A Data-Driven Analysis Using Bank’s Call Reports - Part 1

Welcome to another edition of “In the Minds of Our Analysts.”

At System2, we foster a culture of encouraging our team to express their thoughts, investigate, pen down, and share their perspectives on various topics. This series provides a space for our analysts to showcase their insights.

All opinions expressed by System2 employees and their guests are solely their own and do not reflect the opinions of System2. This post is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of System2 may maintain positions in the securities discussed in this post.

Today’s post was written by Aquiba Benarroch, CFA.

Part 1 - The Collapse of First Republic Bank

We're living in volatile times, especially for the banking sector.

With the Federal Reserve's interest rate hikes (another likely hike expected on July 26) and the ongoing shifts in the commercial real estate industry, it's more important than ever to assess a bank's financial health accurately.

One powerful disclosure is a bank’s Call Report - a treasure trove of financial data that banks must file quarterly. Even better, we can analyze these reports programmatically through the FDIC API, allowing us to sift through vast amounts of data quickly and efficiently.

This multi-part series aims to identify banks that are more at risk in the current environment by analyzing their Call Reports and other public filings.

The impact of higher rates

The Federal Reserve's interest rate hikes have had several ramifications for banks:

**Deposit Flight**: Customers transferred money from the commercial banking system as they realized they were earning no interest on deposits while risk-free assets (like US Treasuries) offered higher returns.
Lower Profitability: Banks were forced to pay customers higher interest to avoid losing depositors, which squeezes their profit margins.
Lower Value of Securities: Many banks invested heavily in Treasuries, Mortgage-Backed Securities (MBS) and other securities during the years of 0% funds rates because of attractive yields. In the current environment, yields are higher, so the value of these securities on banks’ balance sheets is materially lower.
Lower Value of Loan Portfolio: As interest rates rise, the present value of future loan payments decreases. Additionally, these loans can't be easily sold due to their long-term nature and the current interest rate environment, further reducing their value.
Bank Failures: The combination of deposit flight and lower value of securities led to the failure of banks like Silicon Valley Bank and First Republic Bank.

The failure of First Republic Bank

We will take a closer look at the case of First Republic Bank, a bank that experienced a significant deposit flight leading to its acquisition by JP Morgan on May 1, 2023.

By using Call Reports data, we can piece together the events that led to First Republic Bank's downfall and gain a deeper understanding of the factors that can impact a bank's financial health.

The two charts below break down First Republic's Balance Sheet and encapsulate the bank's collapse.

For years, First Republic Bank saw a steady increase in its assets, largely fueled by a rise in customer deposits. Operating in the traditional banking model, the bank lent out most of these deposits to borrowers, with repayment schedules spanning several years.

The bank's profitability was largely driven by the spread between the interest it paid on deposits and the higher interest it earned on loans. This is a common way for banks to generate income. In fact, First Republic Bank consistently reported a Return on Equity (ROE) of more than 10% in the periods leading to its downfall.

First Republic Bank faced a classic liability duration mismatch like many banks. This is a situation where the duration of a bank's liabilities (customer deposits) is shorter than that of its assets (loans). In other words, the bank may need to pay its liabilities before its assets fully mature. This mismatch can be manageable in stable times, but it can quickly unravel when market conditions change or when depositors pull their money quickly.

The Federal Reserve began to raise interest rates in 2022, and the Fed funds rate stood at 4.5%-5.0% at the beginning of 2023. Most banks, including First Republic, were still offering near zero interest for deposits during this period. This discrepancy and the recent panic that ensued after Silicon Valley Bank collapsed due to similar circumstances led to a deposit flight from First Republic Bank.

First Republic Bank faced a sharp decline in deposits, plummeting from $176B at the end of December 2022 to $104B by the end of March 2023. A closer look at the bank's assets reveals the problem, with less than $30B in liquid assets available to cover redemptions and most of its assets tied up in loans that couldn't be easily sold.

Over $100B of these loans had a repayment term of 5 years or longer, while only $32B was due to be repaid through March 31, 2023 (and was likely refinanced or loaned again). Notably, the average loan maturity duration had been increasing in recent quarters, suggesting that deposits were getting locked in loans that would be repaid further out. In fact, the average loan maturity duration increased from 8 years in 2020 to 9 years in 2022.

The bank held $32B in debt securities in Q4 2022, mostly in US Government debt ($22B) and the remainder in Mortgage-Backed Securities ($10B). Due to rising interest rates, the fair value of both of these types of securities had fallen below their book value. While US Government debt, such as US Treasuries, could be sold to cover some deposit withdrawals, the MBS were less liquid and more difficult to sell without a large loss.

With minimal cash on hand ($4B as of Q4 2022), First Republic found itself in a tight spot. The bank had little choice but to seek alternative financing sources to meet deposit redemptions.

Before the crisis, most of First Republic's deposits were uninsured ($119B, or 68% of total deposits). When the crisis hit, $100B deposits fled quickly, almost entirely from this uninsured portion, while the insured portion barely moved. This suggests that there was real concern among depositors about the fate of First Republic, and the bank's deposit mix didn't help to alleviate these worries.

On March 16, 2023, in response to the crisis, First Republic received a lifeline in the form of $30B in uninsured deposits from a group of America’s largest banks. It also accessed additional liquidity from the Federal Reserve Bank, the Federal Home Loan Bank, and JP Morgan Chase & Co.

Total borrowings peaked on March 15, 2023, at $138B and stood at $105B at the end of Q1 2023. Despite these efforts, the bank's situation continued to deteriorate, ultimately leading to its acquisition by JP Morgan on May 1st. Investors holding First Republic’s equity, corporate debt and preferred stock were wiped out.

This deep dive into the case of First Republic Bank illustrates the level of detail we can uncover about banks’ financial health using Call Reports. These reports provide a wealth of data to help us understand a bank's financial condition, lending practices, and risk exposures.

There are thousands of banks in the United States, each with unique circumstances and risks. In our upcoming posts, we'll dive deeper into these. We'll explore how to flag banks that may be at risk and identify those most exposed to the commercial real estate industry.