The drivers of bank profitability are like pieces to a puzzle. To analyze a bank's profitability, or lack of profitability, requires an understanding of each piece of the puzzle and how it fits together with the other pieces. Unfortunately, some community bankers overlook an important piece of the puzzle.
The drivers of profitability include:
- The net interest margin
- Noninterest income
- Noninterest expense
- The level of earning assets
- Leverage
- Taxes
Most bankers are familiar with the role played by the first five factors. Where do taxes fit into the puzzle? While the other drivers are the focus of most boards and management teams, taxes are the lost puzzle piece that has fallen into those dark recesses of the sofa.
Some Banks Can Save Money on Their Tax Bills
The average community bank in the country is paying 32.66% of pre-tax income in taxes. Other community banks are paying as low as 18% of pre-tax income in taxes. A very logical conclusion from that set of facts is that, on average, America's community banking industry is not tax efficient.
Take a look at the numbers. A bank that generates $10,000,000 in pre-tax income would have a tax bill of $3,266,000 at the 32.66% rate or $1,800,000 at the 18% that some tax-efficient banks pay. That difference could pay for a new branch or the launch of a major new product. This is why taxes are a key driver of bank profitability.
But why would a bank pay taxes at a 32.66% rate when it might lower the rate to 18%? The reason is simple: Most tax accountants for banks do very little tax planning, yet they will admit the bank could lower its tax rate.
Thus, the responsibility falls to a bank's executives to know how to lower the tax rate and to create a plan to do that. Every strategic plan should address the tax piece of the profitability puzzle. Community banks should create a goal for the bank's taxes to be at the approximate alternative minimum tax level.
Banks calculate their taxes in two ways: the regular tax and the alternative minimum tax. The bank is required to pay the higher of the two amounts. Tax efficiency is usually reached when the bank does not pay more than the tax computed at approximately 20%, the alternative minimum tax rate. If a board focuses on tax planning as part of the bank's strategic direction, over time, tax efficiency can be attained.
Two Ways to Reduce Taxes
The two major methods to permanently reduce tax liability are:
- Purchasing bank-owned life insurance (BOLI)
- Creating a portfolio of bank-qualified tax-exempt securities
Method One: BOLI
BOLI is a strategic part of succession planning. Compared to most industries, community banking does not typically use key-man insurance to protect the bank from an untimely loss of senior management. BOLI, in most cases, can be a cost-efficient method to provide strategic key-man insurance. BOLI provides income that is tax deferred and will help a bank move to tax efficiency.
Method Two: Bank-Qualified Tax-Exempt Securities
In 1986, Congress repealed the tax benefit associated with a bank buying tax-exempt securities. However, when it did so, Congress was concerned that small communities would not be able to fund their general obligations without the assistance of banks buying their debt. The solution was to create an exception for "bank-qualified" tax-exempt securities. Typically, these securities are issued by communities that issue $10 million or less in debt a year. Whether a security is "bank-qualified" is usually determined by examining the tax opinion that appears with the issue.
The majority of community banks do not take advantage of their ability to purchase bank-qualified municipal securities. Many banks believe they cannot find such securities or that these securities are only available in small individual pieces. As a result, many banks believe there is not an ample supply of these securities to be able to create a tax strategy that uses them.
False Assumptions Can Hurt Bank Profitability
Those assumptions are just not valid. To a large extent, some misinformation about bank-qualified municipal securities has been caused by some brokerage firms. Many brokerage firms do not deal in bank-qualified tax-exempt securities. Other firms do not deal in any type of tax-exempt security. Still other firms may deal in these securities, but they do not have the expertise or the willingness to sell bank-qualified securities. Even if they do, they do not take the time to perform the due diligence required to ensure that the security is truly bank qualified. This leads some brokers to recommend to banks that they buy securities that are easier for the brokerage firm to transact.
The brokerage firm that a bank uses—rather than the bank's tax strategy—can determine whether a bank has an opportunity to have bank-qualified tax-exempt securities in its portfolio. Thus, it is not surprising that some community banks have never used or even considered the use of bank-qualified securities as part of their investment strategy.
The bank-qualified tax-exempt security market is a liquid market that can supply all of the securities that a bank would need to create a tax-efficient strategy.
How does a bank find these securities? Over the years, the dealers in these securities have moved to small and regional brokerage firms.
The Bank's Tax Counsel Must Review the Plan
The bank should receive advice from the bank's tax counsel (which is typically a bank's outside audit firm) and a firm that specializes in community bank tax strategies.
It is imperative that any tax strategy should receive the review and advice of the bank's tax counsel. Tax counsel should also review the implementation of any strategy on the tactical level. Any tax strategy requires a high level of compliance.