Republic First (not First Republic) collapsed last Friday.

Does this mean that banks are investing too aggressively in speculative assets? Not exactly.

The bank under normal circumstances would not collapse. The reason that the peer banks collapsed was because of multiple dominos falling.

First, we need to understand the business model of banks.

Borrow short, lend long.

What do I mean? They borrow from you and me. And better yet, corporations. With a lot of cash.

They borrow funds by allowing us to deposit cash there.

They need to keep certain amounts of cash in reserve as set by regulators.

The remaining cash, they can invest in short-term securities such as treasury bills.

Say they generate a 2% in interest on that cash.

Then, they can pay us 0.1% in interest for keeping the cash in their deposit accounts.

The bank gets to keep the 1.9% spread there.

With some deposits, they can enter into long-term investments such as bonds.

Throughout 2021, there was a massive inflow of deposits.

The economy was buzzing with stimulus and artificially low interest rates.

So, banks started to invest the new deposits into longer-dated securities.

But, this exposes banks to significant interest rate risk. That is risk that arises from interest rate fluctuation.

Having too much interest rate exposure unhedged could lead to financial distress for reasons we will soon see.

Then, the narrative started to turn into 2022 and 2023.

Rates started to increase.

Bond prices trade inverse of interest rates. Meaning if interest rates rise, bond prices fall. And vice versa.

Understanding the accounting here is important. But, this is a later discussion.

The unrealized losses are not really problematic. As with anything unrealized, until the company realizes the losses. Or is forced to realize the losses.

Companies were burning cash. Rates hiked at the fastest pace. Deposits were falling.

Investors were growing uneasy with the large losses posted on the company’s balance sheet and insufficient assets to cover deposits.

This leads to a bank run. When depositors start pulling out funds in fear that the bank will fail.

Then, the company is destined to realize the loss and soon collapse.

It’s a vicious cycle.

The bank needs to work to regain depositor confidence through injecting new capital.

Failure to do so, leads to what we see with Republic First.

Bottom-line? Higher sustained rates leads to massive unrealized losses and falling deposits reduces depositor confidence.