Written by: Michael Farrell
On May 1, 2023, First Republic Bank – one of the largest banks managed by the Federal Deposit Insurance Corporation (FDIC) – experienced the second-largest bank failure in United States history. As of March 31, 2023, First Republic had a total of $232.9 billion in assets and $104.5 billion in total deposits with a focus on offering services to high-net-worth individuals with single-family residential loans as the primary loan product. After careful examination, the FDIC recently released a report, detailing the cause of the bank’s failure and the evaluation of the FDIC’s supervision.
According to the FDIC Supervisory Report the federal regulator concluded, “We cannot say whether taking earlier supervisory action such as criticizing interest rate risk or liquidity risk management would have prevented First Republic from failing, given the significance and speed of deposit withdrawals in the wake of the contagion sparked by SVB’s failure. However, meaningful action to mitigate interest rate risk and address funding concentrations would have made First Republic more resilient and less vulnerable to the March 2023 contagion event.”
The run on the bank’s deposits was subsequent to the failures of Silicon Valley Bank and Signature Bank. Therefore, it is no surprise that a large run on deposits can create a less than well-capitalized scenario for the institution – but what characteristics created an opportunity for failure?
What Factors Played a Role in First Republic Bank’s Failure?
In addition to other characteristics, there are two factors that played a large role in the First Republic’s failure. First, the bank had high levels of uninsured deposits, and its niche customer base also included venture capital clients like Silicon Valley Bank. Second, the bank had large unrealized losses in fair value of securities. Venture capital customers were responsible for a large withdrawal of uninsured deposits at both Silicon Valley Bank and First Republic Bank. However, the deposit run did not stop after the April 24, 2023 earnings call, which disclosed that First Republic lost over $100 billion in deposits during the first quarter of 2023.
The FDIC and the California Department of Financial Protection and Innovation (CADFPI) then downgraded the bank’s rating to “problem status” on April 28, 2023, causing it to drop to Secondary Credit status for the Federal Reserve Discount Window purposes. This effectively eliminated First Republic’s ability to continue borrowing money from the Federal Reserve Discount Window. On May 1, 2023, First Republic was closed, appointed to the FDIC, and entered into a purchase agreement with JPMorgan Chase Bank.
Asset Liability Management Concerns
The Asset Liability Management Committee (ALMCO) at First Republic identified policy limit exceptions in their economic value of equity modeling. The bank performed a static EVE analysis that did not include growth. This modeling is performed to measure the market value of the bank’s equity during various rate environments, and the exceptions were identified in the scenario where interest rates increase (they have continued to do so). The committee discussed the policy exceptions and determined that no action was needed to remediate and chose to increase their risk tolerance for the Economic Value of Equity (EVE) scenarios modeled in the third and fourth quarter of 2022.
The bank chose to model their net interest income projections utilizing a balance sheet that included growth assumptions. This is also known as dynamic modeling, as opposed to static modeling which tests the bank’s position at a point in time. These assumptions include changes in existing business lines, new business, and changes in management and customer behavior. In dynamic modeling, the risk identified is the assumptions’ ability to mask the balance sheet position. The dynamic modeling provides insight that static modeling does not include, but also opens the door for risks involved with the accuracy of forecasting.
Regulatory Guidance
The FDIC Supervisory Report reiterates the importance and expectations for the evaluation interest rate risk management. Similar to the Supervisory Report for Signature Bank, several guidance matters for further examination include:
- Considering the need for enhanced examination guidance related to supervising banks that are overly reliant on uninsured deposit funding or have concentrations in uninsured deposits.
- Evaluating whether Continuous Examination Program (CEP) examination teams should place greater consideration and emphasis on unrealized losses and declines in fair value (in securities and loans) and whether additional information fields should be required in Call Reports.
- Reiterating expectations and examiner resources for evaluating interest rate risk management.
The regulator noted that the speed and volume of deposit outflows at Silicon Valley Bank, Signature Bank, and First Republic Bank was unexpected. In response, the FDIC is actively reviewing regulatory requirements, such as capital standards for adjustment.
The failure of First Republic Bank was a hugely impactful moment in United States banking history and highlighted the importance of effective interest rate risk management. Although the FDIC could have taken a more holistic approach to their supervision of First Republic Bank, the Supervisory Report serves as critical guidance for banks navigating their interest rate management program.
If you have any questions regarding the FDIC’s report, please reach out to a member of our team.
