Summary: Additional margin expansion lies ahead for the US banking industry. That expansion, coupled with lower corporate tax, should allow profitability to nearly reach pre-crisis levels.
• Rising interest rates will support stronger net interest margins at U.S. banks, but tax reform will offer a bigger earnings boost in 2018 and push returns on equity well into the double-digits, even against elevated capital levels.
• In our baseline scenario, which does not include the impact of an upcoming change in banks’ reserve methodology, returns on average assets and average equity will expand due to a lower corporate tax rate and interest rate increases, pushing the industry’s ROAA and ROAE as high as 1.25% and 11.29%, respectively, in 2019. But credit costs will rise shortly thereafter and serve as a considerable earnings headwind to the industry.
• Asset quality should remain strong in the near term, with tax cuts supporting the current credit cycle. However, the rush to lever tax reform’s windfall will spark more intense competition for loans, preventing yields from rising to previously expected levels.
• Before credit quality sours, banks will start seeing more significant increases in deposit costs. Deposit betas, or the percentage of rate increases that institutions pass on to their customers, rose modestly in 2017 and should double in 2018 as the market digests higher interest rates and banks’ funding needs grow.
• Competition will increase as the Trump administration achieves some level of regulatory relief, which could eventually lead to a slippage in underwriting standards. Less prudent lending practices could coincide with further increases in interest rates, causing more borrowers to default.
• The adoption in 2020 of a new accounting standard that changes the way banks reserve for loan losses could come right as credit quality begins to turn.
• That accounting standard, dubbed the Current Expected Credit Loss model, or CECL, will result in a sizable, onetime capital hit for the banking industry.
• Most banks should have ample capital to withstand the blow, but CECL could slow balance sheet growth as some institutions raise rates on loans, while others look to rebuild their capital bases.
Authors: Nathan Stovall, Chris Vanderpool