Talk to any bank CEO, and the one thing they're guaranteed to say is that their institution has superior customer service. It's a line so common that I've stopped paying attention to it.
But at the $153-billion-asset First Republic Bank (FRCB), customer service isn't just real -- it's actually the strategic advantage that has turned the bank into a powerhouse and driven up the stock. At Tuesday's prices, shares of First Republic are trading around $192, the highest they have ever been. The bank now trades around 319% of tangible book value (equity minus goodwill and intangible assets), and it's really because of its relationship-driven model.
Image source: Getty Images.
Getting the most from clients
First Republic services wealthy clients on the coasts in markets such as San Francisco, New York, Boston, Los Angeles, and San Diego. It offers clients a single point of contact for all banking services, including loans, deposits, wealth management, and financial planning.
First Republic's stock only struggled for a very short time during the pandemic, and unlike the rest of the banking industry, it has managed to grow loans, net interest income, and wealth management assets greatly during this time because of its superior service. It recently implemented new digital capabilities that enable clients to connect directly with their personal banker through the bank's mobile app, and now more than three-quarters of First Republic clients use the app, according to management.
First Republic also has a net promoter score (a measure of the likelihood of clients referring their bank to others) of 73, double the U.S. banking industry average. And you can actually see how much customers like them just by looking at their model.
Image source: First Republic investor presentation.
It's pretty impressive that First Republic is getting the bulk of its loans and deposits from existing customers increasing their deposits or taking out new loans, as well as from referrals from those customers. Now that's what I call loyalty. Also, if you look at the bottom of the deposit side of the chart, you can see it says minus 2%. This number stands for annual checking-deposit attrition, which is a measure of deposit losses from lost consumer and business checking customers and diminished balances from existing customers. This 2% number represents attrition between 2007 and 2020, which is significantly lower than the standard 8% attrition during that same time period for the industry.
An unusual outcome
The result of First Republic's customer-centric approach is a banking model that is quite different from most high-performing banks today. For instance, First Republic's success at banking wealthy individuals has made its largest loan segment residential mortgages, whereas most high-performing banks today thrive on the commercial side.
Residential mortgages are often considered less risky than commercial loans, which could partly explain First Republic's exceptional credit quality. The median loan-to-value ratio in the bank's residential mortgage portfolio is 59%, meaning borrowers are typically putting down equity worth about 41% of the home price, which is a lot and makes them less likely to default because they have a huge stake in the home from the beginning.
First Republic has averaged just 0.04% loan charge-offs (debt unlikely to be collected and good representation of actual loan losses) of total loans over the last 21 years.
The bank has also built a very successful wealth management business with its referral system. Assets under management were up 59% year over year at the end of the first quarter.
It's interesting because First Republic also bucks conventional wisdom and runs at a fairly high efficiency ratio (this closely watched metric measures expenses as a percentage of total revenue, so lower is better). At the end of the first quarter of this year, First Republic had a 63% efficiency ratio. Normally, you would not see a bank with a ratio that high trading at more than 300% tangible book value. It's possible that all of the spending by the company to provide customer service that makes a difference in the client relationship has driven up costs, but it's clearly worth it given the returns the bank has generated over the years. And First Republic does not repurchase shares, either, making its earnings performance even more impressive.
The extreme focus on existing clients has also given First Republic inroads to providing banking to generations of families, which it actively concentrates on and succeeds in. First Republic has specific strategies to capture millennial customers early. For instance, it has a program that allows millennials to bundle all of their consumer debt into a single monthly payment, and what the bank calls a professional loan program that enables certain professionals to invest in their company, like, say, an employee at a private equity firm contributing their individual money to the firm's investment fund.
These two programs alone recently made up 17% of all growth in consumer-borrowing households. The average age of the borrowers in these two programs are 33 and 38, respectively, and First Republic is very good about turning these clients into mortgage borrowers and wealth clients down the line. First Republic's president, Hafize Gaye Erkan, said on the bank's first-quarter earnings call in April that 20% of its millennial clients are now mortgage clients.
Just getting started
While having already generated exceptional returns, First Republic only banks about 5% of the high-net-worth households in its markets. The bank also only has a very small dividend payout ratio, frequently below 15%, for a yield of less than 0.50% at Tuesday's prices. Since we know the bank doesn't do share repurchases, there is a good chance that will continue to increase. Obviously, First Republic will need to be careful to not grow too quickly in order to preserve its client-focused model, but it's a bank that has shown that customer service can really drive earnings and the stock price if executed correctly.
