Banks bask in tax reform gains, but they should plan ahead

America’s largest banks have reported substantial profit increases for the first quarter of 2018 over the same quarter last year. That increased profitability is attributable in part to the reduction in the corporate tax rate Congress enacted at the end of last year. 

According to the Wall Street Journal, “Big banks posted strong and rising returns on equity in the first quarter, some as high as 15% — potentially a long-awaited sign that they are finally able to focus on growth again, after the postfinancial crisis years.”

Not to be overlooked, the lower corporate tax rate is benefiting banks of all sizes, including smaller community banks.

{mosads}Competitive forces, though, may drive bank profits, and returns on equity (ROE), back down to the levels of recent years. Put another way, how will banks “spend” the tax savings they began enjoying this year?

Since the large banks, as well as most smaller ones, too, now have strong capital positions, they are using some of their tax savings to increase dividends and buy back shares. All other things being equal, those actions will increase a bank’s leverage, which in turn will boost its ROE.

Other forces, though, will depress bank earnings and therefore ROEs.  For starters, banks are beginning to compete more aggressively for deposits, by raising deposit interest rates. 

Given the continuing intense competition for loans, rising deposit interest rates will squeeze banks’ net interest margin — the difference between the interest earned on loans and investments and the interest paid on deposits and borrowings. A smaller net interest margin will lead to reduced earnings and a lower ROE.

Banks’ net interest margin will be squeezed, too, by a flattening yield curve, as has been occurring recently, as short-term interest rates on deposits and borrowings rise faster than longer-term interest rates earned on many loans and investments.

Rising operating expenses also will cut into bank profits, reducing ROEs. In addition to recent bonuses and salary increases, banks need to invest substantial sums to modernize their computer systems and to strengthen cybersecurity protections. That is a costly, never-ending undertaking.

Some banks view the strong economy as an opportunity to expand their product offerings and to enter new markets. JPMorgan Chase, for example, recently announced plans to open hundreds of new branches, including 70 in the Washington, D.C area. 

While JPM is betting that market expansion will be profitable over the long term, in the short term, the cost of launching that expansion will be a drag on its profits.

Banks may enjoy reduced regulatory compliance costs as the Trump administration chops away at the banking industry’s regulatory burden, but given how expensive fines and penalties can be for compliance failures — witness Wells Fargo’s pending $1 billion regulatory penalty — banks of all sizes need to proceed very carefully in reducing their spending on regulatory compliance activities lest they increase the risk of future penalties.

While banks have largely put the credit-quality challenges of the last financial crisis behind them, they need to implement a new accounting regimen to provide, in advance, for future loan losses. 

Called “current expected credit loss,” or CECL, implementing this new accounting rule may force some banks to increase the amounts they must expense now, or set aside in loan-loss reserves, in anticipation of loss charge-offs during the next economic downturn. 

While prudent, these increased loss provisions will negatively affect bank earnings in the near term and consequently ROEs.

U.S. banks, of course, have many competitors, including banks headquartered in other countries, as well as domestic non-bank competitors. Competition from those banks and non-bank financial firms will keep bank profits in check as will the securitization of bank loans.

The banking industry has moved well past the aftermath of the 2008 financial crisis, which is a huge positive for the banking industry as well as for the U.S. economy, and the industry is enjoying strong profitability and good ROEs on their stockholders’ equity, but strong profits and high ROEs will not continue indefinitely. 

Hence, while bankers should cherish today’s strong profitability, they need to continue to invest some of those profits in improving their banks’ operating efficiency and systems security even if doing so lowers their short-term profitability and ROEs. 

American banking, and the U.S. economy, will be the long-term beneficiaries of such actions.

Bert Ely is the principal of Ely & Company, Inc., where he monitors conditions in the banking industry, monetary policy, the payments system, and the growing federalization of credit risk.  Prior articles by Ely on banking issues and cryptocurrencies can be found here.  Follow Bert on Twitter: @BertEly