Bank Earnings Might Look Bad -- Here's Why You Shouldn't Worry

Earnings season is about to kick off, and the big U.S. banks are among the first companies set to report. Before companies like Bank of America (BAC 1.46%), Citigroup (C 2.64%), JPMorgan Chase (NYSE: JPM), and Goldman Sachs (GS 1.44%) issue their fourth-quarter earnings reports, there's something bank investors should be aware of: Fourth-quarter bank earnings might look pretty bad at first glance.

However, if you own shares in any bank stocks, this isn't anything to worry about. Here's why the recently passed tax reform bill is expected to hurt fourth-quarter bank earnings -- and why it's not really a big deal.

Image source: Getty Images.

Earnings Hit #1: Deferred tax assets

The first reason bank earnings could take a hit is because the deferred tax assets on many banks' balance sheets are now less valuable.

In simple terms, a deferred tax asset is a situation where a company is entitled to lower its taxable income in future years. A common example, especially in banking, is carried losses. When a bank incurs a loss, it is allowed to use that loss to lower its taxable income in subsequent years. There are other ways companies can get deferred tax assets, but the point is that these become less valuable when the tax rate goes down.

Think of it this way. If you can reduce your taxable income by $1 million when the tax rate is 35%, you'll save $350,000 on your tax bill. On the other hand, if the tax rate drops to 21%, you'll only save $210,000. That's why these "assets" become less valuable.

Some banks have pretty large amounts of deferred tax assets on their balance sheets, and the reduction in their value could have a big impact on fourth-quarter earnings. Citigroup, to name a big example, has $46 billion in deferred tax assets on its balance sheet, mainly stemming from the financial crisis. It expects to take a $20 billion charge in the fourth quarter, and analysts estimate that the bank could report a quarterly loss of more than $15 billion.

In another example, Bank of America expects a $3 billion charge, thanks to its $19 billion of deferred tax assets. Other banks will also experience major earnings hits for the same reason.

Earnings Hit #2: Repatriation

Another one-time earnings hit could come from banks that have a lot of foreign profits to bring back to the United States.

The tax reform bill allows companies to repatriate foreign profits at a special, one-time rate of 15.5%. While this is definitely better than the 35% they would have paid if they had brought this money back last year, it's still a large sum of money for some companies.

One bank that is expected to take a major repatriation hit is Goldman Sachs, which had more than $31 billion stashed overseas at the end of 2016, the last full year for which we have finalized data. This will make up the bulk of a $5 billion charge Goldman plans to take in its fourth-quarter earnings.

What banks lose here, they'll more than make up for in the long run

To be clear, tax reform is a very good thing for banks going forward, and any hit they take during the fourth quarter is likely to be made up for and more by the reduced corporate tax rate paid on profits in 2018 and beyond.

Just to give you an idea of how much this could help, these were the effective tax rates for the largest U.S. banks during the third quarter of 2017:

Data source: Company earnings reports.

As one example, Bank of America could earn $4.5 billion more in 2019 than it otherwise would have, according to Keefe, Bruyette & Woods analyst Brian Kleinhanzl, which would more than make up for its $3 billion deferred tax asset charge.

The important thing to keep in mind

The bottom line is that the hits banks are going to take in their fourth-quarter earnings, while they will be massive in some cases, are temporary. Meanwhile, the benefits they'll get from the lower corporate tax rate will be permanent, and in most cases, will greatly outweigh the short-term earnings impact.