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Lower taxes, rising rates lift bank earnings
admin | August 24, 2018
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
The quarterly report on domestic banks from the FDIC released this week showed that US banks reported net income of $60.2 billion in 2Q18 – a 25% increase over the year-earlier period. Higher profitability drove a substantial jump in return on assets (ROA) to 1.37%, up 24 bps from 2Q17. The biggest contributor to higher profitability in 2Q18 was the revised tax code. The lowering of corporate income tax rates allowed the banks to retain an additional $6 billion of income. Net revenues also rose from the year earlier with net interest income 8.7% higher at $134 billion. Banks clearly remain asset-sensitive and are benefiting from assets repricing more quickly than liabilities. Demand for loans and leases remains positive as the economic expansion that started in 2009 continues to foster loan growth, which is up 4.2% year-over-year. We saw a similarly strong 1Q18 with bank earnings of $56 billion, 27% higher than the year-earlier period. Given the material benefit the change of the tax code has brought to financials, it is important to remember that the tax relief is not permanent and is set to expire in its current form in 2026.
While higher profitability is a positive for credit, other core credit measures have been more stable:
- Credit quality – A chief credit metric for banks is undoubtedly the credit quality of their loans & leases. In 2Q18 the industry reported $12 billion of net charge-offs (NCO), which was up slightly from $11 billion in 2Q17. The modest increase in charge-offs was balanced by a continued decline in non-current loans, which reduces risk of future charges in the coming quarters. Allowances stayed flat in 2Q18 as banks matched NCO and provision expenses evenly. Commercial and industrial (C&I) lending remains an area of concern for some investors, but non-current loans decreased to $16.3 billion in 2Q18, and NCO were relatively low at $1.4 billion. However, these levels are still well above the sub-$10 billion of non-performing loans (NPL) in the recent “best period” of 2014. What’s also concerning is the impact that will result from the Financial Accounting Standards Board’s Current Expected Credit Loss (CECL) impairment standard set to take effect in 2020, which we wrote about a couple months ago. This immediate recognition of cumulative losses will increase the upfront cost of underwriting loans and could put downward pressure on availability of loanable funds.
- Capital ratios – These remained high at the end of 2Q18 despite more aggressive efforts by banks to return capital to shareholders. Domestic banks had an aggregate CET1 ratio of 13.22%, 1 bps higher than the prior year.
- Profitability by state shows an interesting pattern, if not some expected contrasts. Utah is the most profitable state for banking assets year-to-date, with an ROA of 2.40%. This is not surprising given the industrial banks and credit card banks set up in Utah as subsidiaries of larger bank holding companies. It may also not be surprising for most investors that Puerto Rico ranks well for profitability, which benefits one credit in particular that we continue to like: BPOP (B2/BB- neg/BB-). This credit is the stand-out PR bank that has been a consolidator in recent years after the tumultuous downfall of finances for the US territory. That said, despite the challenging home market economic conditions, and the low rating that are capped due to PR’s ratings, we think the solid risk management, solid capital and good deposit funding will continue to benefit BPOP. The lone bond outstanding is the BPOP 7.00% July ’19, which has a YtM of around 3.80%. The least profitable place for banking in the US is… drumroll…. Washington DC. The largest banks in DC include: ETFC, BAC, WFC and COF.
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