What the Tax Law Will Do to Bank Earnings

It is going to be a noisy quarter for bank earnings. Because of the tax-overhaul law, big banks are going to record a host of special charges that cut into fourth-quarter profit.

How big is the bill? Five of the biggest U.S. banks are likely to report a total of about $31 billion in tax-related hits for the fourth quarter, according to the banks' recent disclosures and public comments.

Don't expect investors to be overly alarmed, though. The banks should benefit from the new tax law in the longer term. In fact, with the U.S. corporate tax rate falling to 21% from 35%, many banks could make back any losses within a few years, or even sooner.

The new law is "good for us," Bank of America Corp. CEO Brian Moynihan said at a conference last month.

Still, investors will have to be on their toes when the banks' fourth-quarter earnings announcements begin Friday with JPMorgan Chase & Co. and Wells Fargo & Co. Tax-law changes could make banks' core earnings -- which exclude charges and other one-time or nonoperating items -- less clear. Plus, they will probably make earnings announcements and conference calls more complicated, as banks strive to explain the law's impact.

Because the new tax law was signed in the fourth quarter, accounting rules require companies to reflect the law's impact in that period. That means some banks will have to take big upfront charges to write down the value of their deferred tax assets and pay a one-time tax on their foreign earnings.

"It is going to muddy the waters a little bit," said Janet Pegg, an analyst at Zion Research Group, an accounting and tax research firm. "We're going to be depending on clear disclosure from the companies."

Another wrinkle: Because of the reduction in the tax rate, banks and other companies will have an incentive to "kitchen-sink things," said Christopher Marinac, director of research at FIG Partners in Atlanta. That is, to accelerate deductible expenses to record them in 2017 instead of 2018. That would have the effect of lowering taxable profits in the period when the higher tax rate still applies, thus maximizing the deductions' benefit.

Complicating things further: Any 2018 earnings guidance from banks will be harder to interpret since the new lower tax rate means forecasts will be incorporating a dramatically lower tax liability.

Most of the immediate charges banks are expected to take in the fourth quarter stem from two issues: a reduction in the value of the banks' deferred tax assets and a one-time tax imposed on their earnings generated and held outside the U.S.

Citigroup Inc. may be most affected. Finance chief John Gerspach said at a December conference that Citigroup expects a fourth-quarter charge of about $20 billion, mostly from writing down the bank's huge pile of deferred tax assets.

These are past tax credits and deductions that companies can hold on to and use to defray future tax bills, sort of like an IOU. Citigroup has $45.5 billion of them, generated by the losses the bank suffered during the financial crisis.

But when the tax rate declines, companies' tax bills shrink. So many of those credits and deductions become less valuable and must be written down, leading to charges against earnings. The reverse can happen also: Wells Fargo had net deferred tax liabilities, or taxes payable in the future, of about $7 billion as of the end of 2016. That could lead Wells Fargo to record a gain, though it hasn't announced any such move.

Part of Citigroup's charge also stems from a tax on companies' foreign earnings.

In the previous system, the U.S. taxed corporate profits no matter where in the world they were earned, leading many companies to keep foreign profits overseas instead of bringing them back to the U.S. where they would be taxed at a 35% rate. The new law changes the U.S. approach to a "territorial" system, with taxes levied only on U.S.-generated profits.

But the new law also imposes a one-time tax of 15.5% on foreign-held liquid assets like cash and 8% on illiquid assets. Zion Research estimates that will cost financial companies in the S&P 500 a total of $13.56 billion.

Among other big banks, Bank of America has said it expects a $3 billion charge from writing down deferred tax assets; J.P. Morgan sees a potential adjustment of up to $2 billion from the foreign-earnings issue; Goldman Sachs Group Inc. expects a $5 billion charge from a combination of both issues; and Morgan Stanley sees a $1.25 billion charge, mostly from deferred tax assets.

European banks will be affected, too. Deutsche Bank AG expects a charge of EUR1.5 billion ($1.79 billion), Barclays PLC sees a charge of GBP1 billion ($1.35 billion) and Credit Suisse AG expects a charge of 2.3 billion Swiss francs ($2.34 billion).

Apart from their earnings, some banks will see other financial effects from the new tax law. Write-downs of deferred tax assets will lead to reductions in some banks' regulatory capital, and will cut into their book value, a figure closely watched by investors.

But even as banks take their fourth-quarter charges, the tax-rate reduction to 21% is starting to work for them. Large national and regional banks should see an average 15% boost in their earnings per share by 2019 from the lower tax rate, Bernstein analyst John McDonald said in a research note last week.

Despite any hits to profit now, "I think investors will see past it," Mr. Marinac said.

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

(END) Dow Jones Newswires

January 10, 2018 05:44 ET (10:44 GMT)