BANKING CRISIS - PART 1 - Fall of First Republic Bank

Why are banks failing to begin with? 

According to a recent study published on the Social Science Research Network, 186 banks across the United States could be susceptible to the same risk that caused the downfall of Silicon Valley Bank. The report revealed that if half of the depositors in these banks withdraw their funds rapidly, the banks could collapse. Even insured depositors with $250,000 or less could experience difficulties in retrieving their money if these banks suffer from a bank run, similar to what occurred with SVB. These banks are concerned as they have a considerable portion of their assets invested in financial instruments sensitive to interest rates, such as government bonds and mortgage-backed securities. As interest rates increased over the last year, the value of these older, low-interest investments fell sharply, resulting in loss for bank. The bank then have to sell some of these bonds for less than the purchase price to meet customer withdrawal demands, which sparked a panic among its customer base.

FALL OF FIRST REPUBLIC BANK 

Regulators took over First Republic Bank and then sold its assets to JPMorgan Chase , through the competitive bidding process,52 days after the collapse of Silicon Valley Bank (SVB) and Signature Bank. First Republic, one of the regional banks most affected by the banking sector's loss of confidence, experienced a significant withdrawal of deposits from customers, with roughly $100 billion pulled out in March alone. Despite other major banks attempting to rescue the First Republic by placing $30 billion in uninsured deposits with the struggling lender, the bank ended March with $74.4 billion in total deposits, down from $173.5 billion on March 9. Not everyone was happy, with concerns that JPMorgan's acquisition would further contribute to the trend of consolidation in the banking sector. The number of U.S. banks has significantly decreased from 14,469 in the early 1980s to 4,135 by the end of 2022, with the remaining banks operating over 71,000 branches.

Why First Republic Bank failed and What JP Morgan’s deal means?

Under the deal, JPMorgan will pay $10.6 billion to the FDIC, and First Republic's 84 offices across eight states will reopen as branches of JPMorgan Chase Bank. The acquisition will expand JPMorgan's size, with a loss-share agreement with the FDIC covering the acquired loans but not First Republic's corporate debt or preferred stock.

First republic’s growth

• First Republic was founded in 1985 by James "Jim" Herbert, from a family of community bankers in Ohio.
• The bank initially focused on providing substantial loans at competitive rates.
• Merrill Lynch acquired First Republic in 2007, but the bank returned to the stock market in 2010 following its sale by Merrill's new parent company, Bank of America.
• First Republic's business model aimed to attract high-net-worth customers by offering preferential rates on loans and mortgages.

• First Republic catered to other segments of the community as well, with schools and non-profit organizations accounting for 22% of its business loans.
• According to the bank, First Republic's shareholder returns were remarkable, compounding at 19.5% annually in January, which was over twice that of its peers.
• The median single-family home loan borrower had access to $685,000 in cash, significantly higher than the average American.
• The bank's strategy left it vulnerable compared to regional lenders with less affluent customers because U.S. deposit insurance only covers up to $250,000 per savings account. Consequently, First Republic had a high level of uninsured deposits.
• As the U.S. Federal Reserve raised interest rates, the value of the bank's loan book and investment portfolio decreased, hindering its chances of a capital raise.

And how it unwounded?

• Due to the U.S. Federal Reserve raising interest rates to combat inflation, First Republic began incurring unrealized losses on its investment portfolio last year.
• Gross unrealized losses in its held-to-maturity investment portfolio, mainly consisting of government-backed debt, surged from $53 million to $4.8 billion by the end of December, according to the bank's annual report.
• By March of this year, analysts and investors estimated the bank's paper losses to be between $9.4 billion and $13.5 billion.
• First Republic's annual report cautioned investors that over 50% of its loan book was made up of single-family residential mortgage loans that were challenging to dispose of.
• First Republic Bank becomes the second-largest bank failure in US history, sold to JPMorgan Chase by the Federal Deposit Insurance Corp.

Lessons to learn after the failure of First Republic Bank?

• Policymakers and regulators should address incentive structures that encourage excessive risk-taking in the banking industry, a recurring problem since the 1980s savings and loan crisis.
• The 2008 financial crisis exemplifies how short-term incentives encourage risky strategies, as executives benefited by taking excessive risks and passing the consequences to others.

What are possible responses to a bank failure? 

• Bailouts: In some cases, governments may choose to bail out a failing bank by providing financial assistance to prevent its collapse. This could involve injecting capital, providing loans, or even nationalizing the bank. 
• Acquisition by another bank: A failing bank may be acquired by another bank, either through a merger or acquisition, to prevent it from collapsing. 
• Liquidation: In some cases, a failing bank may be liquidated, which means its assets are sold off to pay its debts. Depositors may receive some or all of their deposits back through the liquidation process.
• Bankruptcy: A failing bank may also file for bankruptcy, which means it is unable to pay its debts and is dissolved. In this case, depositors may receive some or all of their deposits back through the bankruptcy process.

What are some effective Risk Management methods to prevent further bank failures?

• In order to reduce the risk of a bank failure, there are different measures that various groups can take. Mid-sized banks, for example, can establish a robust internal system for balance sheet management that can identify and address any significant gaps on their balance sheet. This system should enable banks to run simulations that will allow them to apply a comprehensive risk management framework in times of uncertainty, which can be helpful when a crisis arises. Data is essential in this process since it can help lenders better calculate the secured lending risk exposure. 

• AI and other automation tools can assist financial institutions in gaining a better understanding of their secured position and making more informed decisions. AI can potentially have insights into the creditworthiness and financial stability of other financial entities, including banks. Additionally, AI's risk management practices can serve as a model for banks and regulators to learn from. While AI may provide additional insights into the financial system, it is still essential for regulators to monitor and regulate these entities to prevent systemic risk and protect the stability of the financial system.

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