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Dallas Regional Outlook - Fourth Quarter 1999

Regional Perspectives Subchapter S Election Helps Boost Profitability Levels of Small Institutions When Congress passed the Small Business and Job Protection Act of 1996, insured institutions became eligible beginning in 1997 to elect S corporation status. (S corporations are also known as Subchapter S or Sub S corporations, which refers to the section of the Internal Revenue Code administering S corporations.) Since that time, over 1,300 banks and savings institutions have elected Subchapter S status, representing more than 12 percent of the industry. The Dallas Region was headquarters to 313 Sub S banks as of June 30, 1999, or 24 percent of all Sub S banks nationwide. For federal income tax purposes, an S corporation is treated as a pass-through entity similar to a partnership and is not subject to any federal income taxes at the corporate level. Sub S shareholders include their proportionate share of a Sub S bank's income with their personal federal income tax computation. This generally eliminates tax at the corporate level and usually lowers the overall burden for the bank and its shareholders. Therefore, S corporation shareholders generally pay their share of federal income taxes regardless of whether cash is distributed to shareholders. Small institutions are more likely to elect S corporation status because of the limitation on the number of shareholders that can participate (currently 75). The national median size for S corporation banks was $56 million as of June 30, 1999. In the Dallas Region, 238 small banks and thrifts (institutions with assets of $100 million or less) elected S corporation status as of the end of second quarter 1999; these institutions control almost $12 billion in assets and represent 25 percent of all the Region's small banks. As shown in Table 3, Texas was home to 180 S corporation institutions as of June 30, 1999, up from 40 institutions just two years ago. Texas ranks first in the nation in the number of S corporation banks and assets held. Subchapter S banks and thrifts are located primarily in the central United States (see Map 1); the Dallas, Chicago, and Kansas City Regions account for 83 percent of all Sub S institutions nationwide. The majority of agricultural banks also are located in these areas of the country. The preponderance of small unit banks is one explanation for the geographic concentration of Sub S institutions. In addition, agricultural banks6 represent the largest single bank group electing S corporation status; more than 27 percent of Dallas Region agricultural banks had elected S corporation status as of the end of second-quarter 1999. Twenty-four percent of the assets held by Oklahoma institutions were in Sub S banks as of June 30, 1999, the highest percentage of any state in the nation. Map 1 6 Banks and thrifts with more than 25 percent of total loans held in agricultural land or production. S corporation elections are making it increasingly difficult to examine long-term profitability trends and can mask earnings deterioration between periods. In the aggregate, the growing number of S corporations has helped offset marginal profitability at other small banks. For example, small Sub S banks and thrifts in the Region reported an ROA of 1.81 percent for the second quarter of 1999. Non-Sub S institutions in the Region reported an ROA of 0.98 percent for the same period. Meanwhile, small Sub S institutions nationwide reported an ROA of 1.62 percent, 67 basis points higher than small, non-Sub S banks and thrifts. The net effect of the favored Sub S tax treatment is to increase Sub S banks' profitability. Sub S bank results could make it more difficult to compare current results with prior periods, when Sub S banks were less prevalent. In fact, in an interview with the American Banker, Richard A. Soukup, a partner at Grant Thornton LLP, acknowledged that "S corporation and non-S corporation banks cannot be compared."7 7 "Agencies to Adjust ROA Lists for S Corporation Skewing." American Banker, February 5, 1999, page 6. Other Factors That Differentiate Sub S Banks Because a Sub S bank's tax liability passes through the corporation to the shareholders, Sub S banks have a much higher dividend payout ratio than non-Sub S banks. For calendar year 1998, Sub S banks in the Region paid out almost 90 percent of earnings in dividends, compared with nearly 71 percent for non-Sub S banks (see Table 4). Typically, Sub S banks also have a higher leverage ratio. A lower percentage of Subchapter S banks-2.2 percent-are unprofitable, compared with 7.31 percent of non-Sub S banks for Dallas Region institutions in calendar year 1998. While the S corporation election offers tangible tax savings to shareholders, there are also potential disadvantages: the limitation on the number of shareholders makes raising additional capital difficult, few noncash options are available for making acquisitions, and there is pressure to pay dividends to fund shareholder tax liability rather than retain capital that may be required for safety and soundness purposes. The latter disadvantage may be particularly problematic when an institution takes a large provision for loan losses but has not yet charged off specific loans. These potential disadvantages could raise safety and soundness concerns should an institution incur significant operating losses. Legislative Initiatives The American Bankers Association and other banking trade groups have supported legislation to expand the eligibility of Sub S status to counter credit unions' tax-advantaged status. U.S. House Resolution 2488, known as the Taxpayer Refund and Relief Act of 1999, was introduced on July 13, 1999. On August 5, 1999, the House and Senate approved the bill; however, the president vetoed the legislation. Two of the bill's more popular provisions may be attached to future legislation: excluding bank investment securities from passive income limits and a clarification of qualifying bank director stock.8 In addition, bank trade groups have indicated they will continue to support legislation increasing the number of shareholders from 75 to 150. 8 According to the American Bankers Association Subchapter S Registry Report, August 1999, page 2. While there is no statistical information available on how many financial institutions are eligible to elect Sub S status, almost 5,000 small banks are not currently Sub S. Since many of the eligible institutions have already elected S corporation status, the rate of growth of the number of S corporations will likely slow. However, if some of these legislative initiatives are eventually enacted, more banks may elect this tax-advantaged status. Dallas Region Maintains High Profitability Levels Despite a Higher Allocation of Securities The Dallas Region differs significantly from other parts of the country in its composition of funding liabilities, most notably the higher percentage of core deposits and less extensive use of other borrowings. The advantage of this lower funding-cost structure may help determine how assets are allocated among loan types and securities investments. This discussion examines the asset side of the balance sheet, particularly the securities and mortgage components. Securities Are a Major Component of Dallas Region Balance Sheets The Dallas Region is unique in that it has a higher percentage of securities on its balance sheet than any other part of the country. As shown in Chart 2, Dallas Region financial institutions invested 27 percent of total assets in securities compared with 19 percent for the rest of the nation as of June 30, 1999. Institutions that have more than 30 percent of total assets in securities investments include commercial banks with assets of less than $1 billion and all institutions in Colorado and New Mexico. The Region's savings banks and large U.S. commercial banks hold the smallest percentage of securities to total assets, each less than 15 percent. Chart 2 While there is little empirical data to confirm why Dallas Region institutions, on average, hold a higher percentage of securities than the rest of the nation, there are two possible explanations. First, Dallas Region banks and thrifts enjoy a much lower cost of funding. This cost structure enables institutions to hold lower-yielding assets and achieve similar ROA levels. The Region's commercial banks have a greater share of deposits in non-interest-bearing deposits-19.7 percent of total assets compared with 4.1 percent for savings institutions and 10.8 percent for institutions nationwide (see "Banks and Thrifts Report Strong, but Somewhat Weaker, Performance in Fourth Quarter," Regional Outlook, third quarter 1999). These deposits provide a low-cost source of funding and are a key reason why the Region's commercial banks maintain competitive levels of profitability, even with a relatively low loan-to-asset ratio. The other reason is rooted in Texas' and Oklahoma's real estate and oil crisis in the late 1980s. Harvey Rosenblum, Federal Reserve Bank of Dallas Senior Vice President and Director of Research, describes this as follows: During the second half of the 1980s the Texas banking industry experienced a depression. Unlike a recession, a depression is more than an economic event; it is a psychological trauma that becomes indelibly stamped in one's memory and in the industry's "genetic code." In these circumstances, it takes a long time to forget the ordeal, and behaviors are altered to avoid repeating past mistakes associated with the event.... The balance sheets of Texas banks reflect more caution than they did a decade and a half ago.9 9 Federal Reserve Bank of Dallas Southwest Economy, Issue 3, May/June 1999, pages 5-6. So why does the Dallas Region hold a greater percentage of securities? The answer may very well be a combination of a lower cost of funding and a conservative mind-set. The bottom line is that the Region's banks and thrifts have enjoyed strength in earnings and credit quality since the Region's recovery in the early 1990s. The higher allocation of securities typically indicates a more conservative risk profile. Moreover, the strength and duration of the economy suggest that this asset allocation may be a conscious choice to reduce credit risk. However, there is also the potential for increased levels of exposure to interest rate risk and market risk. In particular, in an increasing interest rate environment, bond values often depreciate and cash flows may suffer. Regional Outlook Information Return to Regional Outlook main page