Banks should be more strategic as they consider tax savings

The recent cut in corporate tax rates has been a boon for bank stocks — but the effect could be short-lived.

Analysts and bankers are focusing on the potential tax savings and their possible uses. Many believe a substantial portion of the initial savings should be returned to shareholders through increased dividends and share repurchases.

But the truth may be more complicated. There’s good reason for financial executives to pause and carefully consider what they should do with this once-in-a-lifetime opportunity — before possibly squandering it.

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That’s because there is a weak correlation between stock prices and tax cuts. The short-term windfall savings tend to be competed away — either to employees through higher wages and increased hiring, or to customers receiving lower prices, including lower spreads and higher deposit rates.

Over time, just as Adam Smith told us, returns will normalize to pre-cut levels. This especially true for tax rate cuts evenly distributed across firms in highly competitive industries like banking. A rising tide may lift all boats, but better boats will rise higher. Thus, bankers should explore the tax rate cut impact at two different levels.

First, there is the static analysis concerning the allocation of the initial savings. Many banks are announcing somewhat vague plans to share the savings among their employees, customers and shareholders.

Yet the second, and often neglected, consideration is the impact of growth-related investments aimed at capturing market share and offsetting possible competitor actions. This second consideration focuses on the key question of how banks will use this unique tax windfall to create lasting value.

The strategic question is whether the savings should be returned to shareholders via higher dividends and repurchases, as some have pledged, or invested to grow organically or by acquisition. The keys to long-term value creation are how much is invested, and how well it is invested.

How much concerns the size of the strategic opportunity. How well relates to the spread between return on equity and the cost of equity. The spread is based on a bank’s competitive advantages and the ability to execute its strategy based on those advantages. Banks lacking such advantages should not reinvest, while those possessing the advantages and skills should. This requires taking the time to explore the new strategic landscape for realistic opportunities.

The return of value through dividends and repurchases affects the allocation of value, not the creation of value. Berkshire Hathaway illustrates this point: It has not paid dividends and it is unlikely to return any of its expected tax windfall going forward, while it continues to look for new investment opportunities.