First Republic demise a symptom of higher rates

Our financials research analysts Mike Holton and Vivek Gautam share their thoughts on the collapse of US regional lender First Republic and what it means for the future of the banking sector.

The collapse of another US regional bank is a symptom of higher interest rates but is unlikely to trigger a global financial crisis, according to our financials research analysts Mike Holton and Vivek Gautam. It could, however, affect lenders’ earnings and the availability of credit, and prompt tighter regulation, they add.

The demise of First Republic Bank and its rescue by JP Morgan Chase in May follows the failure in March of Silicon Valley Bank (SVB) and Signature Bank, as well as the collapse and rescue of European lender Credit Suisse.

Holton describes the latest event as a “big deal” but thinks the writing had been on the wall since SVB went under. This is because the regional banks that have collapsed in recent months had poor business models that became exposed in a higher interest rate environment, he says.

These business models included holding a high uninsured percentage of deposits, significant unrealised securities losses and a loan portfolio of cheap mortgages that became lowly valued in the higher rate environment, says Holton. Additionally, he notes, First Republic had a concentrated client base whose non-interest-bearing deposits quickly flowed to other banks when they became spooked.

“First Republic might have a different name to SVB, but it had similar circumstances surrounding its demise,” he adds. “The end of the free money era is exposing poor business models. Failures like this don’t just come out of nowhere, they are representative of things that can happen in a higher-rate environment.”

Holton thinks any further bank failures would be limited in scope and reflect business models sharing similar characteristics to SVB and First Republic. He expects over the course of 2023 and into 2024 the effect of higher rates will result in sub-par outlooks and earnings performances, and a degradation in returns and margins.

Economic implications

Holton expects a continuing tightening of credit conditions in the US which he notes started in the wake of SVB’s collapse. The question is how long these conditions may last: will banks relax in a couple of months, or will they tighten credit standards throughout the year?

The impact of this on the wider economy is tricky to gauge, Holton adds. “I’m nervous it will have a meaningful impact, but it is too early to assess that because the effect of banks tightening lending now would not be felt in the economy for another six months or so. We won’t therefore really know the full impact until late autumn or the early part of winter.”

Not another global financial crisis

Holton says that while it is “scary” that the higher interest-rate environment has claimed four lenders, it is unlikely to result in another global financial crisis. In 2008 it was different because banks had exposure to mortgage assets that spanned global markets, he says. This time around it is not a question of whether banks can survive but rather how poor their earnings will be.

Our global financials research analyst Vivek Gautam says visibility on banks’ earnings is low. Deposits are under pressure, both volumes and costs, he notes, which is leading to earnings downgrades. “If these conditions remain in place, this could have a meaningful impact on earnings,” he says. “We would stay away from companies where we expect meaningful earnings downgrades.”

Regulatory impact

Another key question is around the regulatory response to yet another bank failing. Holton believes events surrounding First Republic could lead to tighter regulation, not least a revisiting of legislative changes introduced in 2018 that eased restrictions and oversight for banks with fewer than US$250bn in assets.

Holton anticipates regulators will expand measures to beyond just the largest banks, including rules around liquidity and accounting for unrealised losses. Any extra regulatory burden from being forced to hold additional liquidity and capital could hurt banks’ returns, he adds.

“Under the European framework, this is accounted for already, but in the US it is more bifurcated. Some of the relaxation of US regulations that happened in 2018/19 will likely be tightened up.”

Outlook

We were cautious on US financials prior to the collapse of SVB, but have grown even more wary since. Gautam describes SVB’s failure as a structural change for the industry “which tells us to be more cautious”.

Gautam says large banks are preferable to regional players in the US, and European banks are preferred to US banks within developed markets because of Europe’s tighter regulation and the fact there are fewer options for bank depositors.

The team does, however, see opportunities in financials in emerging markets, largely because inflation is more under control in some of these countries. Gautam concludes by saying insurance companies and exchanges offer opportunities, as do areas of direct lending and private credit.

Authors

Vivek Gautam

Global research analyst, Fundamental Equity team

Michael Holton

Head of interest sensitive/stable pod