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Home Community Banking

Tax Reform and Table Setting

March 26, 2018
Reading Time: 4 mins read

By Brian Nixon

While there has been much written about the impact of the recent tax reform law on banks’ bottom lines, less has been said about what it means for financial institutions in the capital markets. Specifically, if bank capital is a form of currency, how is tax reform shaping the dealmaking environment for community banks to midsize and regionals?

Expert consensus is that, as in other areas, tax reform is a positive for the banking industry and the capital markets. Although it will take time to develop more fully, 2018 looks like a year that will set the table for strategic mergers and acquisitions for 2019 and beyond.

That’s the outlook expressed in an end-of-year report from PricewaterhouseCoopers. “Considering most banks have not executed a large scale acquisition in the large decade and M&A strategy execution is highly risky for an organization that does not have recent experience, we expect in 2018 many organizations will develop their M&A strategy, identify potential acquisition targets and develop their M&A execution and integration skills,” PwC says.

Just don’t expect the floodgates to open and deal activity to double, the firm adds. “We expect this to be the year building up to a much more robust deal market in 2019. Those buyers who are more prepared than others may be able to get large scale deals completed in 2018 while others take their time to improve their chances of success.”

The key drivers: Tax reform and a positive economic outlook. PwC estimates that some of the benefits of tax reform to the banking industry were already being priced in last year in terms of stock multiples. For example, price-to tangible book value multiples have increased approximately 8 percent over the fourth quarter of 2017—increasing from 1.64x to 1.77x at year-end. With a substantial reduction in banks’ effective tax rates, PwC projects multiples to rise from 1.64x to above 2x. “The fact that multiples have not increased to this level is proof that some level of tax reform expectation was already built into the multiples pre-announcement of the final tax reform.”

Even further, PwC says tangible book value multiples are up 50 percent since the 2016 election. “As such, tax reform will likely be the first tangible change to banks’ fundamentals since the election that supports this increase in multiple,” PwC notes.

This is all good news that illustrates the banking industry’s difficult journey over the past decade. “Recovery from the financial crisis and the regulation that followed created an environment where banks focused on regulatory and operational improvements and not necessarily on growth,” PwC says. “Underwriting standards tightened, regulatory compliance costs increased and focus stayed on cost cutting. Now 10 years later, banks are entering an environment that should fuel their organic and inorganic growth.”

The bottom line, according to PwC: “If the tax reform achieves its goal of generating economic growth, the Federal Reserve Board should continue to raise rates which will help banks net interest income growth and bring more volatility into the market which should help improve trading revenues.”

Rising interest rates also provide the industry with a tailwind for banks of all sizes, says Josh Siegel, chairman and CEO of StoneCastle Financial. (The American Bankers Association endorses StoneCastle Finanical’s direct capital investment program.)

“As interest rates move up, the health of banks historically tends to improve as banks generate more free cash flow and increased earnings potential,” Siegel told investors in early February. “In addition, with an increasing rate environment, any new investments made by the company may have higher yields.”

Historically, Siegel notes, net interest margin tends to increase in higher interest rate environments and even more so when the rate curve steepens. This is illustrated in the FDIC quarterly banking profile for the third quarter of 2017, which showed that year-over-year net interest margin for community banks increased 7 basis points from 3.58 percent to 3.65 percent. Also in the third quarter, community banks’ net interest margin was about 35 basis points above all insured institutions.

While that’s good news, some concerns remain. For example, Siegel describes the implementation of the Financial Accounting Standards Board’s Current Expected Credit Loss standard a “macro consideration” for banks. Siegel, who authored a recent white paper on the subject, says the increased loan loss reserves that will result from the standard’s implementation will likely precipitate an increased need for capital (so that banks can maintain their well-capitalized status). Even further, he expects that Tier 2 suborbinated debt “is likely the most cost-efficient form for this additional capital.”

Siegel also notes that the broader public may not fully understand the new standard and what has driven it. “CECL implementation may be negatively construed as reflecting on the health of the banks,” he says. “Some have confused the need for higher reserves with an increased risk in loan portfolios. This is not the case. CECL is a result of IASB, FASB, Basel III and Dodd-Frank regulations pushing the auditors and banks to think more conservatively about credit losses and related loan loss reserves.”

Nathan Stovall of S&P Global Market Intelligence noted in a recent report that bank investors are factoring in increased industry competition when evaluating the impact of tax reform. “They have noted that when banks receive an influx of capital, the institutions tend to use the funds to take market share,” he says. “Some investors do not think banks’ response to tax reform will be any different.”

The thinking goes like this: Banks can take share through superior service, but it is often gained by offering lower prices. If that occurs, bank loan yields could come under pressure and deposit costs could migrate higher than they would have absent changes to the tax code.

“While the recent increase in long-term rates could soften the blow, a more competitive landscape could prevent net interest margins from expanding to the levels that some investors have expected when pushing bank stocks higher in the weeks and months since tax reform began to take shape in the Congress,” says Stovall.

Even so, the lowered corporate tax rate will push bank earnings 13 percent higher than results would have been before the passage of the landmark tax reform legislation, according to S&P Global Market Intelligence data. “Scores of banks have announced plans to reinvest portions of the gains in their franchises, but the industry should retain the vast majority of the savings, leaving institutions flush with capital,” Stovall notes. “Bankers and members of the investment community have acknowledged that the industry could use the newfound capital to go on the offensive and compete more aggressively for loans.”

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Tags: Capital marketsMergers and acquisitionsTax reform
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