Tax cuts for banks (if they happen) may not go where you think

It’s hard for banks to resist the temptation to dream about money they don’t have in hand yet when the sum in question could exceed $30 billion.

That is the kind of estimate that has been thrown around for how much banks could save if President Trump and Congress slash corporate tax rates, perhaps to as low as 15%. Many bankers, and investors, have licked their chops over how tax reform could pad profits, fuel reinvestment in new technologies and other expansion, or bolster the return of excess capital to shareholders.

But in the past month, bankers including JPMorgan Chase CEO Jamie Dimon have downplayed the potential impact of tax cuts on their bottom lines. A key reason why? The tax savings — if they become reality — could likely get “competed away” if banks use the extra money to subsidize lower pricing on loans to lure in new business, executives and observes warn.

“That’s a question that investors have been asking: How much of the profit margin would be retained by the bank, and how much would go to more competitive pricing,” Betsy Graseck, an analyst with Morgan Stanley, said in an interview Wednesday. “The investor community is mixed on it.”

The last time corporate taxes were cut, in the mid-1980s, the banking industry saw profitability climb in the short term but decline several years later as competition heightened and as the industry later dealt with the fallout from the thrift crisis and other economic difficulties.

While banks face a different competitive landscape — due to a range of higher regulatory hurdles — a similar dynamic could play out this time around, according to Graseck.

Over the past few months, of course, bank have been riding an unexpected wave of investor optimism — fueled, at least in part, by the prospect of lower taxes in the years ahead. The KBW Bank Index has rallied by roughly 30% since the Republican sweep in the elections.

Immediately following the elections, equity analysts across the industry published a slew of reports illustrating how bank earnings could spike under a range of lower-tax scenarios. Regional banks facing high effective rates could stand to gain the most, they said.

On the campaign trail, Trump promised to lower the corporate tax rate to 15%, from its current level of 35%. Republicans in Congress have previously proposed setting the rate at 20%.

To be sure, it's too early to speculate on possible on changes in tax policy. Though Trump has promised to make an announcement on the matter in the weeks ahead, the details about proposed rate cuts remain unclear. And fights over immigration, Cabinet nominees and various Russia-related scandals have been major distractions and bode poorly for the kind of bipartisan cooperation tax reform would likely demand.

Moreover, even if major tax cuts are achieved, remarks by bankers in recent weeks have clouded the previously rosy outlook for profit growth.

"I think the markets got over their skis a little bit after the election," Lou Maiuri, an executive vice president at State Street, said in discussing fiscal policy at an industry conference last week.

During the latest round of quarterly earnings calls, executives at JPMorgan — the largest bank by assets — told analysts that the company may use tax savings to compete for new business.

“Just on the tax side, so people understand generally, yes, if you reduce tax rates … eventually that increased return will be competed away,” Dimon said during the company’s quarterly call in January. “It’s not good for JPMorgan Chase, per se, but it’s a good thing for the world.”

Other bankers offered a similar note of caution to analysts and investors, who are interested in seeing the lower tax rates drive profits higher.

“It is too early to opine on the dynamics of the competitive environment and how that may ultimately impact the bank's ability to retain any potential benefits” from lower taxes, Tayfun Tuzun, chief financial officer at Fifth Third Bancorp in Cincinnati, said during the company’s quarterly call.

Tuzun noted that Fifth Third is predicting that a “large percentage” of the benefit from lower rates will fall directly to its bottom line.

Questions about how banks will respond to lower taxes ultimately depend on the intensity of competition in banks’ local markets, according to John Graham, an economics professor at Duke University.

And each bank’s financial performance will affect its decision, too. Banks with low profitability have little incentive to lower their spread income on loans, according to Terry Dolan, CFO at U.S. Bancorp.

“I don't believe the industry will ‘compete away’ all of the benefits of lower corporate tax rates … given that many banks are barely earning their cost of capital,” Dolan said during an interview last month. “At least, not until profitability improves."

Return on common equity remains well below 10% for most lenders, after years of declining margins and rising compliance costs have squeezed quarterly results.

Among the largest 15 banks, U.S. Bancorp and JPMorgan led the pack during the fourth quarter, posting returns of 13.1% and 11%, respectively, according to data from Moody’s.

Citigroup and Citizens Financial, in contrast, posted returns of 6.2% and 5.7%, respectively. Analysts generally say that banks need to generate a 10% return on equity to earn their cost of capital.

“The way I think about it is, if your ROE is less than 10%, you’ll retain all of” the benefit from lower tax rates, Graseck said.

During U.S. Bancorp’s earnings call last month, CEO Richard Davis dismissed the idea that price competition will chip away at the potential benefit from lower taxes in the months ahead.

“If someone wants to compete on price, bring it on,” Davis said. “We can beat them every day for the highest-quality customer.”