Banking on Lower Tax Rates

Now that big banks have finished reporting fourth-quarter earnings filled with noise from the new tax law, how much do they expect to actually pay in taxes going forward? A lot less than in the past.

That is just what markets were hoping to hear. In response, investors have kept already buoyant big-bank stocks inching upward.

While some firms will pay higher rates than others, a number of big banks indicated they expect their effective tax rates would decline significantly to around 19% or 20% in 2018, as the corporate tax rate gets reduced. JPMorgan Chase & Co. and Wells Fargo & Co. both said their tax rates would be around that level.

That is significant because financial companies have tended to pay taxes at higher rates than big companies in other industries, since so much of their business is centered in the U.S. What is more, some of the big banks, such as Goldman Sachs Group Inc., Bank of America Corp. and Morgan Stanley, explicitly said they expect lighter tax bills to boost their earnings performance.

That is keeping investors optimistic despite some big, short-term hits in fourth-quarter earnings that were related to the tax law.

Banks took charges as high as $22 billion, at Citigroup Inc, to reduce the value of their deferred tax assets and account for a one-time tax on foreign earnings. Bank of America Corp.'s charge was $2.9 billion; Goldman $4.4 billion. On the other side, Wells Fargo had a gain of $3.35 billion, largely because the tax-rate reduction made its deferred tax liabilities -- taxes it owed -- less onerous.

Investors looked through this noise, though, because it will give way to greater earnings power down the road as the corporate-tax rate falls to 21% from 35%. Indeed, the possibility and then reality of lower tax rates has been a big driver in this latest leg of the bank stock rally.

Financial shares surged in the wake of President Donald Trump's election. They foundered in mid-2017, as the new administration's legislative agenda stumbled. But in September, prospects for a tax-code overhaul brightened, and that marked a renewed upward turn for bank stocks.

Now that investors have a sense of how much banks' tax bills may fall, they are more confident about their earnings power going forward.

Bank of America, for example, said it expects its tax rate to be about 20% absent unusual items, compared with an expectation before the tax law was passed of about 29% for 2018. Its effective rate in 2016 was nearly 29%. (Banks said 2017 rates are skewed by one-time gains and losses related to the tax law.)

Assuming all of the benefits go to the bottom line, that would mean a boost of more than 1.5 percentage points to Bank of America's return on tangible common equity and more than 0.1 percentage point on its return on average assets, Chief Executive Brian Moynihan said on the bank's earnings call.

Morgan Stanley said it expects an effective tax rate of 22% to 25% in 2018, though it will have quarter-to-quarter volatility, compared with a nearly 31% rate in 2016. With more than two-thirds of the firm's pretax income coming from the U.S. "we expect to see a meaningful reduction in our effective corporate tax rate," said CEO James Gorman on the firm's earnings call Thursday.

Goldman, meanwhile, expects the lower tax rate to have "a direct effect" in driving earnings growth and return on equity, Chief Financial Officer Martin Chavez said on the bank's conference call Tuesday. Goldman expects its effective tax rate to decline to about 24% as a result of the new tax law, compared with a 2016 rate of 28.2%.

The prospect of higher returns on equity also has helped keep bank valuations inching higher. Price-to-book value multiples for all the big banks, save Goldman, have risen over the past year. Bank of America and Citigroup were the primary gainers, rising 45% and 40% respectively.

Citi has gotten a double boost in this regard. Even though it expects to have a higher rate than other big banks, its bottom line should still increase. And the bank slashed its deferred tax assets by $19 billion. That lowers its book value, helping to boost its multiple.

But that isn't just a numbers game. Many investors were giving Citigroup scant credit for the value of its deferred tax assets and adjusting their own view of its multiple accordingly. Now, its multiple is more reflective of the bank's balance sheet -- and this week Citigroup's market valuation climbed above its book value for the first time since September 2008.

--Christina Rexrode contributed to this article.

Write to Michael Rapoport at Michael.Rapoport@wsj.com

(END) Dow Jones Newswires

January 18, 2018 15:06 ET (20:06 GMT)