What the protracted game of chicken over First Republic tells us

The writer is an FT contributing editor

Sometimes we get what we need, not what we want. The US (and possibly the global) economy needed a solution to First Republic Bank’s impending failure, and it got one. Once again, JPMorgan Chase stepped up and bought another bank. The acquisition should stem major contagion to the rest of the American banking sector in the immediate term. But it is a sub-optimal solution and this is not likely to be the last bout of financial instability we’ll see in this cycle. Incentives must be better aligned to improve the outcome next time.

First Republic’s failure followed the same trail as Silicon Valley Bank and Signature Bank in March. Much like those banks, First Republic had a privileged clientele, significant uninsured deposits and a lot of underwater loans and securities given the rapid rise of interest rates over the past year. What First Republic had that the other two did not is a lot of friends. In mid-March, the largest US banks deposited $30bn in First Republic to shore up confidence.

Obviously, that did not work. Neither investors nor depositors gained any confidence. Reports of declining deposits fed a downward spiral in First Republic shares. Late last week, the Federal Deposit Insurance Corporation finally stepped up to plan the bank’s funeral. This wasn’t the inevitable outcome, or even the best one. Tougher supervision might have kept First Republic out of trouble in the first place. Once it began wobbling, imposing a sale sooner would have been cheaper, more flexible and efficient. 

In theory, incentives should have been aligned to achieve this. For First Republic, an early sale would have stemmed the run on deposits and collapse in its equity price. For the FDIC, a private sector solution would have left its bailout fund untouched. Instead, it now expects to take a $13bn hit, to be financed by an assessment paid for by the nation’s other banks.

Larger banks were always going to pay for First Republic’s losses no matter what — either by proactively buying its assets or by waiting for the bank to go into receivership and then having to top up the FDIC bailout fund. The big difference between these solutions is the latter involves a much greater risk of contagion.

With regulators closing First Republic down, the size of the hole in it will be specified, and there’s a chance it could spark further concern across the banking sector. As former US Treasury Secretary Larry Summers recently said, “These are things like forest fires, it is much easier to prevent them than it is to contain them after they start to spread.” This was precisely the motivation behind injecting $30bn into First Republic in March.

Instead, there was a protracted game of chicken between the government and larger banks, with each side hoping to stick the other with losses. The longer banks waited to agree a solution, the cheaper First Republic’s assets became. And the more depositors worried about the viability of First Republic, the more they yanked their deposits and moved them to the larger banks. The incentive for larger banks to pay up early was overwhelmed by the incentive to hang around for a better deal.

In this case, the consequences will probably be manageable. It was a sub-optimal solution, but First Republic is small enough to fail without too much contagion. JPMorgan has the balance sheet (and federal loss guarantees) to absorb it (JPMorgan itself will become even larger, controlling more than 12 per cent of the country’s deposits). And as First Republic’s equities cratered last week, the S&P Regional Bank Index stabilised, suggesting contagion should be minor.

One can’t escape the feeling that had the viability of a larger bank been in question, the implications of receivership and sale would have changed the government, FDIC and other banks’ reactions. But it is very difficult to determine which bank failures will be big enough to make a wider splash in the US or global banking system. First Republic, SVB and Signature were clearly smaller banks in life but large banks in death. It is therefore risky to be reactive instead of proactive where small banks are concerned.

And so we got what we needed with the First Republic rescue, but not what we want. We can count on there being further bank instability as major central banks keep rates high to fight inflation and shrink their balance sheets. The more bank resolutions or rescues there are, the more likely the mismatch in incentives between actors could cause an unintended blowup that really does pose a systemic risk.