While the financial crisis may seem like ancient history, the legal and regulatory changes implemented in its wake will weigh on bank stocks for years if not decades to come. But of all the changes, few are as detrimental to profitability as the so-called "tax penalty on equity."

As I've noted on numerous occasions, banks are nothing more than highly leveraged funds; they start with small kernels of capital, borrow heavily against them, and then invest the combined funds into various types of assets, including commercial and consumer loans, government bonds, and other fixed-income securities.

It stands to reason that a bank's profitability is determined in large part by the extent of its leverage. Holding all else equal, for instance, if Bank A has $10 million in equity and $100 million in assets, it will be twice as profitable as Bank B with $20 million in equity and $100 million in assets. Assuming both banks return 1.5% on assets, which equates to $1.5 million in net income, the former's return on equity comes out to 15% while the latter's is only 7.5%.

This is a problem because financial regulators are now requiring lenders to markedly scale down their leverage. In the years before the crisis, the typical bank was levered by a factor of 10. Today, the figure is closer to 7.5.


What's important to appreciate, however, is that scaling down leverage isn't in and of itself detrimental to bank shareholders. To continue the hypothetical from above, let's say that Bank A and Bank B both have 1 million shares of common stock outstanding. In this case, they both earn $1.50 per share, which can then be reinvested in the business or distributed to shareholders via dividends or share buybacks.

But what transforms this into a net detriment is the previously mentioned tax penalty on equity. Namely, because Bank A is borrowing $10 million more to earn the same in $1.5 million, it can deduct the interest expense incurred to do so while Bank B cannot. As the authors of McKinsey & Company's Valuation: Measuring and Managing the Value of Companies explain:

The tax penalty on equity represents one of the most significant costs of running a bank. [I]n contrast to deposit and debt funding, equity provides no tax shield because dividend payments are not tax deductible. Thus, the more a bank relies on equity funding, the less value it creates, everything else being equal.

To the uninitiated, this may seem like a superficial nuance. But taken together with the deluge of other legal and regulatory changes to have swept the bank industry since 2008, it's yet another reason to suspect that banking in the future will be more boring and less profitable than the banking of the past.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.