How to Fix a Failing Bank: A Comparison of Recent Approaches


On May 1, the California Department of Financial Protection and Innovation seized First Republic Bank, which the Federal Deposit Insurance Corporation (FDIC) subsequently sold to JP Morgan Chase, marking the third U.S. bank failure of 2023. The failure of First Republic superseded the failure of Silicon Valley Bank (SVB) to become the largest U.S. bank failure since 2008 and the second-largest failure on record.

First Republic was a San Francisco-based full-service bank and wealth management company. The bank occupied a specialized market in California catering to high-net-worth clients for its wealth management services. Its unique clientele contributed to the bank’s outsized proportion of deposits in excess of the FDIC-insured amount of $250,000. It is estimated that about two-thirds of First Republic’s deposits were uninsured.

The similarities in First Republic’s deposit base to SVB and Signature made it particularly vulnerable to the contagion effects those failures spurred in the regional bank sector. In the days following SVB’s failure, depositors rushed to withdraw funds and First Republic’s share price cratered nearly 70 percent. Like SVB, First Republic had significant unrealized losses as the value of its held-to-maturity bonds dropped with sharply rising interest rates. In this case, interest rate risk was compounded by a concentrated portfolio of ultra-low-rate loans to wealthy clients.

On March 16, a consortium of the country’s largest banks, led by JP Morgan Chase, deposited $30 billion at First Republic in what was regarded as a private sector effort to revive the failing bank. However, the cash infusion proved not to be enough and mostly served to fund the run on the bank. On April 24, First Republic released its first quarter earnings report identifying that its deposits had declined more than $70 billion in the first quarter of 2023. The grim report sent share prices tumbling again and sparked reports that banking regulators would be looking for a resolution.

The FDIC sought bids for First Republic over the weekend and on Monday morning May 1, a purchase and assumption agreement was announced with JP Morgan Chase for all of First Republic’s deposits and substantially all its assets. JP Morgan Chase and the FDIC also entered a loss-share transaction for some of the bank’s loans. JP Morgan Chase will pay the FDIC $10.6 billion to acquire First Republic and the agency expects the remaining cost to the Deposit Insurance Fund to be approximately $13 billion.

Interest Rate Risk and Troubles Ahead

The harsh impact of sharply increasing interest rates on banks’ portfolios is not isolated to regional banks.

One recent study found that the median value of the average U.S. bank’s unrealized losses is around 9 percent after marking to market. Over the past year, the study estimated that the U.S. banking system had accumulated $2.2 trillion in unrealized losses. Additionally, the study found that 10 percent of banks have unrealized losses larger than SVB had at the time of its failure. Suffice it to say, despite optimism that the resolution of First Republic will calm volatility in the bank sector, the root cause that led to these recent failures is not going away.

Other regional banks continue to feel the pressure of rising interest rates and market jitters. PacWest Bancorp has lost about 85 percent of its market value since the beginning of March and is reported to be weighing options, including a possible sale.

Regulatory Approaches

Three ways to fix a failing bank:

  1. Allow the bank to fail. Pick up the pieces.
  2. Conduct a private-sector takeover of the bank with government assistance.
  3. Foster a functioning bank merger and acquisition market that allows weak banks to be consolidated before they fail.

In approach 1, a bank fails before a buyer has been arranged to acquire the institution’s assets and deposits. The bank enters an FDIC receivership, and the regulator guarantees all insured deposits and liquidates its assets. A bank failure leaves uninsured deposits in limbo, either to be covered via the invocation of a systemic risk exemption or to be borne as a loss by the depositors.

During the SVB and Signature Bank failures, bank regulators took approach 1. Regulators shut down both institutions before securing a buyer to take over, and in the case of SVB went so far as shutting down the bank midday. This meant that uninsured depositors, of which both banks had many, had no guarantee of getting their money back and thus sent shockwaves through the market, eventually forcing the FDIC to invoke the systemic risk exemption to guarantee all deposits of both institutions, insured and uninsured. Furthermore, when the FDIC eventually arranged buyers for both institutions, the sales were at steep discounts from the market value of the assets and cost the Deposit Insurance Fund significant sums. It is estimated that the SVB failure alone will cost the Deposit Insurance Fund as much as $20 billion, which is approximately 15 percent of the total value of the fund. On top of the economic consequences of this approach, it also raised significant policy questions surrounding the use of the systemic risk exemption and the appropriate level of deposit insurance.

Regulators took approach 2 in the case of First Republic, in what many agree was a return to a more “normal” way of managing a bank failure via assisted transaction. The FDIC conducted a bidding process for the still solvent bank over a weekend and announced the closure and sale of the bank concurrently before trading opened Monday morning. This mitigated some of the risks of a dramatic deposit outflow and allowed the FDIC to receive a stronger price for the bank by selling the bank when there was still some bank left. The FDIC is obligated by statute to pursue the least cost option to resolution, which, in this case, meant accepting the bid of JP Morgan Chase, the largest bank in the United States, over the slightly lower bids of smaller banks. Notably, this option still came at a substantial cost to the Deposit Insurance Fund of approximately $13 billion.

That leaves the third means of managing troubled banks—fostering a functioning bank merger and acquisition market that allows weak banks to combine with stronger ones before they fail.

From 2007 to 2022, the number of commercial banks in the United States fell from 7,290 to 4,135, a decrease of about 43 percent. In recent years, however, a hostile environment toward very large banks and toward mergers and acquisitions more generally has slowed consolidation and put an artificial chill on merger and acquisition activity.

The fear of “too-big-to-manage” banks and facing blame for the biggest banks getting bigger has led regulators to slow approvals of existing applications and sent clear signs to the industry that now may not be the time to pursue business combinations that otherwise may make good economic sense.

A healthy merger and acquisition process is a healing salve for the industry. It allows the valuable aspects of weaker institutions to be combined with the strengths of other institutions without market-distorting interference. It allows would-be competitors of the largest banks to emerge.

Without a functioning merger and acquisition market, problems fester, value is lost, and big banks swoop in to sweep up bargains at FDIC fire sales.

It remains to be seen whether attitudes toward mergers and size will soften after this most recent event. While advocates of market-driven solutions remain optimistic, it appears regulators and current policymakers have other ideas with Federal Reserve Chair Jerome Powell noting at the May 3 Federal Open Market Committee it is “good policy that we don’t want the largest banks doing big acquisitions.”

Put Patomak’s Banking Expertise to Work

Patomak has deep experience in helping banks and other financial institutions identify and manage risks and respond to developments in banking regulation and supervision. Patomak can work with boards and management to assess their governance and internal risk and control functions proactively to ensure they exceed supervisory expectations and support their business objectives. Contact us to learn how Patomak can help you navigate these challenges and help you meet your business goals.