Just a few weeks ago, market watchers, regulators and risk managers were paranoid about the state of the banking system. Topics related to liquidity risk, deposit run-offs and stable funding roamed financial headlines. We wondered whether there was contagion in financial markets and in the financial system. If there is a stress in one part of the arena, does it imply or lead to stress everywhere?
In just a span of a few weeks, names like Credit Suisse and Silicon Valley Bank disappeared forever. Credit Suisse had been the formidable international bank that absorbed the once-formidable, prestigious investment bank First Boston. Silicon Valley had been the regional bank that found a niche on the West Coast and had begun sprout and establish an untouchable perch among venture capitalists and tech-firm CFOs.
And then there was First Republic.
Some of the first-half, 2023, panic about the health of bank balance sheets has dimmed. Markets and degrees of mania pummel long-standing financial institutions. And then markets move on.
The problem with contagion is that customer mania leads to run-offs, which leads markets to panic in their determination to figure out who's next: What other institutions are suffering from the same risks? Mania transfers to the other banks. Markets react first and ponder the ramifications or root causes later.
JPMorgan in early May pounced on the opportunity to take over First Republic in the same way it seized Bear Stearns in 2008. In the midst of that crisis back then, the bank also acquired a failing Washington Mutual. It absorbed both large financial institutions and would later admit there were reams of lessons it learned from such swift takeovers, risks they learned about after acquisitions had been consummated.
In 2023, its acquisition was similarly swift, but it claims its due diligence was much more thorough. In one public document, it says 800 personnel were devoted to examining the bank's loan portfolios, balance sheet, client lists, etc., as they were determined to find hidden risks. But it helped overall that the FDIC agreed to guarantee 80% of the loan exposure.
That makes due diligence that much easier. Such a government-related guarantee also reduces the capital required to support its bringing in a loan portfolio that exceeds $100 billion.
It's fair to conclude JPMorgan cared little about the First Republic "brand" or expertise of its senior leaders. It wanted clients, accounts, deposits and branches in areas where it has near-invisible presence today--especially valuable private-banking clients and accounts.
Nonetheless, First Republic's demise was a little bit trickier than Silicon Valley's. Both, of course, suffered because of rampant, rash run-offs from depositors. But the scares might have resulted from different causes.
At Silicon Valley, a concentrated group of tech-company and venture-capital fund depositors were alarmed by the mounting losses in the bank's fixed-income investment portfolio. The losses, of course, were caused by steady increases in interest rates throughout 2022. When a handful of depositors requested withdrawals that led to realized losses in the portfolio, other depositors in a near panic sought to do the same.
At First Republic, a large, but conventional bank focusing on private-wealth clients had amassed large portfolios in real-estate and mortgage loans--when interest rates were hovering near record lows. As interest rates crept upward, funding costs steadily increased. Therefore, net-interest spreads and net-interest earned declined. A new mortgage over 10 years ago might have earned 8%; by 2020-21, a new mortgage earned less than 3%. In 2022, deposits matured and had to be refinanced at higher rates.
All banks faced the same net-interest-spread challenge in the same way all banks faced the decline in values in their respective fixed-income investment portfolios. But the impact of such risks proved more harmful to Silicon Value and First Republic than most other institutions--partly because of the concentration of customer base and the lack of diversity in business activities. First Republic shareholders were haunted by the steady deterioration in performance, leading depositors and fund-providers concerned about its solvency in the long term.
Larger banks facing low net-interest spreads, during the years of 2015-2021, could offset such declines with ancillary businesses: investment banking, principal trading, cash-management services, and asset management.
Larger banks, too, would likely have much better expertise and competence using complex derivatives to minimize the losses in their portfolios in fixed-income investments. Imagine almost any bank, besides the derivatives powerhouses of Goldman Sachs or JPMorgan Chase, considering such interest-rate derivatives as "swaptions" or "deferred interest-rate swaps."
In the end, as soon as it could, JPMorgan Chase announced to valued First Republic private-banking clients that they had become JPMorgan clients, and the First Republic name and brand would immediately become sequestered into latest chapters of finance history books.
Along with the names of Bear Stearns, Lehman, Drexel, and Washington Mutual.
Tracy Williams
See also:
The Sudden Falls of Silicon Valley Bank, 2023
Turmoil at Deutsche Bank, 2016
"Where Was the Risk Management Group?" 2012
MF Global's Sudden Demise, 2011
Knight Capital's Darkest Day, 2012
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