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Roleplaying as Chief Strategy Officers

On January 25th, Jonathan and I returned to the studio to record the latest podcast for The Bank Account. We’re trying to live up to our commitment to podcast more often in 2019 then we did in 2018; nothing like setting a low bar!

We first briefly discuss the latest IRS regulations for the taxation of Subchapter S banks and the reactions that we’ve seen from our clients on tax reform. Generalization appears virtually impossible, as we’ve seen reactions ranging from terminating Subchapter S elections, doing transactions and forgoing Subchapter S elections, sticking with the status quo, and, as Jonathan puts it, “Sub S or Die.”

We then turn to a hypothetical scenario that both Jonathan and I think about from time to time; what if we decided to cease providing legal services and instead attempted to become bank officers. What would our first steps be as a new Chief Strategy Officer of a hypothetical depository institution. Jonathan suggests beginning with the question of whether the institution is a true “community bank,” with a provocative definition for the term. Per Jonathan, a “community bank” is one whose existence is self-justified, as an irreplaceable benefit to the community it serves. (Jonathan than proceeds with an approach that even he admits might be better suited for a visual presentation.)

I suggest instead that the first question should be what is expected/desired by the institution’s shareholders. Depending on the shareholder base and their expectations for the institution, different strategic approaches are called for.

Please click to subscribe to the feed on iTunes, Android, Email or MyCast. It is also now available in the iTunes and Google Play searchable podcast directories.

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Tax Reform for Sub S Banks and a 2017 Year-end M&A Review

the-bank-accountOn the latest episode of The Bank Account, Jonathan and I analyzed the Rose Bowl, pitting Jonathan’s Georgia Bulldogs against Jonathan’s In-Laws’ Oklahoma Sooners.  With critical generational analysis, Jonathan won me over to support Kirby Smart and the Georgia Bulldogs; I simply have to support Generation X over a Millennial. We then turned our focus to on-topic banking issues: the impact of tax reform on Subchapter S banks and a look in review at the 2017 banking m&a market.

For Subchapter S institutions, tax reform offers/requires a re-evaluation of the tax consequences of a Subchapter S tax election.  While institutions regularly assess the overall tax difference involved in a Subchapter S tax election at the time of making the election, that analysis is often then put in the closet, and only rarely re-addressed upon future strategic decisions.  However, with the decline in the corporate tax rate to 21%, it now behooves Subchapter S institutions, particularly those that retain a significant amount of their earnings to support future growth, to update that analysis. Jonathan and I discuss some of the factors affecting that analysis, as well as the timing implications to make effective for 2018.

Looking at the final M&A statistics for 2017, it looks like we’ll end the year with a slight uptick in the number of deals (259, up from 250 in 2016), but remain significantly below 2014 and 2015 levels.   In addition, the average size of the selling banks in 2017 has declined significantly (almost 25% smaller, based on averages).  Jonathan and I discuss these trends, and make a few predictions on M&A going forward.

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Too Small to Succeed or Ownership Structure to Thrive?

Two recent federal banking agency reports show very different pictures of the banking environment for community banks.  In “Too Small to Succeed? – Community Banks in a New Regulatory Environment,” the Federal Reserve Bank of Dallas lays out the “apparent” rising regulatory burden confronting banks today.  In contract, “Financial Performance and Management Structure of Small, Closely Held Banks,” published in the FDIC Quarterly, provides an empirical analysis of the success of closely held community banks in the FDIC Kansas City, Dallas and Chicago regions.

Lots of Community Banks Remain

As a reminder (which often seems forgotten in these discussions), the U.S. banking industry is still full of community banks.  As of December 31, 2015 (the latest data available), there were 6,182 insured depository institutions in the United States (banks and thrifts, exclusive of credit unions).  Only 107 of those institutions had more than $10 billion in assets; 595 institutions had between $1 and $10 billion, 3,792 had between $100 million and $1 billion, and 1,688 had less than $100 million in assets.  (That’s not to say there isn’t significant concentration; the 110 institutions over $10 billion in assets hold over 81% of the assets in the industry.)

As indicated by the otherwise down-beat Federal Reserve paper, community banks (measured as having less than $10 billion in this analysis) have still maintained 55% of all small-business loans and 75% of all agricultural loans (and banks under $1 billion in total assets still provide 54% of all agricultural loans).  As pointed out by the Federal Reserve paper, community banks accounted for 64% of the $4.6 trillion of total banking assets in 1992, but accounted for only 19% of $15.9 trillion of banking assets in 2015.  While we have certainly had consolidation (both fewer banks, and larger banks), the community bank’s aggregate market ownership has, based on the Federal Reserve’s percentages and totals, actually gone up slightly from $2.9 trillion to $3.0 trillion.

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Supervisory “Concerns” with Shareholder Protection Arrangements

In December 2015 (following years of sporadic and seemingly random criticism) of shareholder protection arrangements, the Board of Governors of the Federal Reserve System issued guidance that the Federal Reserve “may” object to a shareholder protection agreement based on the facts and circumstances and the features of the particular arrangement.  Federal Reserve Supervisory Letter SR 15-15 does not require submission of such arrangements to the Federal Reserve for comment prior to implementation, but rather directs institutions considering the implementation or modification of such arrangements to “review this guidance to help ensure that supervisory concerns are addressed.”

Supervisory Letter SR 15-15 casts a long shadow, with little clarity as to the line between acceptable and unacceptable arrangements. SR 15-15 cites a wide array of potentially objectionable shareholder protection arrangements, but then indicates that supervisory staff has “in some instances” found that these arrangements would “have negative implications on a holding company’s capital or financial position, limit a holding company’s financial flexibility and capital-raising capacity, or otherwise impair a holding company’s ability to raise additional capital.”  Presumably speaking only of these particular arrangements (although not clearly so stating), SR 15-15 states “[t]hese arrangements impede the ability of a holding company to serve as a source of strength to its insured depository subsidiaries and were considered unsafe and unsound.”

SR 15-15 provides a number of examples of categories of shareholder protection arrangements that have (sometimes) raised supervisory issues.  Some of these examples are entirely consistent with past Federal Reserve precedent and are generally impermissible in bank-related investments, including price protections in offering arrangements whereby a holding company agrees to a cash payment or additional shares to the investor in the event that additional shares are issued in subsequent transactions at lower prices.  These “down-round” provisions have always been viewed by the Federal Reserve as acting as an impermissible disincentive (and potential disabling mechanism) for a holding company to raise additional capital going forward.  (In a surprising move of clarity, the Federal Reserve guidance does, by footnote, specifically indicate that preemptive rights, or the right to participate in subsequent offerings to prevent dilution of ownership, does not, in general, raise any supervisory concerns.)

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S Corp Banks Swing for the Fences, Settle for a Single

On July 21, 2014, the FDIC issued a Financial Institutions Letter (FIL) on the impact of the capital conservation buffer restrictions under Basel III on S Corporation banks.  The guidance essentially states that, even though Basel III restricts an S Corporation bank’s ability to pay tax distributions if it does not maintain the full capital conservation buffer, the FDIC will generally approve requests to pay tax distributions if no significant safety and soundness are present.  The succinct guidance probably raises more questions than answers.  Among those questions are the following.

  • Would a bank that does not meet the capital conservation buffer requirements ever really be 1 or 2 rated and experiencing no adverse trends?
  • Does the FDIC believe Obamacare and the related net investment income tax will be repealed?  What about state income taxes?  The factor limiting the dividend request to 40% may ignore what is actually required to allow shareholders to fund their tax liabilities.
  • What is an “aggressive growth strategy?” Is it the same as an intentional growth strategy?
  • If your institution is a national bank, a Fed member bank, or a bank holding company with more than $500 million in consolidated assets, will the Fed and the OCC follow suit and issue similar guidance?

At the end of the analysis, the guidance is probably similar to the current capital rule stating that 1 rated institutions may have a leverage ratio as low as 3.0% and still be considered “adequately capitalized.”  That rule has little practical impact in that it is awfully hard to find an institution with a 3.0% leverage ratio that is 1 rated.  Similarly, we believe any institution that meets the guidelines set forth in the FIL would almost certainly have no need to make this request.  Indeed, the FIL itself seems to acknowledge that fact.

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2014 Subchapter S Bank Forum

Join Bryan Cave LLP and Porter Keadle Moore on Tuesday, May 20 for the 2014 Subchapter S Bank Forum as we discuss how community banks can make the most of the tax benefits associated with S Corporation status. With all of the added pressure on today’s community banks, we will discuss how to deliver results to your shareholders as a high performing independent bank using an S Corporation structure. We hope to see you there!

Click HERE to register.

DATE: Tuesday, May 20, 2014 – Registration at 8:15 a.m.

LOCATION:
Bryan Cave Atlanta Office
1201 West Peachtree Street, NW | One Atlantic Center
Fourteenth Floor | Atlanta, GA 30309

COST: $125 per person | $75 for each additional person from same institution

CPE: Earn 6 hours of CPE (4 General and 2 Tax)

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