This Is What Legends are Made Of

Zeeshan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

While Bank of America (NYSE: BAC) somehow managed to shake off the mammoth issues which, during the financial turmoil, almost threatened its existence, one of its ex-subsidiaries -- First Republic Bank (NYSE: FRC) has shown remarkable resilience with unflagging resolve. First Republic has never reported a loss since its inception and, more importantly, has been outperforming the industry quite perceptibly.

Although the industry is seemingly getting back on the rails on the back of an improving economy, many banks are still struggling to propel revenue growth. So we need to narrow down to stocks that are fundamentally strong enough to make optimal use of the supposedly favorable conditions ahead.

Solid fundamentals

Credit quality: First Republic has had an impeccable credit history and it is more than likely to continue. During the downturn, when almost the whole industry was blighted and plagued by loan charge-offs, FRC’s management judiciously refrained from reckless lending and managed to keep net charge-offs as low as 0.15% of average loans on an aggregate. Many don’t reach that level even in the best of years. That should be coaxing enough for investors to have faith in management’s ability to ‘pull it off’ in the years to come.

Strong Capital: While most of the banks sweat blood over the revised stringent capital requirements, FRC passed with flying colors. After the recession, FRC came up with its IPO with already strong capital ratios. So it gained an upper hand by solidifying its capital position at a time when others were reassessing and repairing the damage.

Take a look at the table below to get a better understanding of how First Republic fares in terms of credit quality and capital level, when compared with peers and the industry.

<table> <thead> <tr><th> <p><strong>Ratios</strong></p> </th><th> <p><strong>FRC</strong></p> </th><th> <p><strong>SVB Financial <span class="ticker" data-id="205427"></span></strong></p> </th><th> <p><strong>City National </strong></p> </th><th> <p><strong>Proposed regulatory requirements</strong></p> </th></tr> </thead> <tbody> <tr> <td> <p>Net charge-offs to Average Total loans</p> </td> <td> <p>0.00%</p> </td> <td> <p>0.20%</p> </td> <td> <p>0.13%</p> </td> <td> <p>N.A</p> </td> </tr> <tr> <td> <p>Tier 1 capital to RWA*</p> </td> <td> <p>13.50%</p> </td> <td> <p>11.70%</p> </td> <td> <p>9.64%</p> </td> <td> <p>8.50%</p> </td> </tr> <tr> <td> <p>Total capital to RWA</p> </td> <td> <p>14.10%</p> </td> <td> <p>13.00%</p> </td> <td> <p>12.72%</p> </td> <td> <p>10.5%</p> </td> </tr> </tbody> </table>

*RWA=Risk Weighted Assets. Source: Yahoo! Finance (Three months ended March 31, 2013).

The numbers clearly suggest that FRC gets the better of the two. But they also indicate that SVB Financial (NASDAQ: SIVB) and City National (NYSE: CYN) are also impressive on an absolute basis as they have extremely low charge-offs and strong capital ratios. Their comparison with FRC wouldn’t be a conclusive one as I have already pointed out that the latter is the best of the pack by miles.

Promising Prospects

Tapping the existing upscale market: The markets in which First Republic operates represent only 21% of the households of the US. But that is almost 55% of all high net worth households. So instead of exploring new markets, management is focused on penetrating deeper into existing core markets such as New York City, Boston, Silicon Valley and Boston. The US housing market has been showing encouraging signs of recovery and these affluent markets look perfectly leveraged. FRC looks well positioned to make good use of its resources.

A spurt in deposits in on the cards: As demand for loan grows, FRC looks all geared up to witness a strong and sustainable deposit growth in the not-so-distant-future. More importantly, while business loans account for only 9% of loan portfolio, business deposits already account for 41% of its deposits. As business banking gets stronger, both loans and deposits should grow. The importance of these business bank’s deposits cannot be overlooked while ascertaining the outlook of a bank as they are a source of low cost funds to grow the balance sheet.

The stumbling block

Net interest margin (NIM) compression – At the moment, however, deposit growth continues to lag loan originations. To cover the funding gap, the bank may have to sell off its loan production. Perhaps, management has had been a little too aggressive in cutting deposit rates. To rectify it and boost deposit growth, FRC is now raising rates. But when the rates increase, the bank’s funding costs will increase before its earning assets mature. This will further constrict the margin between earning asset yield and funding costs.

Continued pressure on asset yields and higher funding costs will, therefore, result in more pressure on NIM. This, I think, is the biggest issue the bank will have to address. To deal with this, it’s selling fixed-rate loans and growing its core deposits together. This will bridge the gap between its assets and liabilities.

And the bottom line

Make no mistake about it, NIM pressure is not exclusively associated to First Republic but to the industry in general. And with such sound fundamentals, FRC definitely looks better equipped to overcome these hurdles and exploit all the opportunities that come its way. From an immaculate history to promising prospects, everything about FRC makes me bullish about it. What’s your take, Fools?

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Zeeshan Siddique has no position in any stocks mentioned. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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