Community bankers know that achieving superior profitability is much like putting together the pieces of a puzzle. Most community bankers readily identify five drivers of profitability: the net interest margin, noninterest income, noninterest expense, level of earning assets, and leverage.
Unfortunately, most community bankers forget that taxes also are a profitability driver. In the May issue of FOCUS, I analyzed how community banks can save money on their tax bills. I examined two methods—purchasing bank-owned life insurance (BOLI) and creating a portfolio of bank-qualified tax-exempt securities. This article shows how taxes fit into your bank's long-term strategic plan.
Tax Planning is Part of Strategic Planning
Every community bank should have a tax plan as part of its strategic plan with the goal to be tax efficient. Of course, tax strategies are not without risk. No matter how tax efficient and profitable a strategy might look, the first question for directors or management is: "What risk does this entail?" Typically, a bank may only look at a strategy based on how much money will land on the bottom line. The reality is that banks make money based on the assumption of risk.
For instance, a bank may compare BOLI products that have different returns. The key risk of BOLI is the credit quality of the insurance company. On a long-term basis, the bank needs the insurance company to make payments on the death benefits. If the insurance company has problems making the payments, the bank's strategy may not be viable. The best way to minimize this credit risk is to buy policies only from the top-rated companies in the industry.
Bank-qualified tax-exempt securities typically carry a AAA rating and are insured. Credit risk is not a real risk factor if they are insured. Due to their longer-term maturities, tax exempts tend to have more market price volatility. This can impact economic value of equity (EVE) in a rising rate environment. This may have a negative impact on the bank's capital position. Pre-purchase modeling of an individual security will reveal its inherent volatility and whether this security will fit into the bank's overall balance sheet.
Make No Excuses
Bankers often offer excuses for not being tax efficient. In years' past, management and directors were concerned with retaining as much net income as possible. This included doing tax losses at year-end to maximize tax efficiency. In the current banking environment, banks often are more concerned with current earnings. It could be argued that banks are giving away future value by not being tax efficient.
Another excuse is that loans yield more than bank-qualified tax-exempt securities on a taxable equivalent basis. Many banks have been increasing the size of their loan portfolio and decreasing the size of their investment portfolio.
While loans are higher yielding in the current environment, bankers should analyze the loan yield under different scenarios. Of course, credit risk is increased. More capital is needed to support a loan compared to a bank-qualified tax-exempt general obligation. Under the new FDIC assessment, banks may be paying higher FDIC premiums because of credit risk. It can be argued that banks are not getting the level of yield in the current market to compensate them for the risk they are taking by making a loan. More importantly, loans are very susceptible to refinancing risk if interest rates decrease.
Interest Rate Changes Are Factor
The value in bank-qualified tax-exempt securities is that there are longer-term call features available. This call protection is very valuable as interest rates decline. While loan yields are declining overall, a portfolio of call-protected tax-exempt securities will maintain its yield.
The Bank's Tax Counsel Must Review the Plan
You should make sure your bank receives advice from the bank's tax counsel, which is typically your bank's outside audit firm, and from 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.
There are numerous conservative short-term and long-term strategies and tactics that community banks can utilize. The important point is that a community bank must work with its tax counsel to make sure the tax plan is implemented properly. Any tax strategy requires a high level of compliance.