, which had some of the same customers as First Republic including venture capitalists, led to a domino effect. This caused immediate liquidity problems, forcing the bank to borrow extensively to stay afloat.

The situation worsened when negative attention from short sellers and social media caused First Republic’s stock price and deposits to plummet.

Despite initial inflows of deposits from now-defunct SVB customers, First Republic couldn’t shore up confidence. Deposit outflows reached $25bn in a single day, forcing the bank to draw on emergency funding lines. 

Overly-generous liquidity ratings: The FDIC gave First Republic a favourable liquidity rating in 2021, despite its high level of uninsured deposits. This rating didn’t align with the bank’s funding concentration, raising eyebrows.

Unprecedented events: The events of March 2023 were truly extraordinary. Sudden and rapid deposit withdrawals from multiple banks took them – and regulators – by surprise. 

It remains uncertain whether earlier supervisory actions could have completely prevented First Republic’s fall.

And finally… a mea culpa from FDIC

The regulator acknowledged it hadn’t spent enough time monitoring the bank, while examination hours – the amount of time a supervisor spends on a regulated entity – declined 11 per cent as the bank doubled in size. 

The FDIC conceded that “meaningful action to mitigate interest rate risk and address funding concentrations,” could have had an impact. This echoes an earlier Federal Reserve report, which found holes in how Silicon Valley Bank was supervised in the lead-up to its million-dollar-per-second bank implosion. 

Key lessons for banks

Evgueni Ivantsov, chair of the European Risk Management Council, gave banks prescient advice after SVB’s collapse, centring on the same issues that have resurfaced for First Republic in the FDIC’s analysis.

His main pieces of advice were: focus on the potential risks in business strategy, insulate for the impact of the smartphone on liquidity risk, and put in place backstops against the risk that uninsured deposits present.

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