Republican leaders finally unveiled their long-awaited tax reform package and, as expected, the proposal could offer a big boost to bank earnings.
The Trump Administration, the House Committee on Ways and Means, and the Senate Committee on Finance proposed lowering the corporate tax rate to 20%, down considerably from the approximately 30% level paid by the banking industry over the last few years. The details remain unclear, and the path to passage is murky as Republicans have only released a nine-page framework outlining the proposal, but cutting the top corporate tax to 20% would offer a substantial lift to bank earnings.
In S&P Global Market Intelligence's base case for 2018, the banking industry's net income is expected to grow 7.1% from 2017 levels. If corporate tax cuts were passed in 2018, reducing the industry's tax rate by 10 percentage points, bank earnings could grow nearly 23% next year.
The sizable increase in earnings would allow the banking industry to produce returns on average equity of nearly 12%, a level not reached since 2006. At that level, banks would clearly earn their cost of capital, possibly silencing critics who have argued that the nation's largest banks have not earned the right to exist in their current form.
The higher returns would come against a higher level of capital, which currently stands at a 70-year high in the industry. A boost to earnings would bring even more capital onto bank balance sheets and encourage many institutions to increase shareholder returns through dividends and share repurchase activity. The newfound capital could also make acquisitions incrementally more attractive for some banks.
Lower corporate tax rates could breathe new life into bank stocks as well, serving as another leg in the rally that followed the U.S. presidential election in November 2016. While investor enthusiasm toward the bank group has recently waned, corporate tax reform would offer a considerable boost to EPS, making bank stocks even cheaper relative to the broader market.
The prospect of stronger earnings growth in the years to come could attract more investors to the bank group and allow bank stocks to narrow their current discount to the broader market, potentially pushing bank stock currencies back to the levels witnessed earlier this year. Higher currencies could serve as a tailwind for bank M&A activity, allowing buyers to more easily ink accretive acquisitions while satisfying sellers' expectations.
Still, there could be some offsetting factors emerging from corporate tax reform policy that likely would have the most significant impact on the largest U.S. banks, whose activities extend beyond commercial and retail banking.
Corporate tax reform could reduce corporate bond issuance activity, if history is any guide. The last time the U.S. had a tax holiday, many institutions used the repatriation of profits for dividends and share buybacks, possibly limiting future debt issuance since many of those transactions in recent years have been used to return capital to shareholders. It should be noted, though, that cash piles are currently concentrated among fewer companies when compared to the last tax holiday more than a decade ago, with the technology sector currently holding nearly half of the cash sitting overseas.
Large banks produce substantial revenues from fixed income, currencies, and commodities trading. The fixed income, currencies, and commodities business seems unlikely to be significantly threatened by tax reforms since cash repatriation rather than a turn in the credit cycle would be responsible for slower issuance activity in the markets.
There are some concerns that cash repatriation could hurt international deal-making and, accordingly, the M&A advisory business of the largest banks. Companies have used offshore funds for international deals, but if those funds are repatriated, that could lead to fewer deals overseas.
There was concern that limits on the deductibility of net interest expense payments, as outlined in previous Republican tax proposals, would serve as an even greater headwind to M&A activity and corporate bond issuance. Such limits likely would increase financing costs for borrowers and issuers, which would probably translate into weaker capital markets activity. However, the revised Republican plan only contemplates a partial limitation on the deductibility of net interest payments, suggesting that the impact might not be as great as feared.
Corporate tax reforms should serve as a net positive for the banking industry and just might benefit larger community and regional banks the most since they will receive benefits and have little to no exposure to the capital markets.
Investors will offer their outlook and discuss the changing fundamental environment for the banking sector at the Big Decisions in Banking conference on Oct. 11-13. Click here for more information on the S&P Global Market Intelligence event, which will also cover M&A prospects, the implications of rising interest rates and CECL.