What Will Banks Do With Their Tax Gift?

Banks got a huge Christmas gift from Congress: a new law that significantly cut their tax bills. By early estimates, the largest banks in the country will see savings of hundreds of millions-or even billions of dollars per year.

In fact, banks could see their average effective tax rate, the rate that corporations actually pay after deductions and credits, plummet from about 30 percent to 21 percent, according to an early estimate by investment banking firm Keefe, Bruyette & Woods.

Bank stock investors reacted positively to the tax law, and at least initially, the vast majority of the savings will benefit earnings. But what will banks do with the boost to earnings and how long will it last? Will the holiday present, neatly wrapped under the IRS Christmas tree, stick around, or will banks compete for business, passing along the gains to customers?

Banks were busy in January figuring out the implications of the complicated tax law and what to do with the money, but they gave some early indications of their plans. Many of them made public announcements about giving a portion to employees and communities in the form of wage increases, bonuses and charitable giving, and more often privately, also were discussing dividend increases for shareholders, as well as accelerating investments in technology to make themselves more competitive.

For banks in particular, the law is a big deal, because banks pay relatively high corporate taxes. Among other provisions, the Tax Cuts and Jobs Act trims the federal statutory corporate tax rate from 35 percent to 21 percent. Because of the availability of deductions, few corporations actually pay the statutory rate. The banking industry qualified for fewer deductions than some other industries, such as mining and manufacturing, and banks ended up paying a relatively high effective tax rate of close to 30 percent before the law was passed. Effective tax rates vary widely not just between industries, but on a state and local basis as well, as banks in high-tax jurisdictions such as New York City tend to pay higher effective tax rates than banks in lower tax jurisdictions.

The last time Congress enacted major tax reform was in the 1980s, but a cut in the corporate tax rate then was accompanied by the loss of deductions that a lot of banks enjoyed, so effective tax rates actually went up, according to an analysis of Federal Deposit Insurance Corp. data by Frank Schiraldi, a managing director at Sandler O’Neill + Partners.

To see what will happen when banks get a more generous federal tax cut, you’d have to go back more than 50 years. After President John. F. Kennedy lobbied Congress to cut corporate taxes, Congress passed a tax break in 1964 a few months after his death. The next year, the effective tax rates for FDIC-insured commercial banks fell to 26.45 percent from 30.61 percent, even as net income for banks continued to rise. The tax cuts might have given a bit of a boost to earnings. Profits grew each year 10 percent, 6 percent and 15 percent, respectively, between 1965 and 1967. But the tax cuts were short-lived. A subsequent change in the tax law in 1969, designed to mitigate “the tax advantages of banks” raised the effective rate for banks to 33.3 percent in 1969, according to the analysis.

This time around, stock analysts also expect a boost to earnings, but no one is certain how long that will last. “In 2018, we expect 80 percent of the [tax] benefit to fall to the bottom line,” says Fred Cannon, global head of research at Keefe, Bruyette & Woods. There are a variety of reasons why not all the tax savings will fall to the bottom line. Some banks have significant deferred tax assets, which they deduct against future profits. The value of those fall greatly under the new tax law, which forced some banks to take significant tax write-offs in the fourth quarter.

Plus, many banks already have made announcements about raising their minimum wage, paying bonuses and making charitable contributions. That’s not a huge portion of the tax savings, though. Among the nine initial banks making such announcements, KBW estimates that the cost is around $1 billion, most of it impacting the fourth quarter of 2017, while the banks receive an estimated $2.8 billion tax benefit. Some banks also mitigated the long-term impact by offering one-time bonuses instead of wage increases for all employees.

Analysts agree that most of the savings will fall to earnings, but over time, that will shrink, as banks make deposit rates more attractive for customers and lower their loan rates in response to competition. “In general, banks price loans based on their cost of capital,” says Cannon. “Their after-tax cost of capital has gone down.”

Marty Mosby, the director of bank and equity strategies for the investment firm Vining Sparks, is optimistic that the tax savings will stick around for a few years, although he also thinks time and competition will erode the gains. He points out that bank earnings are still low compared to the few years before the financial crisis, when many banks topped 20 percent return on equity. Now, he thinks the industry will gain an average of 1.5 percentage points on return on equity, and top 15 percent, because of the tax gains.

Cannon estimates that the public banks on average have achieved about a 12 percent return on equity since the 1960s.

What else might banks do with the extra money? Schiraldi says much of the savings will be invested into bank franchises, but not right away, as banks have already completed the budget process for 2018. “Over time, a lot of it will be competed away, but that’s going to take years,” he says. “It’s not going to be a 2019 event.” Also, for the biggest banks, it will take time before they’re able to increase dividends or buy back shares-the largest bank holding companies need Federal Reserve approval for their capital plans after undergoing annual stress testing.

John Gavigan, the chief financial officer for First Financial Bancorp in Cincinnati, Ohio, an $8.8 billion asset bank, says the majority of the benefit will go to shareholders, but his board was scheduled to discuss how in the January meeting. “Does any of this get competed away?” he asks. “We hope not.”

First Financial is in the midst of an acquisition of MainSource Bank, to be completed early this year, and Gavigan says the savings will help accelerate the bank’s previously announced $1.74 billion community investment plan as part of that merger. The bank made a $3 million contribution to a newly established charitable foundation following the signing of the tax law. It also announced an increase in the bank’s minimum wage to $15 per hour, affecting 220 people out of 1,335 employees. (Although pay varies widely based on whether employees are in a large city or rural area, the average bank teller makes a salary of $25,788, or if they work part-time, $12.05 per hour, according to the Crowe Horwath Bank Compensation and Benefit Survey.)

There was an outpouring of such announcements at publicly traded banks in the weeks following the signing of the tax law. Leading the banks were companies such as Wells Fargo & Co. and BB&T Corp., which were matched by similar announcements at more than 125 other companies, according a list from the conservative group Americans for Tax Reform.

Brooklyn-based Dime Community Bancshares President and CEO Ken Mahon says the bank made its announcement to offer $1,000 bonuses to all employees who aren’t part of the executive group as a way to give back to employees and the community. To make sure executives don’t benefit from the tax law’s gains, the board will make adjustments to executive bonuses tied to earnings metrics. His bank’s minimum wage already was set at $15 per hour, in accordance with New York City law. The bank also instituted a corporate matching gift program to encourage employee giving, and hopes to double the amount of the bank’s philanthropy in 2018. (It made $450,000 in donations in 2017.)

Mahon says the bank, in general, tends to pay out 45 percent of earnings to shareholders, so shareholders will have the expectation that the bank increase dividends or do share buybacks. He also thinks a portion will be reinvested in the bank in terms of hiring more commercial lenders and investing in technology. The bank is going through a core conversion and wants a better customer-facing experience on all its platforms. “What the tax savings is allowing us to do is accelerate some of the changes we have to make here,” he says.

But the full investment figure is up in the air. How much banks will decide to put into their franchises, or give to their customers in the form of lower loan rates and higher rates on deposits remains to be seen. For now, shareholders can rejoice, at least for the time being.

How the Tax Law Could Impact Your Bank

Executive compensation: Changes to the tax law will impact important compensation metrics, such as earnings. Boards will have to decide how to change incentive payouts as a result. Banks won’t be able to deduct compensation above $1 million for certain executives anymore, regardless of whether that compensation comes in the form of performance-based incentives.

Deferred tax assets and liabilities: The value of deferred tax assets and liabilities are reduced by the drop in the corporate tax rate.

Foreign earnings: Banks that have foreign earnings will pay tax on their accumulated foreign earnings, but will be able to repatriate these earnings at lower rates, providing an incentive for banks to bring earnings back to the U.S.

Loss of interest deductions: Most banks don’t have much of a net interest deduction on their tax return, but their clients do. It will be important to assess the impact going forward of debt-heavy clients possibly choosing equity as a way to fund business expansions rather than debt, and for mortgage customers with more than $750,000 in mortgage debt to possibly scale back future home purchases. Clients who use home equity loans also lose the deductibility of interest on those loans.

u2013Pat Tuley, tax partner, Porter Keadle, Moore, LLC, and Jason Marmo, principal, Deloitte Tax LLP