Reaction to concerns about First Republic Bank

On April 24, 2023, First Republic Bank (NYSE: FRC) released its Q1 earnings report and reported that 40.8% of deposits were withdrawn from the bank since December 31, 2022. As of March 31, 2023, FRC's loans-to-deposits ratio was over 166%.

FRC shares fell dramatically after the announcement, reigniting concerns over US regional banks.

Deposit Flight from FRC has Slowed

In its release, FRC stated that "deposit activity began to stabilize beginning in the week of March 27, 2023, and has remained stable through Friday, April 21, 2023. Total deposits were $102.7 billion as of April 21, 2023, down only 1.7% from March 31, 2023, primarily reflecting seasonal client tax payments that occur

each April."

FRC stated it needs to attract insured deposits "while taking steps to reduce expenses, including significant reductions to executive officer compensation, condensing corporate office space, and reducing non-essential projects and activities. The Bank also expects to reduce its workforce by approximately 20-25% in the second quarter."

FRC's additional strategic options to repair its balance sheet include an asset sale, dilutive re-capitalization, or some form of partnership. It is unlikely that regulators will step in until the bank is put into receivership.

Background

FRC’s issues stem from its unrealized mark- to-market losses on both its fixed income and mortgage portfolios due to rising interest rates. If held to maturity, these unrealized losses would dissipate. However, if FRC was forced to sell the assets to meet market redemptions, it would create material losses and impact its capital position.

FRC’s situation is similar to—although not as extreme as—what happened to Silicon Valley Bank (SVB) earlier in the year.

FRC has been tapping borrowing facilities of the US Federal Reserve to get liquidity to meet deposit outflows, but the cost of that funding is materially higher than the interest FRC was generating; creating a negative spread.

Under normal circumstances, FRC’s situation likely would have been manageable. However, when SVB got hit with a bank run, it triggered a similar fear and bank run at FRC. Enough deposits have left that FRC’s funding costs have risen materially and its net interest margin (NIM) will face material pressure going forward.

Contagion Risks Remain Low

It is important to recognize that balance sheet strength varies from bank to bank. With thousands of financial institutions in the United States, some occasionally run into trouble. Fortunately, recent banking issues have been limited to smaller—less systemically important—regional banks with idiosyncratic problems.

Similar to Silicon Valley Bank (SVB), FRC made some missteps in managing its assets and liabilities that are very specific to FRCs exposures. From a fundamental perspective, contagion is unlikely. However, market sentiment plays a significant role.

Importantly, FRC is primarily a high-net-worth and mass-affluent retail-focused bank, with deposits and mortgages as its bread and butter. It isn’t an investment bank and has very limited capital markets operations. For this reason, the counter-party risks and fundamental contagion risks remain low.

Canadian Banks Likely Not Impacted

It is unlikely that Canadian banks are directly impacted. However, another spike in negative sentiment is undesirable for Schwab, as it is in a similar but less extreme predicament. TD owns a 12% stake in Schwab, which has been acting as a drag on TD’s share price.

While the North American banking sector might experience near-term volatility, we believe the systemically important banks in both the United States and Canada remain well-positioned. Canadian banks in particular benefit from the following:

• Canadian banks have been selective in their US acquisitions, are well capitalized, and are more active in managing interest rate and liquidity risk than US regional banks.
• Canadian banks face greater scrutiny by regulators on their liquidity requirements than US regional banks and have a more diversified deposit and funding base.
• The Office of the Superintendent of Financial Institutions (OSFI) increased capital ratios effective February 1, 2023, which will further enhance the stability and resiliency of the Canadian banking sector.

It remains important that investors work with asset managers who have the resources and experience to conduct in-depth research. We believe in, and continue to take an active management approach to investing in high- quality companies with strong management teams and solid long-term fundamentals.

CIBC Asset Management is committed to providing market insights and best-in-class research to help you find the right investment solutions. If you'd like to discuss this update in more detail or have questions about your investment portfolios, please get in touch with your CIBC representative.

Commentary provided by David Andrich, CFA, Senior Equity Research Analyst