Credit Risk Council 2017 Industry Insights: Perspectives from the Front Line

The RMA Credit Risk Council is pleased to present its 2017 Industry Insights: Perspectives from the Front Line. Started in March 2014, the Industry Insights are an annual review of the critical credit topics currently affecting the industry. While the issues and challenges change from year to year, RMA’s commitment to thought leadership and providing value to our membership remains at the forefront of our mission.

The Credit Risk Council, currently chaired by Meg Mueller of Fulton Bank, supports professionals who are responsible for establishing, maintaining, or carrying out credit risk management policies. The council focuses on funded and off-balance sheet risk management, including capital markets activity, and other forms of credit intermediation and risk mitigation.

Political and Economic Uncertainty in the Trump Presidency
The election of Donald Trump as President has introduced a new level of uncertainty into the economic landscape which may impact borrowing customers and the level of risk associated with both their business models and associated credits. The administration’s failure to pass healthcare reform has only raised the level of uncertainty. This commentary will touch on a few of the key areas where policy decisions may have significant impact – tax reform, trade policy, and interest rates – however, the agenda continues to be a moving target.

One of the cornerstones of the new Trump administration’s plan is tax reform and, specifically for corporations, a reduction in the corporate tax rate from 35% to 20% or even 15%. At the same time, Trump’s plan includes cutting nearly all business tax credits, deductions, and other incentives. So while a corporation’s top line tax rate may be considerably reduced, its effective tax rate might remain relatively unchanged. The problem is that the impact will likely vary widely across sectors, but to be sure, there will be winners and losers. 

One key area will be tax-advantaged deal structures with tax credits such as low income housing (LIHTC), new markets (NMTC), historic (HTC), renewable energy investment (ITC), and production (PTC). While the credits are not likely to be repealed, the decrease in the tax rate will clearly impact the valuation of the tax credit. In some areas, for example, affordable housing developers are getting as much as $1.15 of investor capital for every $1 of tax credit offered. 

With lower tax rates, investors have less incentive to pay top dollar for LIHTCs which can create funding gaps for developers. It is not clear how these gaps will be filled, whether it comes from more credits provided by the state per deal (likely than fewer deals), or from finding another source of soft money. In the meantime, most investors are taking a wait and see approach to buying tax credits to avoid a loss should the tax rate decline. Given the pressure on the banking industry to fund affordable housing, tax reform may make it more difficult to find opportunities in an already competitive market.

The tax cut also reduces the tax advantages of structures such as real estate investment trusts (REITS). However, another potential reform, the election to expense capital investments and disallow current deduction for interest expense, would have a dramatic impact on REITs and the real estate industry. This could result in more volatile taxable income for REITs as opposed to the current system of predictable and fixed annual depreciation deductions. This may also render Section 1031 transactions (for like-kind exchanges of real estate) unnecessary, which currently allow REITs to defer the payment of taxes on gains made on the exchange of property.

The expectation is that tax reform on its own will be revenue negative, so it will likely be combined with a change in trade policy. There are two possible options – border tariff versus border adjustment tax. The tariff is simply a tax on imported goods at the border. It is considered more unpredictable because it could discourage trade altogether as well as create possible retaliation.

The border adjustment tax would exempt revenues generated from export sales while the cost of imports would not be deductible as a business expense for tax purposes. The theory is that exempting exports would reduce taxes by approximately $480MM while the tax impact on imports, which are a larger part of our economy, would increase by $600MM, generating a net $120MM gain annually. The theory also projects that the dollar would increase in value in an amount sufficient to effectively reduce the cost of imports, such that it becomes neutral to prices in the U.S.  

Unfortunately, it is difficult to determine if the border adjustment tax could achieve an equilibrium as presented without unintended consequences. It is unlikely that the impact would be felt equally across all industries, companies, and geographies. The potential winners are likely to be companies with a majority of their input costs contained within the U.S. and those that are primarily exporters. Examples would be health care service providers, U.S. cable/telecom, oil refiners that source from the U.S., U.S.-based manufacturers, and consumer staples providers.  Potential losers include automakers, semiconductors, oil and gas, chemicals, and retailers, particularly apparel.

If the administration pursues the border adjustment tax, there is also concern that inflation will increase as exports do not affect the CPI, but the cost of imports does. Inflation is a key driver of interest rates, and there are already signs of growing inflation due to lower unemployment and higher growth expectations. The Federal Reserve accelerated a quarter point interest rise in the first quarter of 2017, increasing expectations of more increases in the future.

While the anticipated change in rates is not too onerous, it is going to be an adjustment for many borrowers who have not experienced this type of rate increase in over a decade. Rising rates will not only impact the cost to business, but may affect the ability to refinance.

As an industry, we need to be proactively discussing interest rate protection strategies, such as swaps, with our borrowers to offset the potential impact. Stress testing of interest rates on customers individually and portfolios as a whole will become a more critical tool should these trends continue.

Along with encouraging borrowers to hedge interest rate increases, banks have to be mindful of the rise in cost of funds. As banks are enjoying the interest rate hikes, we are also seeing increased pressure to raise the ECR rates offered to commercial clients as well as money market and CD rates for both consumer and commercial clients.

As noted before, the administration’s inability to pass healthcare reform (although not necessarily dead yet) may impact its ability to pass meaningful tax reform or modify trade policies in the future. Fundamentally, it will be imperative for banks to remain nimble and diligent in monitoring the political climate to respond to changes that might impact their loan portfolio’s credit risk profile.


Please look for the next Industry Insight on Tuesday, August 8, The Rise and Risks of Lending to Non-Depository Financial Institutions.

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