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Tax Reform Could Prove a "Double-Edged Sword" for Banking Industry, Analysts Say

May 31, 2018, 08:02 AM
Filed Under: Banking News

U.S. bank profits are projected to reach pre-crisis levels but CECL could slow overall balance sheet growth, according to a new report from S&P Global Market Intelligence that also questions the benefits of newly enacted tax reforms.

S&P Global Market Intelligence sees improving profitability for U.S. banks, including smaller community banking institutions, at least in the near term, according to its latest bank market reports.

Banks should experience additional expansion in net interest margins even as funding pressures and heightened competition stemming from tax reform mitigate the benefits of higher interest rates. That expansion, coupled with a lower corporate tax rate, should allow profitability to nearly reach precrisis levels, before credit quality sours and serves as a headwind to earnings.

As credit quality slips, banks will begin complying with a new reserve methodology, dubbed the Current Expected Credit Loss model (CECL), which could slow balance sheet growth as some institutions raise rates on loans, while others look to rebuild their capital bases.

The detailed outlooks for both the U.S. banking and community bank industries were outlined in the 2018 US Bank Market Report and the 2018 US Community Bank Market Report published in the early spring. The reports, which offer a five-year comprehensive analysis for the two groups, also highlight performance over the last decade and explain how banks have reacted to changes in the regulatory and interest rate environment.

The Tax Cuts and Jobs Act lowered the corporate statutory tax rate to 21%, well below the roughly 30% effective rate regularly recorded by the banking industry since the credit crisis. The lower tax rate and the benefit of being compared to a lower earnings base in 2017 should allow earnings to grow by more than 35% and 19% in 2018 for large banks and community banks respectively.

There is hope that tax reform will spur greater economic activity as well, but loan demand has not increased yet. Lackluster growth has led to fiercer competition for quality credits and tax reform likely will only intensify the fight since economic growth will not be strong enough to lever the windfall from the legislation. If growth fails to materialize, tax reform could prove to be a double-edge sword for the banking industry.

The reports indicate that:

  • Higher funding costs loom as deposit betas jump at some large US banks
  • CECL will create large capital hit, earnings volatility for US banks
  • Community banks are winning the battle for deposit costs
  • Community banks are well-positioned to absorb capital hit from CECL
  • Banking profitability is poised to improve

Including the impact of CECL, which banks will adopt in 2020, the report projects that while the banking industry could record slightly higher net interest margins, it should report lower capital ratios and experience greater earnings volatility.

The banking industry’s earnings are projected to jump 36.3% in 2018 for large banks, and 19% through 2018 for community banks, according to the reports. Earnings should rise 4.2% for large banks in 2019 as higher interest rates continue to bolster profitability, while community bank earnings are projected to dip modestly in 2019 as funding costs rise and impede margin expansion. However, the reports see earnings falling in 2020 for all banks as credit quality begins to deteriorate.

S&P Global Market Intelligence analyzed nearly 10,000 banking subsidiaries, covering the core banking industry from 2005 to 2017. The analysis includes all commercial and savings banks and savings institutions and historical institutions as long as they were still considered current at the end of a given year. It excludes several hundred institutions that hold bank charters but do not principally engage in banking activities, among them industrial banks, nondepository trusts and cooperative banks.

The analysis examined long-term performance over periods outside the peak of the asset bubble from 2006 to 2007 to inform projections both in good and bad times. S&P Global Market Intelligence has created a model that projects the balance sheet and income statement of the entire industry and allows for different growth assumptions from one year to the next.

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