3 Catalysts That Could Move the Universal Banks Higher

In this clip, Industry Focus: Financials host Michael Douglass and Fool.com contributor Matt Frankel discuss the potential effects of tax reform, rising interest rates, and the stock market's performance on the three largest universal banks -- Bank of America (BAC 1.53%), Citigroup (C 0.26%), and JPMorgan Chase (JPM 0.65%). Here's how bank profits could be affected, and what investors should keep a close eye on.

A full transcript follows the video.

This video was recorded on Jan. 29, 2018.

Michael Douglass: Let's talk about these companies going forward. Of course, one of the weaknesses of the framework that Anand developed is, it's really good for a snapshot in time only. It's not necessarily that's helpful if you're looking really far in the future or really far in the past, with the usual caveats that nobody can predict the future. But let's talk about what are going to be some big catalysts for these companies in the coming months and years. Of course, the first one is something that's been in a lot of headlines if you've been watching the stock market recently, and it's tax reform and what its implications are for businesses.

Matt Frankel: Yeah. Banks in particular, tax reform is kind of interesting. It was negative at first. We talked about this a little bit last week. But tax reform caused a lot of these banks, all three of these that we're talking about here, to take pretty big hits. They carry what's called a deferred tax asset on their balance sheet, pretty much old losses they can use to lower future taxes. Citigroup's is enormous, as you might imagine. They all took pretty big hits this past quarter, which is why, if you read any of the bank earnings reports, they're kind of tough to follow in some cases.

Douglass: Right. [laughs]

Frankel: But, generally speaking, all three of these banks operate at effective tax rates in around the 30% ballpark. Bank of America's last year was 29%, Citigroup's was 30%, JPMorgan's was 28% in 2016, 32% this year. So, these are pretty high tax rates. The corporate tax rate drop to 21% will undoubtedly produce a big boost in profits on these banks' income statements. This is why you've seen in the headlines, Bank of America giving out $1,000 bonuses to employees, banks raising their minimum wages. Just to give one example of a bank that's quantified this, JPMorgan estimates that their effective tax rate is going to drop to 19%. This is a bank that's generating billions and billions of dollars in profit each quarter. Now you're telling them they can keep roughly an extra 10% of that. So, this is a big deal. Some of it is going to go to employees. Some will eventually be competed away, which is kind of an after-effect of tax reform in historical cases. But some of this is just going to boost their returns, boost to profitability.

Douglass: Right. And they've certainly been upfront about the potential that this could mean additional share repurchases and higher dividends. So, that's certainly something that all bank investors should be keeping an eye on for the next year. I think it's easy to say, "We want to return $X billion to shareholders." What I'm always more interested in seeing is how and in what way is they plan to reinvest at least a portion of that money into the business. Is it improving online capabilities? Is it figuring out how to do better automation so that they can remove some costs from their structure? Is it developing new platforms, new ways of doing things? There's a lot of opportunity for a bank that is forward-looking and can really think through how to better thread the needle. So that's something I always want to see.

Another thing to keep in mind for all banks, just about, is interest rate increases. The Fed has signaled that they're planning to put in three interest rate increases next year. Some of the big banks are even expecting perhaps more than that. So, there's a lot of opportunity there for them there to basically boost that net interest margin further. Particularly for Citigroup, that's good news. Although, frankly, Bank of America and JPMorgan are still about 50-50 interest income vs. non-interest income, so that's certainly an opportunity for them as well.

Frankel: Yeah. Bank of America actually has a disproportional share of low-cost deposits, like savings and checking deposits that they're paying virtually zero interest on. So, Bank of America has a lot of that, so they should see a nice little benefit here. These won't benefit as much from interest rate margins as, say, a pure commercial bank like Wells Fargo. But, we'll see.

Douglass: Yeah. And that's, again, because there's that substantial proportion that's not non-interest income. The third thing to keep in mind looking at these guys broadly is, the stock market is doing really well. Certainly, I think we've all noticed that. That means wealth management balances are up. All three of these banks have substantial wealth management divisions. So, that's good for them because that means their assets under management fees are going up. But, if you've been listening to Industry Focus: Financials for a little while, you will probably expect what's coming next, trading desk revenue is down because volatility is down. So, it's one of those things where, the banks have this kind of safety net that helps them in a counter-cyclical way, so that when the economy is doing poorly, the stock market is doing poorly, usually trading desk revenue boosts. But, flip side, that does mean that, right now, it's a bit of a drag for them.

Frankel: Yeah. A couple of things to watch in this case. Wealth management balances, yes, they're going up and up and up for market performance. The term you want to pay attention to on these earning statements are net inflows, or outflows, unfortunately. An inflow means the bank is taking in more investor deposits than are being paid out as withdrawals. This means they're going to grow over the long run, whether or not the market continues to go up. That's kind of a sign of a healthy wealth management business, more so than just the market going up. Trading revenue, as Michael said, can help to balance out poor market performance, which actually gives these universal banks an advantage over pure commercial banks. It gives them a rising income stream when things go poorly. A bank that relies heavily on trading revenue, Goldman Sachs, never made more than they did in 2009, just to give you an idea. So, it's kind of an interesting dynamic on the investment banking side. But, yeah, wealth management, definitely keep an eye on the inflows. Some banks are actually starting to experience some outflows, which is concerning, so keep an eye on that.

Douglass: Yeah, for sure.