The hornet's nest that a $25.9-billion AUM RIA owner stepped on and how much it cost

Brooke’s Note: There was a web chatter while First Republic’s quarterly call with analysts was still in the works. I perked up. This is a bank but it is also like a big RIA and in fact “owns one of the biggest RIAs around, Luminous Capital.”: See: First Republic pays a staggering sum for Luminous Capital, sources say, and shifts the breakaway and M&A games in the bargain. It was once part of Merrill Lynch. The UBS analyst covering the call put out a note today that included subheads down the page in bold print that included: “It all seemed so innocent at first”, “What happened?” and “We believe this was a case of poor communications.” I have reached out to First Republic periodically as a journalist and been told that as a blanket policy I shouldn’t expect any access or comments. First Republic, for the record, declined comment for this article. It’s not big on communicating. Not communicating has its benefits — and its price. In this case, its share retreat had a clear price of a $1-billion-plus paper loss in market cap in the wake of the call.

“If you could just help us understand — what changed, like what happened? Because it feels like last quarter, things were fine…”

It was the middle of First Republic Bank’s afternoon conference call and Ken Zerbe, analyst at Morgan Stanley, was still trying to wrap his head around the announcement with which the bank’s chairman and chief executive had led off the call. Instead of launching into a rundown of the quarter’s results as usual, Jim Herbert went in a different direction, offering up his estimates for the firm’s compliance costs over the next six quarters. The ratio of the bank’s expenses divided by its revenues would increase from the mid-50% range to a range of 60% to 62% over the next six quarters.

Listening analysts quickly ran the calculations and discovered that First Republic was facing extremely large new compliance expenses; at the low end of estimates they could to face a cumulative $100 million in costs by 2016.

Big enough to fail badly?

Dodd-Frank regulations mandate significant regulatory and compliance measures for those banks with over $50 billion in assets. That is, those systemically important financial institutions colloquially said to be “too big to fail.” See: A $5.5 billion LA-based RIA is getting purchased by First Republic Bank.

With $46.2 billion in assets, First Republic Bank is fast approaching that level.

In his prefatory speech, Herbert said First Republic Bank, which owns a $25.9 billion RIA, had started to ramp up its compliance work, and that because of these costs its efficiency ratio would rise substantially. For a bank whose 2013 net income was $462 million, the effect of $100 million in expenses over six quarters is no drop in the bucket. Shares dropped immediately and the more First Republic’s management explained, the more steadily they plunged. The shares [NYSE:FRC] regained a little ground today

Analysts strove to be polite but honest about their stung emotions as the data sunk in.

“Were you surprised at sort of what you needed to do … to get to that level?” asked analyst Erika Najarian of Bank of America. “I think that we are all a little bit surprised as to the level of investments that you have to make when crossing that threshold,” she added, sounding more than a bit surprised.

Very long list

“The answer is yes, a little bit,” said Herbert. The company had described the impending problem in their 2013 annual 10-K filing, but had not, it seemed looked further into the costs and requirements associated with becoming too big to fail. See: A different take on too-big-to-fail.

“So there’s a wide range of things,” continued Herbert. “The list, quite frankly, is quite long. But we’re doing a form of all of these and we’re basically enhancing in every single case. There is nothing in the list that is brand new.”

Herbert gave stress-testing as an example of how the bank needed to scale up its organization to meet Dodd-Frank requirements. While First Republic currently runs three to four stress test scenarios, it will be expected to run eight or nine after hitting the $50 billion mark. “That takes a considerable additional database and quantitative capability. It also takes an ongoing reporting capability that we have, but needs to be enhanced,” he said.

In addition, First Republic now needs improvements in their risk management operations, resolution planning and money-laundering protections, as well as more upgrades to their financial infrastructure and an overall enhancement of their compliance work. Many, if not most, of their costs will be one-time events as they ramp up their operations, but some, like added headcount, will remain fixtures on their books.

Herbert said the company expects its efficiency ratio to fall to 60%, if not lower “sometime in 2016.” However, he also made it clear that an elevated ratio was the company’s new normal and they would not be returning to historical efficiency at any point, at least without significant help from interest rates. They face millions in quarterly compliance costs on into the future.

First Republic also guided its loan-growth rate lower to 11% to 13%, which caused analysts to wonder if it was trying to slow its growth and manage its balance sheet so it wouldn’t arrive at $50 billion before they were ready. See: How the Luminous deal is rocking the recruiting world — and may set the stage for more fireworks.

$1.1 billion gone

By the end of the day, First Republic’s shares had dropped from $55 to $46.70 — more than 15% — and wiped $1.1 billion off the books of shareholders. Shares have rebounded only slightly today. At press time, First Republic Bank stock was trading around $48.

“We believe this was a case of poor communications,” writes Dean Ungar of UBS in a note to clients. “In our view, if this had been presented as a restructuring program, with a one-time cost component (even if realized over several quarters), the market reaction would have been much more benign. This is not a broken story in any sense, in our view.”

Nevertheless, he found sufficient reason to reduce earnings per share estimates by $.30 for 2015, and to in turn cut the bank’s price target from $62 to $57.

Bright spot

These new Dodd-Frank regulations are for a company with just one-third of 1% of the nation’s banking wealth.

First Republic Bank was founded in 1985 and has offices in six states. The company doesn’t engage in many of the riskier financial practices typical of larger banks like proprietary trading, subprime or leveraged lending or credit derivatives. It primarily serves small businesses and personal accounts, but it also uses these practices to cross-sell its private wealth management group. This group has $48.7 billion in assets under management, up 7.8% on the quarter and 34% for the year, and continues to be a bright spot for the company. None of the impending compliance costs are attributable to business in this segment. See: Why Chuck Schwab is fine with boosted taxes — and even Dodd Frank — and believes RIAs should be, too.

Onerous regs

First Republic should be well aware of the potential dangers banking behemoths pose, having gone through the 2008-2009 financial crisis under the ownership of two of them.

It was bought by Merrill Lynch in 2007 before it got scooped up by Bank of America on at the beginning of 2009. Bank of America then spun First Republic off as an independent company in July 2010, and its been publicly traded since December of that year.

Despite the short-term news, shareholders and bankers alike might take heart from recent stirrings in Washington. Major public officials have noted the injustice of an arbitrary $50 billion threshold that catalyzes highly onerous regulations.

Daniel Tarullo, a member of the Federal Reserve Board of Governors gave a speech in May attacking Dodd-Frank regulations and the threshold, saying many of the compliance requirements that threshold activate are too elaborate for these relatively small banks. See: The SEC will often 'tell’ advisors what compliance issues deserve attention.

And coincidentally, just four hours before First Republic’s disastrous conference call, the Senate Banking Subcommittee on Financial Institutions and Consumer Protection held a hearing on the “systemically important” designation. Chaired by Sen. Sherrod Brown (D-OH), a staunch advocate for raising the $50 billion threshold, the subcommittee heard testimony from various experts who decried the Dodd-Frank’s capricious categorization of too-big-too-fail institutions. See: The dark side of the 'good’ regulatory changes get scrutinized at MarketCounsel Summit 2011.

Overemphasis on size

“Just relying on size does not give us an understanding of how to design laws and regulatory infrastructure to deal effectively with systemically important institutions,” said James Thomson, professor of finance and department chair at the University of Akron.

Paul Kupiec, a resident scholar at the American Enterprise Institute agreed. “There is no science evidence that supports a threshold of $50 billion for subjecting bank holding companies to heightened prudential standards,” he said. “In my opinion, the $50 billion threshold set for enhanced prudential standards in Section 165 has erred on the side of excessive caution.”

Consensus is that nothing will be done during this election year, but there might be relief on the horizon for First Republic Bank and other small, regional banks in 2015.

If that happens and when is First Republic Bank’s $100 million question.