NEW YORK (Reuters) - Quirks in the new U.S. tax code are sowing doubts over how much big banks can boost dividends and stock buybacks this year, threatening to take the shine off what are likely to be strong quarterly profits.
Changes in how companies can measure and apply past losses to tax bills, coupled with more extreme scenarios in the Federal Reserve’s annual bank stress tests, could make it harder for lenders to secure approval in June to increase payouts.
“The strength of first quarter results could be overshadowed by disappointing talk about capital returns,” said analyst Steven Chubak of Nomura Instinet.
Analysts expect JPMorgan Chase & Co (JPM.N), Wells Fargo & Co (WFC.N) and Citigroup Inc, (C.N) the first, third and fourth-ranked U.S. banks by assets, to report higher first-quarter profit on Friday.
Eight years of U.S. economic growth have been a tailwind for banks, but the Fed has since 2013 made its stress test scenarios more challenging each year. The tests are meant to ensure banks have enough capital in sharp downturns to meet regulatory requirements.
Meanwhile, the new tax law could deliver a one-two punch to capital measured in the stress tests.
After first writing down deferred tax assets to account for a lower corporate rate, banks now face being prevented from carrying back losses in stress testing to past profitable quarters to benefit from tax rebates.
Analysts are likely to push executives for details on the complex tax issues and already opaque stress tests. Lenders submitted their balance sheets for testing last week.
First-quarter net income for JPMorgan, Wells Fargo and Citigroup likely rose 34 percent, 5 percent and 12 percent, respectively, according to analysts surveyed by Thomson Reuters I/B/E/S.
They see banks boosted by higher interest rates, stronger lending and underwriting and the 14 percentage point cut in the federal corporate tax rate.
Banks will likely see bigger reductions in projected capital levels in this year’s exam, a banking industry economist said.
Chubak and the economist said they cannot estimate the extent of the capital hit without more information from the banks.
In a March 2 supervisory letter here, the Fed cited elimination of carrybacks as one reason the tax law could have "material" negative effects on some banks in this year's stress test.
Goldman Sachs said in January that a key measure of capital shrank by 0.7 percentage points to 10.7 percent at Dec. 31 because of one-time tax charges, which included marking down deferred tax assets, such as credits against future taxes known as loss carryforwards.
In stress tests before the tax law change, carrybacks from losses could support capital levels and improve the odds of bigger approved buybacks. Now, more potential losses would eat into capital.
Capital One Financial Corp (COF.N) in December cited the elimination of carrybacks for reduction in its buyback plans.
To be sure, executives could flag offsets to those effects. Goldman, like other banks with profits kept overseas, picked up deferred tax liabilities for so-called repatriation taxes it booked in the fourth quarter but had not yet paid.
Still, under changes to factors in the Fed’s “severely adverse” economic and financial scenarios, banks could be tested against the most extreme change in conditions since the reviews began in 2009.
In this year’s test the most extreme hypothetical unemployment rate surges almost 6 percentage points to 10 percent.
The March letter also said changes to several scoring models are likely to reduce capital, with “material effects” in some cases.
For example, the Fed will calculate the probability of default on U.S. credit cards differently. JPMorgan and Citigroup are two big card issuers but have not discussed their outlook for payouts in light of the letter.
Reporting by David Henry in New York; Editing by Meredith Mazzilli