First Republic was engulfed in a distracting internal succession crisis in the months before the US Federal Reserve imperilled its business model by embarking on an aggressive cycle of interest rate rises, according to people briefed on the matter.
After decades of rapid growth, when it won plaudits for providing personalised service to wealthy customers, First Republic found itself scrambling in early 2022.
Not only did founder Jim Herbert, 79, go on medical leave in December 2021 due to a heart condition, but Hafize Gaye Erkan, who had been groomed as his successor, left the company a month later. Erkan, a Turkish former Goldman Sachs banker with a PhD in risk management, served less than six months as co-chief executive and was involved in a series of interactions with other senior executives that two of the people described as “toxic”.
The C-suite drama would be followed by much bigger problems. The San Francisco-based bank’s share price has tumbled 90 per cent since March and depositors have pulled out tens of billions of dollars of cash, amid fears that First Republic will be the next lender to face a liquidity crisis after the collapse of Silicon Valley Bank.
A search process to replace Erkan did not result in a strong external option, so the bank appointed chief financial officer Mike Roffler, who had been acting co-chief executive, to the role permanently in March 2022. Herbert became executive chair but his plan to stay on as an active presence turned off at least some outside candidates approached by First Republic, said people familiar with the bank’s process.
Analysts cheered Roffler’s appointment. But behind the scenes, the management tumult had absorbed attention at First Republic in the months leading up to the Fed’s interest rate increase in March 2022, the first in more than three years. A string of aggressive rate rises throughout last year challenged First Republic’s business model of sucking up cheap deposits and offering very competitive rates on loans to wealthy customers.
“This is a tale of failed succession. Jim built an A-plus service-oriented bank for mid-level executives but then they flubbed it on the five-yard line,” said a person who has been familiar with First Republic’s management and strategy for years. “These guys were running a great bank but then the world changed on them.”
First Republic declined to comment for this article. Erkan did not respond to a request for comment on LinkedIn.
‘White glove’ customer service
First Republic’s recent struggles amount to a swift comedown for the bank. Over 38 years, it had built a reputation for providing “white glove” customer service. It targeted people, often connected to the tech industry, who were very well off but not so rich that they qualified for top-end service at bigger banks such as Citigroup and Goldman.
In January this year, Herbert told shareholders that customer satisfaction with the bank was at an all-time high. But the more interest rates rose, the more vulnerable the business model became. It had relied on making home loans using cheap funding from customers who were offered lower mortgage rates in exchange for putting large deposits into accounts that paid little or no interest. Two-thirds of deposits were in accounts too large to be covered by US government-backed insurance that maxes out at $250,000.
As competitors wooed depositors with better rates, First Republic came under pressure to match them. Its interest expense shot up 10-fold, to $525mn in the last three months of 2022, from just under $50mn a year earlier, data from the Federal Deposit Insurance Corporation shows. At the same time, it had amassed $5bn of paper losses on bonds bought when rates were lower.
First Republic management was aware of the risks, and began warning of potential headwinds from rate increases more than a year ago. In ordinary times, these issues would have hit profits and probably made for a tough few quarters. But the March 10 collapse of SVB fundamentally changed how banks are viewed by investors and customers alike. First Republic’s reliance on uninsured deposits and the tech industry, as well as its paper losses, put it near the top of the list of lenders that resembled SVB.
The response has been brutal: about $70bn in deposits have been pulled from the bank and its market capitalisation has fallen from a high of almost $40bn in 2021 to about $2bn this week.
Erika Najarian, banking analyst at UBS, said the general feeling in the market was that First Republic was “a very important domino to stand up” in order to maintain confidence in the broader banking system.
From Ohio to California
Herbert grew up in Coshocton, Ohio, where his father worked at Coshocton National Bank. He founded First Republic in San Francisco in 1985 with nine employees, $8mn in capital and a simple premise: “Deliver exceptional client service and growth will follow.”
In early 2007, Merrill Lynch, which was trying to break into wealth management and banking, paid $1.8bn to acquire First Republic. But Merrill unravelled during the 2008 financial crisis and was forcibly merged into Bank of America. As a large commercial bank, BofA had little need for First Republic, so it allowed Herbert to put together a 2010 management buyout with backing from General Atlantic.
After relisting the company, Herbert was soon turning heads. In 2014, the trade publication American Banker named him banker of the year, a plum usually reserved for heads of much larger lenders. By the end of 2022, First Republic had grown to 7,200 employees.
According to longtime customer and angel investor Tim McCarthy, First Republic went out of its way to court wealthy clients with personal touches.
“It’s like the casinos in Macau and Vegas — you make money on the whales, so you focus on servicing them. The reason I’ll continue using them is because I know all their branch employees,” said McCarthy.
Clients describe being assigned a specific contact, who makes an effort to get to know their preferences, such as the way they like to be addressed and the kinds of services they are likely to require.
“My wife does all of our banking and she loves them. Why would we ever leave?” said David Hou, a former First Republic wealth manager who kept his personal checking account with the bank when he left to start an independent advisory business in 2019.
Over the years, Herbert has been a reliable Republican donor to the party’s leadership committees, initially from California where he was writing five- and six-figure cheques to the party up until August 2020, and more recently from Wyoming, where he joined his daughter and grandchildren during the pandemic.
The bank also employed the services of Richard Hohlt, a top Washington lobbyist, who has been advocating for less aggressive policing of the industry since before the savings and loan crisis in the 1980s. First Republic’s spending peaked in 2018 when it shelled out $150,000 to lobby lawmakers as they were considering whether to water down parts of the 2010 Dodd-Frank reforms enacted after the financial crisis. After a 2018 law exempted banks of First Republic’s size from some of the most onerous requirements, the bank significantly reduced its federal lobbying spending.
Late last year, when the FDIC proposed reinstituting some but not all of the regulatory requirements for midsized banks, including holding additional capital in part to cover losses in bond portfolios, First Republic opposed the idea. In January, Roffler wrote a letter to the Fed and the FDIC arguing that such measures were not necessary because First Republic, and other banks like it, “do not pose the same, if any, financial stability risk” as the big lenders.
Rising rates put pressure on income
First Republic entered this year on a positive note. Deposits had risen more than 10 per cent to $176bn in 2022, even as some competitors saw outflows. Lending had more than doubled in the past two and a half years with few losses. Banks of similar size ended last year with a default rate of 1.5 per cent while First Republic’s default rate was just 0.08 per cent.
But the bank was vulnerable. Herbert admitted on a January earnings call that rising interest rates were putting pressure on net interest income — the difference between what First Republic pays to depositors and what it earns from loans and other assets. Roffler warned that 2023 would be a “more challenging year”.
While management had been dealing with an internal struggle that led it to pay Erkan $10mn in severance, First Republic had left itself very exposed to the Fed’s rapid rate increases. By early this year, the effects were starting to show.
Both its mortgage book and its securities holdings had dropped in value, at least on paper. Nearly $100bn of its $166bn in loans were single-family mortgages with at least 15 years to run, most of which were written during the period of ultra-low rates. None of this mattered as long as First Republic did not have to sell them. But if deposits were to flee, forcing it to offload assets, the losses on the bonds alone would be enough to wipe out roughly a third of the bank’s overall $17bn of book value.
First Republic had less room for error than most. By the end of last year, its cash on hand had shrunk from 8 per cent of total deposits at the end of 2021 to just over 2 per cent by the end of last year. The average for its peers was close to 10 per cent.
This meant that if the bank’s customers collectively asked for more than 2 per cent of their money back, First Republic would have to increase borrowing, sell securities or otherwise scurry to find the cash.
The day SVB failed, some customers lined up at one of First Republic’s California branches to pull out their money. Many more used online banking to transfer out some or all of their money instantly.
Last week, 11 of the largest US banks sought to restore confidence by depositing $30bn of their own money with First Republic in an effort to bolster its liquidity position. The move has slowed but not arrested the drop in its share price. First Republic this week added investment bank Lazard alongside JPMorgan Chase to help advise it on strategic options.
“They didn’t have a leader able to pivot when interest rates rose,” said one of the people who knows the bank well. “They did not see the tsunami coming.”
Additional reporting by Courtney Weaver in Washington