Lowering Our Fair Value Estimate for First Republic, We See Little Left for Shareholders

Strategist

Eric Compton

First Republic Bank is one of the more unusual banks under our coverage. It has a uniquely focused business model, with a high service offering aimed at wealthy clients concentrated in costal urban areas. The bank was exclusively led by its founder, Jim Herbert, until mid-2021, and has been able to churn out remarkably high organic growth year after year, resulting in compounded asset growth of roughly 20% over the past 10 years compared with an industry growth rate of closer to 5%.

The strength of First Republic Bank's approach is the strict adherence to its strategy of retaining and attracting high net worth clients through uniquely personal service. This requires training and retaining talent, which the bank accomplishes through its culture and compensation structure. As such, the bank’s efficiency levels tend to be middling compared with peers. However, the model has worked, and the bank is able to generate substantially lower client attrition rates and higher client satisfaction levels as measured through Net Promoter Score. The bank is also a conservative underwriter, with losses consistently coming in below peers through the cycle, and often near zero.

With the recent run on the bank, we think First Republic's previous business model is broken. We think the bank will have a hard time resizing the balance sheet so that it makes sense again and equity shareholders have some value left over.

Business Strategy & Outlook

We assign First Republic an economic moat rating of none. While we think the bank has historically been well run and had found a successful business model, we believe its success primarily comes down to being well run, having good customer service, and paying for talent. We do not believe this leads to a moat within our framework. We'll also highlight that the tail risks of running a relatively highly concentrated (mostly fixed-/hybrid-rate residential mortgages) business model can indeed lead to scenarios where risks are realized and the business model becomes much less profitable. Other risks we have highlighted in the past include the fact that the quality of management can change over time, other banks can try to pay even more for talent, and other banks could try to rework their service structures to better compete for the same clients. All of these could theoretically pressure returns over time. We do admit there are signs of switching costs for the bank, as evidenced by superior customer attrition rates (2% versus an industry level of closer to 8%) and superior Net Promoter Scores (72 versus an industry average of closer to 35), but we'd like to see these switching costs backed up by a more structural cost advantage (funding costs, credit costs, or operating costs) and a more robust fee mix. And as we've seen, these switching costs can disappear seemingly overnight under the right circumstances.

We argue that bank moats are derived primarily from two sources: cost advantages and switching costs. We see cost advantages as stemming from three primary factors: a low-cost deposit base, excellent operating efficiency, and conservative underwriting, with regulatory costs being a final factor that must also be considered. Within the operating efficiency bucket, we also see room for economies of scope leading to a cost advantage via lower relative customer acquisition costs, and we tend to view banks with more robust fee franchises as more moaty than those that rely primarily on net interest income. 

First Republic Bank has one of the best underwriting histories under our coverage and has consistently outperformed peers through multiple downturns. The bank controlled its charge-offs relative to average loans quite well during the financial crisis, even though it had a sizable exposure to real estate in 2008. The bank's average net charge off has been only 4 basis points over the past 21 years when compared with 37 basis points for the top 50 U.S. banks during the same period. The bank consistently has better credit metrics than peers, and during cyclical peeks the bank spends less of its interest income on provisioning. 

While this may appear advantageous on the surface, we think much of this can be explained by the significantly different mix of its loan book. Approximately 80% of the bank’s total loans are collateralized by real estate, with the majority of that exposure being residential mortgages. While the bank deserves credit for superior performance during the 2008 financial crisis—where real estate-related lending in general and residential mortgage lending specifically did see large losses in the industry—banks generally do not see large losses on these types of loans. Hence, having most of the loan book dedicated to this type of lending would naturally lead to lower overall loss rates. Therefore, we view much of the lower credit costs as being driven by the mix of the loan book, not necessarily a vastly superior underwriting process or culture. For example, if we isolate mortgage-specific yields and mortgage-specific losses and compare these with peers, First Republic looks much more average on this mix and yield adjusted basis. We don't want to take away all credit from the bank here, as we believe its culture is a good one, we just don’t believe this leads to maintainable credit adjusted pricing power that is large enough to create a moat.

We do not believe that First Republic Bank has a maintainable funding cost advantage as its deposit costs are consistently in line with or above its peer group. Deposits fund roughly 90% of the total liabilities of the bank, and more than two thirds of these deposits are in checking accounts. If we look at the overall cost of funding, First Republic might appear at first glance to have a funding cost advantage as its overall funding costs (which include deposits and other forms of funding such as debt) tend to be a bit lower than peers. However, we have isolated this overall funding advantage to one primary factor, which is the bank’s higher mix of funding from relatively low-cost FHLB advances instead of higher cost bond-related funding. The primary reason First Republic is able to use a higher mix of FHLB funding is simply because of its higher mortgage lending mix. FHLB funds must be used to fund mortgage lending, and other banks have similar access to FHLB advances. Therefore, this is once again a mix effect, and if we isolate the mix effect, First Republic's funding costs are similar to peers. 

The bank’s operating efficiency has not historically been the best among peers, and we think this is in large part due to its high touch business model and higher growth rates. Management has repeatedly emphasized that it does not want to cut expenses at the cost of compromising on the quality of client service or long-term growth prospects. We also think having a higher cost base is fundamentally part of First Republic's business model, where the bank must pay for talent and offer greater levels of service to clients. We estimate that the bank pays its employees more generously compared with its peers in an effort to create higher workforce retention and stronger banker-client relationships. The bank has maintained its average efficiency ratio in the low-60s over the last five years as compared with mid-50s efficiency ratio of some of its advantaged peers. As such, we don't believe the bank benefits from a maintainable operating cost advantage. 

As the bank continues to grow, and as it builds out some of its fee business lines, we think the efficiency and return profile could improve over time and eventually could lead to a moat, but as of today we don't see strong signs of a cost advantage for the bank to help back up its relationship-driven switching costs.

From a systemic standpoint, we believe the U.S. offers a fair but improving banking environment (recent liquidity stress aside). Regulation has become considerably stronger since the crisis, and capital levels have never been higher, though the country still uses a complex and somewhat archaic system of regulation. Furthermore, the U.S. banking market remains relatively fragmented; First Republic must compete with a variety of regional and community banks as well as large money center institutions. Our outlook is positive from a macroeconomic and political standpoint. The U.S. is still the world's leading democracy, has increased GDP at a steady pace for years, and maintains the world's reserve currency, all of which contribute to banking stability. 

From a regulatory perspective, First Republic Bank is not regarded as a bank holding company and is classified as a non-member state bank. Therefore, the bank avoids some of the more onerous regulatory capital requirements as it does not have to participate in the official supervisory stress tests. As a result, the bank also avoids extra liquidity coverage and funding ratio requirements. Overall, because the bank avoids much of the extra regulation that peers are subject to, we view the bank’s regulatory burden as slightly advantageous. Further requirements will be triggered if First Republic surpasses $250 billion in assets as the bank would be required to undergo company run tests.

None

Economic Moat

First Republic Bank

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First Republic Bank engages in the provision of private banking, private business banking, and wealth management. It operates through the Commercial Banking and Wealth Management segments. The Commercial Banking segment gathers deposits, originates and services loans, and invests in investment securities. The Wealth Management segment includes investment management activities of FRIM, money market mutual fund activities and brokerage activities of FRSC, sales of life insurance policies and annuity contracts through FRSC, trust and custody services, and foreign exchange activities. The company was founded by James H. Herbert II in 1985 and is headquartered in San Francisco, CA.

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