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Banking: Tax Reform Creating Big Opportunities

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Banking: Tax Reform Creating Big Opportunities

While the details remain unclear, corporate tax reform could provide a considerable shot in the arm to the U.S. banking sector.

It’s expected that the reduction in corporate income tax rates would allow the banking industry to produce returns on average equity in excess of 10%, a level not seen since before the financial crisis. That level of return would allow many banks to earn their cost of capital, putting to bed the post-crisis debate over whether the nation's largest banks have earned the right to exist in their current form.

Bank stocks have rallied close to the 25% since the U.S. presidential election on the prospect of higher interest rates, fiscal stimulus and corporate tax and regulatory reform. Among those changes, corporate tax reform would have the most significant and certainly swiftest impact on bank earnings.

If corporate tax reform was enacted this year, bank earnings would receive a substantial lift. In S&P Global Market Intelligence's base case for 2017, the banking industry's net income is expected to grow 6% from year-ago levels. If the industry's tax rate declined by even 10 percentage points, bank earnings could grow more than 20% this year.

That level of return would also come against a higher level of capital, which currently stands at a 70-year high in the industry. A boost to earnings would also bring even more capital onto bank balance sheets and encourage many institutions to increase shareholder returns through dividends and share repurchase activity.

The newfound capital could also make acquisitions incrementally more attractive for some banks. Corporate tax reform likely would provide another leg up in the recent bank stock rally, allowing bank stock currencies to increase further. Higher currencies will allow buyers to more easily ink accretive acquisitions while satisfying sellers' expectations.

Still, there could be some offsetting factors emerging from corporate tax reform policy that likely would have the most significant impact on the largest U.S. banks, whose activities extend beyond commercial and retail banking.

Corporate tax reform could reduce corporate bond issuance activity if history is any guide. The last time the U.S. had a tax holiday, many institutions used the repatriation of profits for dividends and share buybacks, possibly limiting future debt issuance since many of those transactions in recent years have been used to return capital to shareholders. It should be noted, though, that cash piles are currently concentrated among fewer companies when compared to the last tax holiday more than a decade ago, with the technology sector currently holding nearly half of the cash sitting overseas.

Large banks produce substantial revenues from fixed income, currencies and commodities trading, or FICC. The FICC business seems unlikely to be threatened by tax reforms since cash repatriation rather than a turn in the credit cycle would be responsible for slower issuance activity in the markets. Also, foreign exchange activity could benefit if there is currency volatility arising from border taxes that are included in some tax reform proposals.

There are some concerns that cash repatriation could hurt international dealmaking and accordingly, the M&A advisory business of the largest banks. Companies have used offshore funds for international deals, but if those funds are repatriated, that could lead to fewer deals overseas. If tax reform attacks interest expense deductibility as well, financing costs for deals could go higher and could limit deal activity longer term.

Ultimately, corporate tax reform is generally expected to be a net positive for the banking industry and might benefit larger community and regional banks the most since they will receive benefits and have little to no exposure to the capital markets.