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The Tax Cuts and Jobs Act: Impact on PrecisionLender Assumptions

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With the recent Tax Cuts and Jobs Act, our clients have another item or two to add to their 2018 planning activities. Among other changes in the tax code, one that stands out for banking clients is the 21% tax rate – drastically lowered from 35% for C corporations.

(Note: Throughout this article, we will reference C corporation tax rates. For clients who are structured as a pass-through S corporation and for our credit union clients, your circumstances and rates may be different.)

The PrecisionLender platform utilizes corporate tax rates as a key factor in calculating account-level and relationship-level profitability. Bank management and PrecisionLender administrators will want to consider the impact on the bank’s improved cash flows resulting from a lower tax liability – and whether to retain those savings for the bank’s shareholders or to pass along the savings to the bank’s borrowers.

Similarly, bank management and PrecisionLender administrators should anticipate and readily adjust to how their bank’s competition will handle this tax windfall. 

Finally, other aspects of the Tax Cuts and Jobs Act will undoubtedly have an impact on the bank’s growth prospects and their borrowers’ appetites for debt. 

We strongly recommend PrecisionLender administrators and bank management consult with tax advisers to understand their bank-specific impacts, but we also wanted to provide a high-level overview of what has changed, the potential magnitude of the impact, and the actions bank management and PrecisionLender administrators should consider in configuring their PrecisionLender tool.

ROE is defined as net income after taxes divided by equity. The equity portion of the ROE calculation is not affected by the new Tax Act. However, the lower tax rates will increase net income after taxes by approximately 20% for C corporations. Since this is the numerator of the equation, absent any other change, the ROE will increase by a comparable amount.

A PrecisionLender client can take one of several approaches when considering this tax cut:

  • Retain the tax savings for bank shareholders
  • Pass along the tax savings to the borrower in the form of lower spread, rate, structure, etc.
  • A blend of the two approaches above.

Let’s look at the mathematics behind the first two strategies.

Retaining Savings

If the bank decides to set a new higher ROE target to turn those tax savings into increased profitability, the change can be expressed as follows:

ROEnew = ROE * (1-z2)/(1-z1), where

z1 = the prior tax rate

z2 = the new tax rate

ROEnew = the new ROE target

ROE = the present ROE target

 

The table below shows how ROE targets might be increased for a product, using the new, lower corporate tax rate of 21% to retain these tax savings for bank shareholders. For example, on a product with a current ROE target of 16%, the new target should be raised to around 19%.

Tax_Savings_Retained_by_Bank.PNG

Passing Along Savings

For the second strategy, in which all the tax savings are passed along to the borrower, the reduction in loan interest rate can be mathematically expressed as:

Interest Rate Reduction = (1-(1- z1)/(1- z2)) * EA * ROE/ (1- z1), where

z1 = the prior tax rate

z2 = the new tax rate

EA = the equity to average asset ratio for the loan

ROE = the present ROE target

 

While there are numerous ways to impact loan profitability but for this piece we’re focusing on the borrower-rebated tax savings in terms of loan spread reduction.

The table that follows, using the new corporate tax rate of 21%, shows what the decline in the loan interest rate would be if based on the targeted ROE and the Equity to Average Asset (EA) ratio. As illustrated, these figures vary, from a 26-basis point reduction for a 12% ROE target with an 8.0% EA to a 65-basis point reduction where the ROE target is 24% and the EA is 10%. For many of our clients, the “rule of thumb” is a ~45-basis point reduction.

 

Tax_Savings_Passed_Along_to_Borrowers.PNG


Tables 1 and 2 illustrate the bookends of the new Tax Act strategy. Most clients will find that some blend of retaining profitability while also passing along some of the savings to borrowers maximizes loan and NIM growth. 

There will undoubtedly be other impacts from the Tax Cuts and Job Act. Some notable ones, which our clients should consider when configuring PrecisionLender ROE target assumptions, include:

  • For banks with an international presence, they are now more competitive globally – which should spur loan growth.
  • Wealth management products may get a boost from wealthier, less taxed individuals – improving the value of cross-sell and relationships generally.
  • For corporate borrowers, a reduction on interest-expense deductions will likely weigh on earnings. Limiting interest expense deductibility to 30% of adjusted taxable income may cause companies to deliver and borrow less on commercial loans.
  • For banks with large real estate books, it is important to note that at the taxpayer’s election, the interest expense limitation above does not apply to interest incurred by the taxpayer in any real property activities.
  • The effect on tax-exempt loans is complex, but largely these investments are less profitable under the new Tax Act.

This Tax Act change not only impacts new opportunities but also the bank’s existing relationship profitability. While best practices suggest that loan ROE targets should be periodically reviewed, this Tax Act change is so material that we urge clients to accomplish this in early 2018

PrecisionLender’s Client Success team is available to provide tools and assistance in this endeavor.  Please see the following article if you have questions on the mechanics of making these changes:

https://support.precisionlender.com/hc/en-us/articles/206935867-Setting-The-Target-ROE

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