With the Presidential Election in the United States now decided, attention has shifted to the nation’s budget deficit and what has been called the ‘’fiscal cliff”. The term refers to the automatic expiration of Bush-era tax cuts and the across-the-board reductions in government spending mandated by the Budget Control Act of 2011, both set to happen on January 2, 2013 if the current Administration and Congress fail to work out a budget deal. 

No one knows for sure how events will play out should Congress fail to act in time. However, the Congressional Budget Office recently warned that, if lawmakers don’t avert the over $530 billion of tax increases and over $130 billion of spending cuts due to take effect in the new year (and more of both to come over the decade ahead), economic activity in the United States would contract an estimated 0.5% in 2013 and the unemployment rate (recently 7.9%) might surpass 9%. The situation has implications for the nation’s banks, which play a major role in keeping the economy’s wheels greased via their lending activities.

As is true for most industries, an economic slowdown or contraction would hurt revenue growth in the banking business. In fact, uncertainty regarding the tax increases likely to take effect if the fiscal cliff is not addressed, and worries that economic activity might slow, may already be causing some businesses to cut back on capital spending and acquisitions, reducing their need for bank loans. Increased caution may also cause businesses to use less of existing lines of credit.

Likewise, hit by higher taxes and reduced benefits, consumers might also borrow less in 2013.  Housing activity and mortgage lending, which have been on the upswing, might moderate, notwithstanding the currently low interest rates. For the banks, slower loan growth would hurt net interest income, which is already under pressure in the currently very low interest rate climate. The smaller, community banks would be especially hurt since net interest income accounts for the lion’s share of their revenues.

Moreover, many investors fear that the political wrangling leading up to an eventual budget compromise may dampen investor sentiment, which could hurt bank brokerage operations, or result in heightened stock market volatility. The latter scenario might present big bank-owned wealth management operations with investment opportunities, but also more room to make investment mistakes.  

Failing to resolve the fiscal cliff might also hurt banks’ credit quality which, of late, had been improving. Slower business activity would make it harder for companies to meet their debt obligations. Notably, a recent article in American Banker (by Rachel Witkowski, October 24th) suggested that banks may be more cautious about lending to government contractors should the automatic government spending cuts take hold. Too, higher unemployment would have a negative effect on consumers’ ability to repay loans, although probably a lagging effect, according to U.S. Bancorp’s (USB) Chairman Richard Davis.

Meanwhile, some banks, mainly the smaller ones, have decided to pay their shareholders special cash dividends before the start of 2013, when the tax rate on dividend income is expected to increase. One of these banks is Kansas City-based Commerce Bancshares (CBSH), which recently declared a special $1.50-a-share dividend payable on December 17, 2012, citing “the potential significant increases in tax rates on dividends beginning next year”. 

In the end, most Washington-watchers expect legislators to reach some sort of budget agreement before 2012 draws to a close. Although any compromise will include some increase in taxes and some government spending cuts, just clearing up the uncertainty regarding the shape of a budget deal should positively affect bank customer sentiment, and mitigate any negative effect on bank revenues and earnings.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.