One of the most important things an investor can do is find a comfortable balance between risk and reward, which will be different for everyone. In the end, this is the big question with regard to First Republic Bank (FRCB), a financial institution that has gotten caught up in the current banking crisis. With the shares down 88% in a month, are investors overreacting, or is the risk still too high here?
The big picture
Without getting too deep into the technicalities, the U.S. has seen a series of bank runs. These are very scary events, as they can quickly become contagious. All it takes is a mere hint of worry, and people will run to pull their money from a bank, often causing a worsening spiral. And that remains true even with government safeguards in place for customers with relatively modest amounts of cash -- i.e., FDIC insurance for amounts of $250,000 or less.
Image source: Getty Images.
The basic problem arises because banks take in deposits and lend out the money to borrowers. So at any given time, they simply don't have the cash available to pay back all of their depositors. This isn't a flaw in the banking system; it's how it is supposed to operate. In fact, even in the current bank run, the issue isn't really that banks don't have the money, per se; it is that there was a mismatch between long-dated assets (for example, U.S. government bonds) and near-term cash needs (customers who wanted their money back right away).
To simplify, interest-rate increases reduced the value of bonds that were intended to be held to maturity. If there weren't a sudden spike in withdrawals, the banks that got hit might have muddled through in relative stride. However, as money flowed out, the banks basically needed to sell bonds that had declined in value to raise cash, leading to big losses.
The complicating factor was technology. That includes the fact that Silvergate Capital was highly concentrated on providing services to cryptocurrency companies and Silicon Valley Bank was focused on funding tech start-ups. Such niche approaches increase risk. But the ability to quickly and easily access, and move, cash through technology platforms also magnified the problem, since people didn't need to show up in person. This is a highly uncertain time. Yet First Republic Bank, which also experienced a run, is a fairly generic bank.
Is this an opportunity?
It appears that First Republic's problems relate to its generally wealthy clientele. This customer group tends to be more financially savvy and can more easily move money around. Yes, there's a mismatch between long-term investments and current cash needs (well articulated by The Motley Fool's Bram Berkowitz), but there doesn't appear to be anything highly risky about the bank's business focus. In fact, at one point, serving high-net-worth customers was seen as a positive. So some investors might be wondering if the steep stock sell-off here is a contrarian buying opportunity.
If you lived through the Great Recession, you know that things can get worse before they get better in the finance industry. While the current banking crisis isn't anything like what happened between 2007 and 2009, it's hard to know what will happen with investor sentiment. Since that's what dictates stock prices, even after a huge price decline, First Republic's stock is still a risky proposition.
And then there's the bank itself. The list of negatives is material, from the elimination of the dividend to the destruction of customer trust to the fact that it was forced to take a $30 billion lifeline from its banking peers. And until the bank next reports earnings, it will be hard to tell just how bad things are from a business perspective, given how recent the bank's troubles are. Even after that update, it will probably take a material amount of time before the bank is back on track.
Not worth the risk
Yes, the stock price decline at First Republic has priced in a lot of bad news. But the full picture is far from clear for the bank and for the entire banking industry. It's even hard to suggest that aggressive investors would find the risk/reward balance here attractive given the still huge unknowns. This is not the time to swing for the fences. Most investors will be better off sitting this one out until there's materially more clarity about First Republic and the entire banking sector. And if you just have to buy a bank stock today, it's probably advisable to stick to the largest and financially strongest industry participants.
