Three shorter reads for you this week. We start with a look at Republic First Bank of Philadelphia and Metro Bank of the UK, two banks in distress. Then we turn to a pet topic of mine: equity research. Finally, there’s a section on bank bashing, before some closing comments on crypto lit. Thanks for being a subscriber.

Vernon’s Legacy

Republic First Bank of Philadelphia and Metro Bank of the UK have more in common than their shareholders may realise. Despite the ocean that divides them, their strategies were heavily influenced by one man: Vernon W. Hill II. After founding, chairing and then departing Metro Bank under a cloud, he invested in Republic First Bank, taking on the role of chairman and then chief executive officer before departing under a cloud. While unconnected operationally, the two banks share similar branding, an open-door policy for dogs, and similarly styled branches fashioned by a firm of designers owned by Hill’s wife.¹

They are also both facing severe financial difficulty. Their stocks trade at a distressed 8% of tangible book, and management at each is casting around for fresh capital. 

The reasons for the banks’ problems aren’t identical, but they do share a common thread. Vernon Hill’s big idea was deposits. “Banking is, essentially, a government license to borrow money cheaply,” he wrote in his memoir. “Anyone can make loans, but only licensed, government-sanctioned banks can accept deposits. That’s why the legal and economic value of a bank is in gathering deposits from loyal customers.”

Both Republic First and Metro prioritised the growth of deposits. They used the model Hill honed at his first banking venture, Commerce Bank, to think about selling deposits like selling consumer goods. “From our inception, Commerce has refined a business model patterned after the great retailers of America, i.e., Home Depot, WalMart, McDonald’s, Starbucks, rather than the typical bank or financial institution,” he told shareholders in his 2000 annual report. 

In an environment of rising rates, this strategy should have paid off with higher net interest margins. Unfortunately, trained to think more like retailers than bankers, management didn’t focus sufficiently on where they were putting the deposits and are now suffering the consequences.

Republic First invested heavily in securities. At the end of 2022, its balance sheet ran with a loan/deposit ratio of 62%, giving its treasury team a surfeit of deposits to invest. By the end of that year, they had built up a portfolio comprising $898 million available-for-sale (AFS) securities and $1,629 million held-to-maturity (HTM) securities. But higher rates mean lower securities values and mark-to-market losses of $172 million opened up in the AFS portfolio and $264 million in the HTM portfolio. While AFS losses may be reflected in the balance sheet, HTM losses are not. With tangible common equity of $193 million, the bank was mark-to-market insolvent, just like Silicon Valley Bank and its close namesake, First Republic.²

By June this year, the hole was even bigger, with losses in the HTM portfolio having widened to $304 million. Not that any of this is recorded in SEC filings: Republic First still hasn’t filed audited financial statements for 2022, because of its “former executive team’s failure to maintain adequate internal controls.” All numbers come from the bank’s regulatory filings. 

Metro Bank invested in real estate lending, including a portfolio of commercial loans secured on immovable property (so-called CLIP Loans). All loans require careful risk bucketing to assess the amount of capital that needs to be allocated against them. Metro management thought its CLIP Loans were eligible for a 50% risk-weighting but it turned out the regulatory requirement was 100%. After the error came to light in 2019, the bank was fined for failing to maintain adequate internal controls. “There are multiple gaps in the controls framework at every stage of the process, from data sourcing through to report generation,” reported an external consultant. Metro Bank was later fined again when it emerged that management had sat on the error for longer than was appropriate. 

Metro never really recovered. It harboured hopes that regulators would allow it to use internal models to calibrate capital rather than rely on the standardised models it was subject to as a new entrant. This would have released significant capital. But last month the regulator announced that more work was required and approval would not be forthcoming in the current financial year. That leaves Metro skating on minimum capital requirements (its fully-loaded common equity tier 1 ratio is around 9.7% versus a minimum of 9.2%). The stock has fallen by 60% since.

So far, customers are taking these banks’ problems in their stride. Deposits were down less than 4% in the second quarter at Republic First, in the aftermath of Silicon Valley Bank’s collapse, even as 60% of them remain uninsured. But, as my friend Sam Haskell points out, its customers are less very online than those of the California banks that failed. “Many of these customers work in office parks and commute home to 3 bedroom houses. They are not looking at crypto quotes, nor funded by VCs. They often don’t have a CFO.”

In Metro’s case, up to three-quarters of deposits are insured.³ The bank survived a mini-run back in 2019 when the risk-weighting error surfaced. A false rumour spread on WhatsApp that “the bank may be shut down or going bankrupt” and soon the Harrow branch was filled with anxious customers. This week, management released a statement saying that they’ve seen continued momentum in personal and business account growth and customer acquisition during the third quarter.

Loyal customers give the banks breathing room to fix their capital problems. Vernon Hill at least had that foresight: “the legal and economic value of a bank is in gathering deposits from loyal customers,” he wrote. Last week, a shareholder group led by George E. Norcross III offered to inject $35 million into Republic First on the basis it can raise $40 million from other investors. George Norcross III had worked alongside Vernon Hill II at Hill’s first banking venture many years previously.⁴

Yet even if it’s able to raise the full amount of capital, the bank still has challenges. It has to resolve its filing issues; until then its stock is barred from Nasdaq and trades only over-the-counter. And it has to arrest deteriorating profitability. In the second quarter, Republic First earned only 2.33% on its securities against non-interest bearing deposit costs of 2.23% leading to a very narrow net interest margin of 1.42%, off which it couldn’t make money (assuming the regulatory filings are reliable).

Metro Bank is rumoured to be looking to raise up to £600 million in equity and debt from investors. The bank confirmed that it is evaluating a range of options, including a combination of equity issuance, debt issuance and asset sales. However, Metro’s weak profitability makes a capital raise hard as its high cost, branch-centric business model weighs on earnings. Even with a tailwind of higher rates, the bank reported losses over the eighteen months since the beginning of 2022, its cost/income ratio last year hitting 104%. 

Vernon Hill may have been right about loyalty, but he was sneering of cost control. “There are two ways to make money,” he wrote. “Grow your top line – that’s the best way. Cost cutting is your way to extinction.”

In the meantime, although Metro’s depositors may show forbearance, its bondholders may not. A £350 million senior bond issue drops out of a key regulatory capital calculation (MREL) in October 2024 one year ahead of its maturity, and unless it can be refinanced, it presents a dangerous cliff edge. An alternative to a public capital raise may be for an existing shareholder to step up, as in Republic First’s case, for bondholders to take control, or for a rescue bidder to emerge.⁵

Vernon Hill is not involved in either of these banks any more; he has retired to his home, the biggest in New Jersey. But as a great bank analyst once said, “Bank profitability is 50% macro and 40% decisions taken five years ago.” Vernon Hill’s shadow still looms.⁶

More on Vernon’s legacy here.

Equity Research

Regular readers will know that I harbour a deep fascination for the equity research industry. It’s a topic I’ve written about several times before, starting three years ago in The Cautionary Tale of Equity Research. Part of it is nostalgia: I used to work in the industry and subsequently, as a professional investor, became a consumer of its product. Part of it is that equity research presents a useful, ongoing case study in how to craft an economic model in the tricky segment of the Venn diagram where businesses that produce public goods meet businesses that operate at zero marginal costs. ...