Since 1997, commercial banks have been allowed to operate as S Corporations. This research investigates the impact of ownership on the profitability and capital structure of S Corporation banks in comparison to C Corporation banks. The agency hypothesis predicts that S Corp. Banks exhibit greater operating profits on both a pre-tax and after-tax basis.
Original Description:
Original Title
Impact of Taxes and Ownership OnCapital Structure S Corp Banks May2010 to JFI
Since 1997, commercial banks have been allowed to operate as S Corporations. This research investigates the impact of ownership on the profitability and capital structure of S Corporation banks in comparison to C Corporation banks. The agency hypothesis predicts that S Corp. Banks exhibit greater operating profits on both a pre-tax and after-tax basis.
Since 1997, commercial banks have been allowed to operate as S Corporations. This research investigates the impact of ownership on the profitability and capital structure of S Corporation banks in comparison to C Corporation banks. The agency hypothesis predicts that S Corp. Banks exhibit greater operating profits on both a pre-tax and after-tax basis.
Performance and Capital Structure of S Corporation Banks *
Ken B. Cyree University of Mississippi
Scott E. Hein ** Texas Tech University
Timothy W. Koch University of South Carolina
May 2010 Abstract Since 1997, commercial banks have been allowed to operate as S Corporations thereby avoiding taxation at the federal corporate income tax level. This research investigates the impact of ownership on the profitability and capital structure of S Corporation banks in comparison to C Corporation banks. Because ownership and managerial control of S Corp. banks are highly concentrated relative to that for C Corp. banks, the agency hypothesis predicts that S Corp. banks exhibit greater operating profits on both a pre-tax and after-tax basis. We find evidence consistent with S Corporation banks having lower agency costs of equity and thus higher profitability even before tax. The fact that interest expense is not tax deductible at S Corp. banks leads to the tradeoff hypothesis, which implies that S Corp. banks operate with less interest-bearing debt relative to comparable C Corp. banks. One the other hand, if S Corp. banks see themselves as more profitable, they may feel better able to add to the capital stock when needed, and thus choose to hold less capital on average. Indeed, we find empirical evidence that S Corporation banks operate with less equity capital than C Corporation banks, ceteris paribus, as well as reduce their capital holdings following conversion. JEL: G21, G32, M40, C30 Keywords: Agency cost of equity, Bank Performance, Capital structure, Commercial banks, S Corporations, Taxes * We thank David Becher, George Cashman, Jack Cooney, Ray DeGennaro, Bill Dukes, Alton Gilbert, William Jackson, Jeff Mercer, Mike Stegemoller, Steve Swidler, Sergey Tsyplakov, Larry Wall, Drew Winters, Tim Yeager, John Ziegelbauer and participants at several conference sessions and seminars for comments on earlier versions of this paper. ** Corresponding Author: Ken B. Cyree, University of Mississippi, 253 Holman Hall, University, MS 38677. Email kcyree@bus.olemiss.edu, phone 662-915-1103. 2
The Impact of Taxes and Ownership on the Performance and Capital Structure of S Corporation Banks
May 2010 Abstract Since 1997, commercial banks have been allowed to operate as S Corporations thereby avoiding taxation at the federal corporate income tax level. This research investigates the impact of ownership on the profitability and capital structure of S Corporation banks in comparison to C Corporation banks. Because ownership and managerial control of S Corp. banks are highly concentrated relative to that for C Corp. banks, the agency hypothesis predicts that S Corp. banks exhibit greater operating profits on both a pre-tax and after-tax basis. We find evidence consistent with S Corporation banks having lower agency costs of equity and thus higher profitability even before tax. The fact that interest expense is not tax deductible at S Corp. banks leads to the tradeoff hypothesis, which implies that S Corp. banks operate with less interest-bearing debt relative to comparable C Corp. banks. One the other hand, if S Corp. banks see themselves as more profitable, they may feel better able to add to the capital stock when needed, and thus choose to hold less capital on average. Indeed, we find empirical evidence that S Corporation banks operate with less equity capital than C Corporation banks, ceteris paribus, as well as reduce their capital holdings following conversion. JEL: G21, G32, M40, C30 Keywords: Agency cost of equity, Bank Performance, Capital structure, Commercial banks, S Corporations, Taxes
3 The Impact of Taxes and Ownership on the Performance and Capital Structure of S Corporation Banks
A popular criticism of U.S. federal income tax policy is that owners of corporations are taxed twice, first at the corporate level under the corporate income tax and again at the shareholder level as individuals pay personal income tax on any dividends and capital gains. Such criticism, however, applies only to C Corporations. S Corporations avoid this double taxation, with certain limitations, because the underlying entity does not pay corporate federal income taxes. Instead, individual shareholders pay tax at personal tax rates on any income allocated to them. To the extent that S Corporations are able to avoid double taxation they provide a natural experiment to examine the impact of taxes on the firms choice of capital structure. Furthermore, because S Corporations are closely held due to restrictions on the number of shareholders, their owner-managers may exhibit different perspectives on risk and profitability objectives. Researchers, such as Modigliani and Miller (1958 and 1963), Scott (1976), and Miller (1977), have long debated the influence of taxes on the capital structure decisions of corporations. Many argue that corporations find it optimal to hold at least some debt because interest payments are tax deductible for the corporation, while dividend payments on equity are not similarly treated. In a survey of firm managers, Graham and Harvey (2001) verify that firm managers trade-off the benefits versus distress and tax costs of debt via target debt ratios.
4 Adherents of this trade-off theory implicitly argue that S Corporations, which pay no federal income tax and thus have no advantages from debt, would hold proportionately less interest- bearing debt and more capital. Whether a firm operates as an S or C Corporation also likely affects operating performance and managements risk tolerance. Clearly, the avoidance of corporate income taxes should improve a firms bottom line. Equally important, however, is the prospect that concentrated ownership may reduce agency problems and subsequently improve risk management practices. When Congress initiated legislation allowing certain corporations to elect S Corporation structure, it imposed limits on the maximum number of shareholders allowed. The current maximum is 100 shareholders with broad definitions that, in some instances, allow family members to constitute one shareholder. The possibility of improved risk management practices is linked to the types of firms that select S Corporation status and the tendency of owner-managers to lead the firms. With constraints on the number of shareholders, S Corporations are generally smaller in terms of asset size and market value than their C Corporation counterparts. Limiting the number of shareholders concentrates ownership, especially among the Board of Directors and management. According to Berle and Means (1932), Jensen and Meckling (1976) and subsequent researchers, concentrated ownership mitigates negative consequences of the separation of ownership from control of the corporation. As such, S Corporations could have smaller agency problems and stronger operating profits, ceteris paribus. While S Corporations outnumber C Corporations in recent years, little research has examined the structure and performance of S Corporations likely due to data limitations. Because S Corporations are generally small in size and non-public, comprehensive financial data are not 5 as readily available as for publicly-traded corporations. However, detailed balance sheet and income statement data are available for S Corporation commercial banks. The Small Business Job Protection Act of 1996 authorized qualifying insured commercial banks to be taxed as S Corporations (S Corp. banks) effective in 1997. 1 Not surprisingly, the ability to avoid federal corporate income taxes (and in some cases, state taxes) has been quite attractive and the number of banks that selected S Corporation status has increased sharply. Figure 1 highlights changes in the number of S Corp. banks from 1999 to 2009 when almost one-third of U.S. commercial banks operated as S Corporations. This research empirically examines the operating performance and capital structure of S Corporation commercial banks relative to that of C Corporation commercial banks. In doing so, we examine a tradeoff hypothesis associated with managements choice of financial leverage and an agency hypothesis associated with firm operating performance. First, because interest expense on debt is not tax deductible for S Corp. banks, the tradeoff hypothesis implies that S Corp. banks operate with less interest-bearing debt relative to comparable C Corp. banks. Second, because ownership and managerial control of S Corp. banks are highly concentrated relative to that for C Corp. banks, the agency hypothesis stipulates that S Corp. banks exhibit greater operating profits after controlling for risk. This latter hypothesis reflects, in part, reduced agency problems associated with managers and owners who are closely aligned when making managerial decisions. In conducting the empirical analysis, we address potentially serious endogeneity problems. For example, while we could easily compare key performance ratios between banks representing the two groups, differences might be driven by the types of banks that choose to be taxed as S
1 Prior to 1997, commercial banks and savings associations were prohibited from electing to be organized as S Corporations regardless of the number of stockholders. 6 Corporations versus C Corporations. Given the limitations on the maximum number of shareholders, S Corporations are likely to be smaller, more frequently located in rural settings, and more likely to be regulated by state banking departments rather than the OCC or Federal Reserve System. Differences in performance or capital structure may simply reflect these structural differences. We focus our attention on banks in large part because of data availability. S corporations, by their very nature, are small entities and thus generally dont have publicly-traded securities. However, all U.S. commercial banks are heavily regulated and are required to publicly provide basic financial information on a quarterly basis. Regulation, in turn, encompasses allowable balance sheet mix, minimum capital standards, and other elements that make commercial banks unique. We discuss some of these unique features in our development of hypotheses. Finally, our research does not allow us to explore market prices for securities which are not available for virtually all S Corp. banks. As such, we are forced to consider non-traditional measures of risk and return (i.e. those not directly related to modern portfolio theory) in our analysis. The remainder of the paper describes the nature of the empirical analysis and presents estimates of differences in performance and capital structure.
1. RELATED BANKING LITERATURE Given that S Corporation banks have only been in existence in the U.S. following 1996 Congressional legislation, little empirical research exists regarding their performance. Hodder, McAnally and Weaver (2003, HMW) were among the first to examine S Corp. banks and identified tax and nontax factors likely to influence the choice to incorporate as an S Corporation. They find that banks are more likely to convert to S Corporation status when the 7 conversion lowers dividend taxes and minimizes state income taxes. They also find that banks are less likely to convert when conversion would lead to capital constraints or create penalty taxes on unrealized gains. Hein, Koch and MacDonald (2005, HKM) build on the importance of relationship banking to smaller, community banks in the U.S. They note that a growing proportion of smaller banks organize as S Corporation banks each subsequent year. These smaller banks, in turn, are shown to be more profitable than larger banks. HKM (2005) emphasize that part of this increased profitability is simply attributable to the fact that S Corporations pay no federal income tax such that after-tax comparisons between S Corporation banks and C Corporation banks are not appropriate. Gilbert and Wheelock (2007, GW) go one step further and show that S Corporation banks have higher earnings than their peer C Corporation banks even after the formers earnings are reduced by estimated federal income taxes. The better profitability is largely attributed to higher net interest margins and greater operating efficiency. GW does warn, however, that there is no perfect way to compare S Corporation and C Corporation bank earnings to one another. Thus, there is some evidence suggesting that S Corporation banks are more profitable than their C Corporation counterparts, even after controlling for tax differences. There are two limitations to this evidence, however, that this paper attempts to rectify. First, no theory has been offered to explain why these differences exist. We argue that because S Corporation banks are likely to be smaller and more closely-held, they will engage in more relationship banking activities, which have been shown to be more profitable, and they are likely to be better able to mitigate the agency costs of equity. Second, the earlier evidence has not controlled for problems with self-selection bias. For example, it might be the case that more profitable banks have an 8 incentive to convert to S Corporations and the evidence of greater profitability may be attributable to this fact rather than S Corporation status. The hypothesis linking S Corporation status to increased bank profitability is related to literature on smaller organizations ability to better exploit soft information and to literature on mitigating the agency costs of equity. Brickley, Linck and Smith (2003), for example, provide evidence showing that locally-owned bank offices in Texas grant more decision-making authority to local managers, allowing for better exploitation of soft information. They find that small locally-owned banks have a comparative advantage over larger banks. While they do not examine the corporate status of the banks in their study, S Corporation banks are more likely to be locally-owned. Berger, Miller, Petersen, Rajan, and Stein (2005) also find evidence consistent with the observation that small banks are better equipped to collect and act on soft information than are large banks. Mehran and Suher (2009) also give explicit consideration to S Corporation banks. They focus primarily on dividend payouts and bank acquisitions and find evidence that S Corporation banks dividend payouts increase following conversions from C Corporations. They also find evidence that S Corporation banks are significantly less likely to be sold relative to C Corporation banks. Finally, they find that S Corporation banks operate less efficiently on a pretax basis in contrast with the results of GW (2007).
9 2. A PRELIMINARY COMPARISON OF C CORPORATION AND S CORPORATION BANK PERFORMANCE To conduct our preliminary analysis, we use year-end balance sheet and income statement data from Federal Financial Institutions Examination Council (FFIEC) bank reports of income and condition (Call Reports) for 1999-2008. 2 We initially report key bank performance and balance sheet ratios for S Corp. banks in the year of conversion versus the same measures for C Corp. banks. Generally, S Corporations cannot own other S Corporations. 3
We conduct our analysis at the bank level as opposed to the holding company level. 4
Figure 1 shows recent trends in the number and proportion of S Corporation banks. As indicated, the proportion of S Corporation banks increased dramatically over time from 16 percent in 1999 to 30 percent in 2008 and higher thereafter. Summing the number of banks across all years gives a final sample of 15,637 S-Corporation and 44,360 C-Corporation bank-years. S Corporation banks differ from their C Corporation counterparts in many ways. Consider the summary univariate data in Table 1 which document size, location, and capital differences for all banks separated according to S or C Corp. status. For comparative purposes, C Corp. banks are those operating in each year with total assets no greater than that of the largest S Corp. bank that year. At year-end 2008, 48 percent of S-Corp. banks had less than $100 million in assets and only 160 had more than $500 million in assets. The largest S Corp. bank in our sample at the end of 2008 had $3.5 billion in assets. Not surprisingly, almost 70 percent of S
2 While banks were first allowed to choose S Corporation status in 1997, we omit data for 1997 and 1998 because the FFEIC reports do not explicitly identify which banks are S Corp. banks. 3 An S Corporation that owns 100 percent of the stock of another corporation, however, can elect to treat the subsidiary as a qualified subchapter S subsidiary. 4 We have also conducted the analysis at the holding company level with similar results. These results are available upon request. 10 Corp. banks were headquartered in rural areas. The number of S Corp. banks increases systematically over time as does the relative size of the average bank. Generally, the reported data for capital ratios, equity-to-total assets and the adjusted capital ratio (stockholders equity divided by the difference between total assets and non-interest bearing deposits) are systematically lower for S Corp. banks, but sufficiently close to the ratios for C Corp. banks to necessitate further investigation. We compare key performance measures for S Corporation banks to the same measures for C Corporation banks matched by total asset size. Variables are separated into three categories: 1) profitability, 2) balance sheet mix and risk, and 3) capital measures. The measures are widely used in the banking literature, but some might be new to those not familiar with banks. Table 2 presents means of key ratios for S Corporation banks versus means for a size- constrained, matched sample of C Corporation banks. Specifically, the matched sample for each year includes all C Corporation banks that reported total assets no greater than the amount of total assets for the largest S Corporation bank in that year. The table provides t-statistics, testing for differences in the means between S Corporation and C Corporation banks. Because these results are simple partial comparisons and we have not controlled for potential endogeneity problems, we view these findings as primarily descriptive. Still, the results described here are broadly consistent with the more sophisticated two-stage estimation provided in Section 5.
2.1 Profitability Our findings regarding bank profitability comparisons are broadly consistent with those of GW (2007) as S Corporation banks have, on average, much higher after-tax aggregate profits measured by both ROE and ROA. They also report net interest margins (NIMs) that are 17 basis 11 points higher, on average, while our estimate is 24 basis points. In order to neutralize the tax advantage of S Corp. status, we also construct pre-tax profit ratios. Importantly, S Corp. banks report significantly higher average ratios for pre-tax ROE and pre-tax ROA. This finding is similar to that of GW (2007), but the opposite finding of MS (2009). The difference in the pre- tax and after-tax ROA for S Corporation banks is small and largely reflects differential state taxes. This preliminary evidence supports the view that S Corp. banks earn higher returns, even ignoring their tax advantages, with the differences in pre-tax ROE and ROA between the two groups at 1.84 percent and 0.16 percent, respectively. After subtracting taxes, average ROE and ROA are approximately 60 percent greater at S Corporation banks. This latter comparison clearly demonstrates the error in treating these two corporate structures equally when evaluating performance based on traditional benchmarks like ROE and ROA. Not surprisingly, S Corp. banks pay a higher fraction of income as dividends as most S Corp. shareholders are subject to income taxes on their share of bank profits. This finding is consistent with the evidence provided in MS (2009). Finally, profit growth is significantly higher for S Corporation banks over the prior three years.
2.2 Balance Sheet Mix and Risk Data for the balance sheet mix variables reveal that S Corp. banks fund their operations differently. First, they operate with proportionately more demand deposits but fewer other core deposits, such as small time deposits, MMDAs, and savings accounts. Second, they have fewer purchased liabilities, such as repurchase agreements and FHLB advances, compared with their C Corp. bank peers. Demand deposits are unique to commercial banks as they represent non- interest bearing liabilities. Historically, individuals viewed their primary bank relationship to be 12 with the firm that provides these checking account services. Demand deposits held by individuals are highly interest inelastic and represent a stable, low cost source of funds. Thus, most banks view demand deposits as a core driver of firm value. Banks pay market rates on purchased liabilities which are generally higher than rates paid on core deposits. The overall funding characteristics suggest that S Corp. banks have a lower average cost of funds and less liquidity risk. The fact that other core deposits is lower at S Corp. banks may mitigate this claim, but may also reflect the widespread acquisition of time deposits and MMDAs via internet CDs and rate boards during this time frame by C Corp. banks. Finally, as noted below, S Corp. banks have lower equity-to-asset ratios and thus greater financial leverage. This raises interest expense, ceteris paribus. On the asset side, S Corp. banks hold proportionally fewer total loans, but more agriculture and commercial loans. With the different loan mix and loan levels, S Corp. banks report higher past-due loan ratios, but there is no difference in net charge-offs suggesting that their credit risk management experience has been comparable to that of C Corp. banks, on average. Interestingly, S Corp. banks have lower asset growth than their C Corp. counterparts. Given that we havent controlled for whether S Corp. banks compete in more restricted geographic markets, the differential asset growth may simply reflect that more C Corp. banks operate in faster-growing metropolitan areas. Additionally, S Corp. banks are more likely to be de novo banks and thus might purposely limit asset growth, something we control for in the following analysis. It may also reflect the fact that S Corp. banks pay more in cash dividends. Finally, S Corp. banks hold more liquid assets possibly reflecting a greater need to pledge securities against public deposits and greater reliance on unpledged securities for liquidity given their more limited access to purchased liabilities. 13 2.3 Capital Finally, the various capital ratios indicate that S Corp. banks operate with less stockholders equity to assets, both before and after adjusting for non-interest bearing demand deposits, and lower Tier 1 risk-based capital ratios. 5 A banks equity-to-asset ratio is a traditional measure of financial leverage. The adjusted capital ratio subtracts demand deposits from total assets in the denominator in recognition that most banks will accept all the demand deposits that they can attract. They can effectively spread the deposit servicing cost over a larger base and easily invest the funds earning a positive spread. The adjusted capital ratio attempts to control for financial leverage not associated with interest expense. Given likely constraints on the amount of common stock that a limited number of individual shareholders can often acquire, even if tax considerations dont matter, S Corp. banks likely obtain proportionately more capital in the form of trust preferred stock that is sold to external constituents. The data, however, indicate that S Corp. banks operate with relatively less preferred stock and subordinated debt financing.
5 The Tier 1 risk-based capital ratio is a measure of capital adequacy that was developed with the Basel I capital standards. The ratio is simply Tier 1 capital to risk weighted assets. Tier 1 capital is the regulatory definition of capital that is most closely aligned with common stock holders equity. The risk-weighted assets of a bank are found by classifying all assets into one of four categories, each with weights between 0% and 100%. The measure of risk- weighted assets also includes certain off balance sheet items to capture non-balance sheet financial risks. S Corp. banks similarly have greater demand deposit financing which is quite stable. They may choose to operate with relatively less equity given the lower risk sources of debt utilized. 14 3. EMPIRICAL DESIGN The previous findings are consistent with those of GW (2007) indicating that S Corporations are generally more profitable, even allowing for their tax advantage, than their C Corporation counterparts. Our univariate findings are also generally contrary to the tradeoff theory, as S Corporation banks have less equity than their counterparts, on average. Finally, the findings are consistent with the agency view that S Corporations have higher risk-adjusted returns. However, this investigation suffers from potential endogeneity problems, as we have not controlled for factors that might shape the decision to elect S Corporation status. The univariate analysis may simply indicate that banks which elect to become S Corporations may themselves be more profitable and hold less capital. We attempt to mitigate the endogenous variables problem by using the Heckman (1979) correction procedure which requires the empirical analysis of factors that are likely to lead a commercial bank to elect the S Corporation structure. Fortunately, HMW (2003) suggest factors that appear to influence this choice. We begin by outlining their analysis, which is used to develop the first step in our Heckman estimation. The empirical results follow.
3.1 Factors Influencing the S Corporation Election HMW focus on tax matters that shape a banks decision to elect the S Corporation structure. The comparison of tax benefits between S and C Corporations, in turn, requires an analysis of expected taxable income and dividend payouts and the relationship between marginal corporate and personal income tax rates. HMW represent the tax benefit of conversion to an S corporation as the sum of two terms; the savings from avoiding individual taxation of dividends and an offset reflecting incremental taxes due because marginal corporate income tax rates are 15 less than marginal personal income tax rates (at least for the maximum income tax rate schedules): Tax benefit = [dividends x t i ]
+ [taxable income ( t c - t i ) ] , (1) where dividends and taxable income represent cash dividend payments and earnings subject to taxes as a C Corporation, respectively, and t c and t i refer to the banks marginal corporate and shareholder marginal personal income tax rates, respectively. Equation (1) indicates that higher dividends should produce a greater tax benefit from S Corporation conversion, ceteris paribus, and that an increase in taxable income, holding dividends constant, may result in a lower net benefit because income may be taxed at the higher individual shareholder tax rate. The special circumstances of individual stockholders and the amount of taxable income determine the magnitude of the overall tax benefit. For example, consider a bank owned by one stockholder who is a dairy farmer with an effective personal tax rate of zero (t i = 0). Operating as a C Corp. bank generates a dead weight cost by reducing the amount of income available for payment as dividends. In contrast, S Corp. taxation avoids this cost and increases the after-tax value of cash dividend payments to the stockholder. Similarly, a C Corporation with substantial built-in gains will be required to pay taxes on the unrealized built-in gains over time at the maximum corporate tax rate if it converts to an S Corporation. Thus, conversion to an S Corp. bank would sharply increase taxable income. Not converting defers any recognition of the gain which may induce management to not seek S Corporation status until the built-in gains are minimal. The role of dividends is likely to be even more important than that suggested by this framework. Suppose a commercial bank makes a positive profit, retains all earnings, and pays no dividends. As a C Corporation, it would pay corporate taxes on all earnings but the double taxation is minimal as shareholders pay no income taxes because they receive no dividends. In 16 this scenario, shareholders can effectively postpone individual tax obligations indefinitely. A tax event at the individual level occurs only when the shareholder sells stock with the tax impact determined by whether the sale is at a gain or loss and whether the marginal personal income tax rate is greater (lower) than the capital gains tax rate. As an S Corporation, the bank would pay no corporate income tax, but taxable income would be allocated to shareholders regardless of whether cash dividends were paid, so shareholders would pay income tax at a (presumably) higher tax rate with t c - t i < 0. HMW generally argue that banks are more likely to convert from a C to an S Corporation when conversion reduces stockholder dividend taxes and state income taxes and helps stockholders avoid the alternative minimum tax. 6 They also argue that smaller banks are more likely to make the S Corporation election. On the other hand, banks in growth markets with limited access to the capital markets and those with significant corporate tax loss carry-forwards are less likely to convert. HMW estimate a logistic regression model where the choice of S Corporation status is related to a banks cash dividend payments, taxable and tax-exempt income, growth rate in total assets and purchased liabilities during the three prior years, unrealized gains on investment securities, the existence of tax loss carry-forwards, age of the bank since incorporation, and the natural log of total assets. They also include a series of dummy variables to capture favorable tax and regulatory factors, labeled tax variables, non-tax variables and control variables. Tax
6 When a C Corp. elects to operate as an S Corp., it must treat any unused AMT credit as a carry-forward item and can use it to offset built-in-gains taxes over the 10-year recognition period. Many banks buy municipal bonds that pay interest exempt from federal income taxes and this interest increases the banks alternative minimum taxable income under the AMT. The key issue is how to determine how many municipals to own and the amount of the AMT credit. 17 benefits are determined by the amount of dividends paid along with aggregate bank taxable income. Importantly, dividends will have a positive impact on the election of S Corporation status as long as the respective marginal corporate tax rate is less than the relevant marginal individual income tax rate. In general, any factor that creates less benefit of conversion to S Corp. status, such as having large built-in-gains that would offset the tax benefit, should decrease the likelihood of conversion. In order to assess performance differences, we need to control for selection bias. Our first stage analysis is based largely on the framework proposed by HMW that models managements decision to elect the S Corporation organization form. We estimate a probit regression of the form: S Corporation = f (BUILTIN, LOSSCF, AMT, DIVPAY, Yearly Dummies, STATEDUM, RURAL, AGE, LNASSETS) (2) with S Corporation equal to one if the bank chooses to be an S Corporation for the first time in that year, and zero otherwise; BUILTIN equals unrealized capital gains on investment securities scaled by total assets if positive, and zero if a capital loss exists; LOSSCF is a zero-one indicator that takes a value of one if the prior three years losses are greater than the current years profit; AMT is HMWs proxy for the alternative minimum tax, defined as tax-exempt interest divided by assets; DIVPAY is the banks total cash dividends for the year divided by operating profits; Yearly Dummies, YR00-YR08, are indicator variables that equal one if in the year suffix, and zero otherwise with 1999 the excluded set; STATEDUM is an indicator for the state in which the bank is located and zero otherwise, omitting Washington, DC 7 ; RURAL is one if the bank is not
7 While for sake of space we do not report the coefficients on the state dummy variables, we should note these coefficients are generally highly significant. This reflects the fact that the treatment of S Corp. banks varies greatly 18 in an MSA, and zero otherwise; AGE is the number of years from charter date; and LNASSETS is the log of total assets. The Heckman (1979) correction uses the inverse Mills ratio from the first stage probit regression that estimates the probability of selecting S Corporation status. The correction helps account for possible selection bias because banks that elect to become S corporations may also have better profit performance, differential capital ratios, and balance sheet mix. We are particularly concerned whether banks that choose to be S corporations generate higher profits or may operate with differential financial leverage independent of the choice.
3.2 Comparative Bank Tax Treatment, Operating Performance and Capital Structure
The different tax treatment of S Corp. versus C Corp. banks potentially leads to different balance sheet structures and operating performance which may be compounded by differences in ownership structure of the two types of banks. We are first interested in bank performance and agency effects on risk management practices. We hypothesize that the close alignment of ownership and control of many S Corp. banks mitigates potential agency conflicts between owners and managers. One implication is that S Corp. banks may, on average, better manage banking risks and subsequently produce higher risk-adjusted profits. For example, managers of S Corporations are likely less willing to engage in perquisite consumption due to their (generally) larger pro-rata share of ownership than most C Corporation managers. They are also likely to be better incentivized to find profitable, risk-adjusted investment opportunities. This discussion leads to the agency hypothesis:
from state to state which is reflected in the fact that some states have very few S Corp. banks while other states have large numbers of S Corp. banks. 19 Agency Hypothesis: S Corp. banks exhibit greater profits than comparable C Corp. banks. This should be obvious in the case of after-tax returns, as S Corp. banks avoid the federal income tax burden of their C Corp. brethren. However, we also argue that S Corp. banks will be more profitable than their C Corp. peers on a before-tax basis. Next, we consider two competing theories and their capital structure implications. First, we consider the tradeoff hypothesis, which emphasizes the lack of tax deductibility of debt for S Corp. banks. In particular, the avoidance of federal corporate income taxes eliminates the tax advantages of interest-bearing debt for S Corp. banks, suggesting a tradeoff hypothesis: Tradeoff Hypothesis: S Corp. banks operate with less interest-bearing debt and more equity capital than C Corp. banks. To the extent that S Corp. banks do not directly derive tax benefits from the interest expense on debt, they may hold relatively less of this debt relative to their C Corp. counterparts. Importantly, S Corp. banks may rely proportionately more on trust preferred stock. Banks with a limited number of shareholders and strong growth prospects historically found such stock attractive due to its low cost and ready availability without diluting the ownership of existing shareholders. Trust preferred stock and subordinated debt qualify, with limitations, as Tier 1 capital which helps meet regulatory capital requirements. Trust preferred stock has the distinct advantage over common equity because dividend payments are effectively tax deductible. Thus, the use of preferred stock and subordinated debt lowers a banks cost of capital and we include both in our capital structure equations. 8
In contrast to the tradeoff hypothesis, we build on the agency benefits of the S Corp. structure and develop an alternative hypothesis. Traditional theories of capital structure start with a presumed target level for the capital stock that is achieved by flow changes over time. The
8 The use of trust preferred stock by community banks largely disappeared with the credit crisis that began in 2007. 20 flow changes achieved are taken as given. In contrast to this view, we hypothesize that S Corp. banks start with the presumption that they will be more profitable and thus will be able to add to their capital stock by retaining earnings, at a greater rate in the future. Thus, we presume that S Corp. banks anticipate an enhanced ability to add to capital relative to their C Corp. counterparts. This greater earnings capacity, in turn, may allow S Corp. banks to adopt lower capital stock targets than their C Corp. peers. Because this prediction is opposite that of the trade-off theory, we view this as mutually exclusive to the trade-off theory. To investigate these relationships, we estimate a two-stage regression where the first stage is the Heckman (1979) correction. In the second stage, we alternate dependent variables between capital and performance-based measures such that the second stage model becomes: c
o | o + + + + + + + + + + + + + + + + + + + + =
= AST PREF PURLIABAST OTHCOREAST AST DD DEP LOAN CNILOANS AGLOANS TA LLR LNASSETS PROFGRO ASSETGRO AGE DENOVO RURAL PUBLIC YRi CAPRATIO SUBS Dependent i i 2 2 2 2 16 15 14 13 12 10 9 8 7 6 5 4 3 2 1 08 00 (3) where the variables are the same as the first-stage with the addition of the variables discussed below. The first dependent variable is CAPRATIO, the equity-to-assets ratio, used to test the tradeoff hypothesis and its competing counterpart. The second dependent variable is either EBTROA or ROA, the before-tax or after-tax return on assets, respectively, which we use to test the agency hypothesis. We distinguish between pre-tax and post-tax return on assets to first remove the corporate tax effect and then to illustrate the error of blindly comparing accounting performance of S Corp. banks with C Corp. banks without recognizing the impact of the tax difference. In our equations for capital structure and profitability, we include yearly indicator variables to help control for temporal time-series effects as well as clustering effects of many 21 conversions around the initial regulation. Additional independent variables also include PUBLIC, which equals one if the bank is publicly-traded and zero otherwise; RURAL, which equals one if the bank is located in a non-MSA county and zero otherwise; DENOVO, which equals one if the bank is less than five years old and zero otherwise because start-up banks typically have worse performance as shown by DeYoung and Hasan (1998); AGE is the banks age since inception in years; ASSETGRO is the banks past three years arithmetic average growth rate in total assets; PROFGRO is the past three years arithmetic average growth rate in net income; LNASSETS is the log of total assets; LLR2TA equals loan-loss reserves to total assets; AGLOANS is agricultural loans to total assets; CNILOANS is commercial and industrial loans-to-total assets; LOAN2DEP is the ratio of loans-to-deposits; DD2AST, OTHCOREAST and PURLIABAST equal demand deposits, other core deposits under $100,000 and purchased liabilities, respectively, each divided by total assets; SD2AST is subordinated debt to total assets and PREF2AST equals preferred stock to total assets. The LAMBDA variable is the inverse Mills ratio from the first-stage Heckman correction to account for possible sample bias. We test these hypotheses using balance sheet and income statement data for U.S. commercial banks from 1999-2008.
4. EMPIRICAL EVIDENCE
Table 3 contains the probit results for S Corp. selection by banks. The first two columns present the probit regression estimates and p-values for the raw data, while the last two columns contain standardized coefficient estimates (each variable is standardized by dividing the value by the full sample standard deviation for that variable) and the rank of each variables impact based on the standardized data. The standardized data estimates indicate which variables have the 22 greatest influence on the probability of becoming an S corporation for banks in this sample. The last column contains the ranking (1 indicates the highest and 17 the least impact) based on the absolute value of the effect. 9
Our first stage findings are similar to those of HMW except for investment capital gains as a fraction of assets (BUILTIN) where the coefficient estimate is not statistically different from zero and LOSSCF where we find that a higher loss of tax benefits is associated with a higher probability of S Corporation election. Regarding the LOSSCF variable, we follow HMW and have an indicating variable that take on a value of one if the prior three years losses are bigger than this years profit. These differences may be due to our longer sample period or the different empirical specification. However, we confirm HMWs finding for AMT, where higher proportions of tax-exempt securities owned are associated with lower probabilities of S Corporation election. Similarly, the coefficient on the dividend payout rate variable has the anticipated positive sign and is significantly different from zero indicating that banks electing to become S Corporations generally have higher dividend payout rates. Dividends better enable S Corp. shareholders to satisfy their personal income tax obligations which have been passed on to them at the personal income level. The dividend payout variable is the most significant variable in shaping the decision to adopt S Corporation status as indicated by the highest rank for the standardized estimates (aside from the yearly dummy variables and intercept). Surprisingly, rural banks are not more likely to elect S Corp. status, on average. Table 4 presents the results from the second stage regressions which represent our tests of the trade-off and its alternative, as well as the agency hypotheses. First, consider the results for
9 Note that for consistency with the raw data results, we do not report the standardized state indicator estimates even though they are included in the model. 23 CAPRATIO and the capital structure implications. While the control variables exhibit the anticipated signs, S Corp banks appear to operate with less equity-to-assets, ceteris paribus, and thus greater financial leverage in contrast to the predictions of the tradeoff hypothesis. Importantly, the more banks rely on preferred stock the lower are overall capital ratios such that this other form of regulatory capital appears to contribute to lower traditional equity ratios. While the evidence is broadly inconsistent with the tradeoff hypothesis as outlined above with S Corporations having less equity than C Corporations, it is supportive of the alternative view that managers of S Corp. banks feel that they dont need as large of a capital stock to begin with since they are better equipped to add to it by retaining earnings from their higher profits. The significant LAMBDA coefficient estimate suggests that the sample bias correction is necessary in all three models. The interpretation is that the higher the probability of choosing S corporation status, the lower is pre-tax and after-tax ROA, but the higher is the capital ratio. These effects offset the higher performance and lower capital of actual S Corp. election as shown by the indicator variable, hence the differences in the model accounting for selection bias and the one that does not. Consider next the agency hypothesis. The results for pre-tax ROA demonstrate that S Corp. banks have higher pre-tax ROAs than their C Corp. counterparts, ceteris paribus, suggesting that S Corp. banks perform better even after accounting for possible selection bias. The estimates indicate a 42 basis point increase in pre-tax ROA, a 76 basis point increase in after-tax ROA, and an approximate 86 basis point decline in the capital ratio. 10 The estimates are
10 The derivative of the inverse Mills ratio is not linear so that including the LAMBDA variable as an independent regressor in a second stage OLS model does not give a true derivative. These results are thus not true partial derivatives for S Corporation status. 24 similar to the model without the Heckman correction (not shown), which indicates a statistically significant 17 basis points pre-tax ROA, 49 basis points after-tax ROA, and 38 basis points lower capital ratio. Regardless of the model used, these estimates are economically meaningful and indicate higher performance and lower capital ratios for S Corp. banks that are not due to sample bias. The implication is that S Corp. banks appear to manage risk comparably with C Corp. banks while generating greater profitability. As such, we cannot reject the agency hypothesis which suggests that S Corp. banks operate with higher risk-adjusted profits than C Corp. banks. Other control variables provide additional insight into S Corp. bank performance and risk. Rural banks have higher ROAs while de novo banks have lower ROAs as expected, and correspondingly operate with less and higher capital, respectively. De novo banks must have sufficient start-up capital to offset poor early performance. S Corp. banks that have grown assets quickly have lower performance and capital ratios suggesting a tradeoff between asset growth and accounting performance. Larger banks have higher profitability and lower capital ratios, all else equal. 11 Banks with higher loan losses have lower profitability and capital ratios while banks with higher proportions of total loans and commercial lending have higher performance and lower capital. Finally, the structure of funding greatly influences performance. Banks with the greatest proportion of funding from demand deposits are more profitable and operate with less equity, while those that rely proportionately more on other core deposits and purchased liabilities are less profitable yet also operate with less equity.
4.1 A Comparison of Bank Performance after versus Before S Corp. Selection In this section, we incorporate another method for analyzing performance differences after controlling for conversion to S Corp. status. Specifically, we examine differences in means
11 Note that the largest banks in the sample have total assets no greater than the largest S Corp. bank. 25 in key variables for S Corp. banks in the 3-year period prior to conversion versus the first three years after conversion. The final two columns of Table 5 provide t-statistics and z-statistics, respectively, for differences in means and medians when comparing post-conversion minus pre- conversion performance variables. The results demonstrate that capital ratios did not change significantly, except for the Tier 1 risk-weighted ratio, which fell, on average after conversion. Again, the lower Tier I capital ratio finding is consistent with our alternative hypothesis to the trade-off theory. Post-conversion, S Corp. banks also relied proportionately less on preferred stock as a capital component. In terms of profitability, after-tax ROA and ROE increased sharply, as expected, but both pre-tax ROA and ROE declined, on average. This latter finding is not expected, but may reflect the different timing of when banks converted to S Corp. status relative to the economic cycle or alternatively a general decline in profitability at S Corp. banks over time. Or, it may reflect the view that S Corp. banks follow expense preference behavior after conversion when there are fewer owners and managers consuming greater perquisites. As expected, S Corp. banks pay much higher dividends after conversion. In terms of balance sheet mix, S Corp. banks increased loan-to-asset and loan-to-deposit ratios, but also experienced greater past due loans and net charge-offs after conversion. These results may similarly reflect timing differences between when banks converted across the business cycle. Finally, S Corp. banks appear to have reduced their reliance on other core deposits but increased their reliance on purchased liabilities after conversion. This change in mix of liabilities would have contributed to lower profits, ceteris paribus. In order to control for changes in the business cycle, we conduct the same tests pre- and post-conversion after subtracting the yearly mean or median for all banks from each variable. 26 These results are presented in Table 6 and serve to confirm the previous analysis. Using adjusted means, capital ratios generally fell post-conversion except for S Corp. banks use of preferred stock. In terms of profitability, both pre-tax ROA and ROE increased after conversion, as did post-tax ROA and ROE, net interest margin, profit growth and the dividend payout ratio when accounting for industry performance. In other words, the results in Table 5 where pre-tax performance fell after S Corp. conversion were due to yearly effects and performance did increase for S Corp. banks after conversion when accounting for these annual industry effects. Combined with the earlier results, the implication is that S Corp. banks reduce their capital, but increase their aggregate profitability, both pretax and post-tax, following conversion.
5. SUMMARY AND CONCLUSIONS S Corporations provide an interesting corporate structure to examine the influence of taxes on financial decision making. Because these organizations generally avoid income taxes at the corporate level, leverage and tradeoff theories appear to suggest that S Corporations would employ more equity and less debt in their capital structures given that debt is not tax-advantaged at the corporate level. Our examination of the behavior of S Corporation banks, however, provides no evidence consistent with this hypothesis. Indeed, S Corporation banks are found to operate with less equity, ceteris paribus, than their C Corporation counterparts. We view these results as consistent with our alternative hypothesis to the trade-off theory that emphasizes the strong profitability of S Corp. banks. Specifically, managers of these banks recognize their greater ability to add to their capital by retaining earnings in the future, so they have a lower capital stock target. Our results suggest that tax associated with interest expense on debt play a 27 small role in shaping capital structure matters, consistent with the broader implications of Miller (1977). Because there are limitations on the maximum number of shareholders a firm may have to qualify as an S Corporation, S Corporation banks also provide an interesting mechanism to examine the impact of potential reductions in agency costs on risk-adjusted performance. Specifically, during most of our sample, S Corporations were limited to no more than 100 shareholders. Because of this restriction, many S Corporation banks are closely held with a strong link between owners and managers. The agency hypothesis proposes that S Corporation banks are able to mitigate key agency costs and thus will generally earn higher risk-adjusted returns than their C Corporation counterparts, ceteris paribus, due to a better alignment between shareholder interests and those of management. The empirical evidence provided appears to be broadly consistent with this claim, as S Corporation banks have higher pre-tax returns on assets, on average, than matched C Corporation banks. We also find evidence that S Corporate banks indeed increased their aggregate pre-tax profitability after conversion, but only after adjusting for annual industry performance. There still is much to do in this area of research. One of the more interesting lines of investigation in our view would entail a more explicit examination of ownership of S Corporation banks in comparison to C Corporation banks. We conjecture that S Corporation banks have a larger proportion of ownership held by managers, but dont have direct evidence on this matter. Importantly, the empirical results suggest that when forming peer groups for bank performance analysis, researchers must consider corporate tax structure as an important differentiating factor as C Corporation and S Corporation banks exhibit significantly different profiles. 28 LITERATURE CITED Berger, Allen, Nate Miller, Mitchell Petersen, Raghuram Rajan, and Jeremy Stein. (2005) Does function follow organizational form? Evidence from the lending practices of large and small banks. Journal of Financial Economics, 76, 237-269.
Berle, Adolph, and Gardiner Means. (1932) The Modern Corporation and Private Property. New York. Macmillan Publishing Co.
Brickley, James, James Linck, and Clifford Smith Jr. (2003) Boundaries of the firm: evidence from the banking industry. Journal of Financial Economics, 70, 351-383.
DeYoung, Robert, and Iftekar Hasan. (1998) The Performance of De Novo Commercial Banks: A Profit Efficiency Approach. Journal of Banking and Finance, 22, 565-587.
Gilbert, Alton, and Gilbert Wheelock. (2007) Measuring Commercial Bank Profitability: Proceed with Caution. Federal Reserve Bank of St. Louis Review, November/December, 515- 532.
Graham, John, and Campbell Harvey. (2001) The theory and practice of corporate finance: evidence from the field. Journal of Financial Economics, 60, 187-243.
Heckman, James. (1979) Sample Selection Bias as a Specification Error. Econometrica, 47, 153-161.
Hein, Scott, Timothy Koch, and Scott MacDonald. (2005) On the Uniqueness of Community Banks. Federal Reserve Bank of Atlanta Economic Review, 90(1), 15-36.
Hodder, Leslie, Mary Lea McAnally, and Connie Weaver. (2003) The Influence of Tax and Nontax Factors on Banks Choice of Organizational Form. The Accounting Review, 78 (1), 297- 325.
Jensen, Michael, and William Meckling. (1976) Theory of the firm: managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3 (4), 305-360.
Mehran, Hamid, and Michael Suher. (2009) The Impact of Tax Law Changes on Bank Dividend Policy, Sell-offs, Organizational Form, and Industry Structure. Federal Reserve Bank of New York Staff Report No. 369, April.
Miller, Merton. (1976) Debt and Taxes. The Journal of Finance, 32 (2), 261-275.
Modigliani, Franco, and Merton Miller. (1958) The Cost of Capital, Corporate Finance, and the Theory of Investment. American Economic Review, 48, 261-297.
Modigliani, Franco, and Merton Miller. (1963) Corporate Income Taxes and the Cost of Capital: A Correction. American Economic Review, 53, 433-443. 29
Scott, James. (1976) A Theory of Optimal Capital Structure. The Bell Journal of Economics, 7 No. 1, 33-54. 30
Table 1 Demographic Characteristics of S Corporation and C Corporation Banks by Year S Corporation banks are those indicated in the FFIEC call reports for each year. C Corporation banks are those that have total assets in each year no greater than the total assets of the largest S Corp. bank that year. Rural banks are those not located in SMAs. Adjusted Capital is equity divided by the difference between total assets and non-interest bearing deposits. 1999 S Corporation Banks C Corporation Banks Minimum Mean Maximum Minimum Mean Maximum Number of banks 1034 5315 Percent in rural locations 0.0000 0.6905 1.0000 0.0000 0.5883 1.0000 Percent state- chartered 0.0000 0.7631 1.0000 0.0000 0.7466 1.0000 Total Assets (TA in $000s) 6587 91686 1771333 2306 153191 1729259 Trust Preferred Stock x 1000 /TA 0.0000 0.0000 0.0000 0.0000 0.0082 3.9766 Tier 1 Capital/TA 5.29 9.33 21.40 5.28 9.79 22.09 Adjusted Capital/TA 5.72 10.76 25.80 5.56 11.19 26.90
2000 Number of banks 1164 5027 Percent in rural locations 0.0000 0.7079 1.0000 0.0000 0.5753 1.0000 Percent state- chartered 0.0000 0.7663 1.0000 0.0000 0.7513 1.0000 Total Assets (TA in $000s) 5899 96776 2353746 4304 173986 2306571 Trust Preferred Stock x 1000 /TA 0.0000 0.0018 2.0471 0.0000 0.0057 3.3947 Tier 1 Capital/TA 5.91 9.88 22.65 5.86 10.12 22.70 Adjusted Capital/TA 6.63 11.39 25.91 6.14 11.56 26.66 2001 Number of banks 1194 4433 Percent in rural locations 0.0000 0.6993 1.0000 0.0000 0.5552 1.0000 Percent state- chartered 0.0000 0.7563 1.0000 0.0000 0.7528 1.0000 Total Assets (TA in $000s) 6470 109847 2354825 4342 198900 2328256 Trust Preferred Stock x 1000 /TA 0.0000 0.0000 0.0000 0.0000 0.0011 1.4106 Tier 1 Capital/TA 5.81 9.98 22.58 5.78 10.06 22.57 Adjusted Capital/TA 6.34 11.53 29.26 6.01 11.51 29.00 31 Table 1 cont. S Corporation Banks C Corporation Banks Minimum Mean Maximum Minimum Mean Maximum 2002 Number of banks 1356 4281 Percent in rural locations 0.0000 0.6888 1.0000 0.0000 0.5445 1.0000 Percent state- chartered 0.0000 0.7471 1.0000 0.0000 0.7585 1.0000 Total Assets (TA in $000s) 6935 114168 2171743 4570 209240 2164971 Trust Preferred Stock x 1000 /TA 0.0000 0.0000 0.0000 0.0000 0.0007 1.2205 Tier 1 Capital/TA 6.31 10.27 22.94 6.23 10.35 23.08 Adjusted Capital/TA 6.80 11.84 26.92 6.60 11.84 50.03 2003 Number of banks 1535 4319 Percent in rural locations 0.0000 0.6912 1.0000 0.0000 0.5355 1.0000 Percent state- chartered 0.0000 0.7459 1.0000 0.0000 0.7627 1.0000 Total Assets (TA in $000s) 7618 121829 2343666 4652 224696 2326807 Trust Preferred Stock x 1000 /TA 0.0000 0.0000 0.0000 0.0000 0.0003 0.3190 Tier 1 Capital/TA 6.06 10.12 23.89 6.03 10.32 24.32 Adjusted Capital/TA 6.85 11.78 29.95 6.54 11.88 85.35 2004 Number of banks 1674 4280 Percent in rural locations 0.0000 0.6864 1.0000 0.0000 0.5343 1.0000 Percent state- chartered 0.0000 0.7522 1.0000 0.0000 0.7754 1.0000 Total Assets (TA in $000s) 7114 131553 2642138 4486 247304 2612423 Trust Preferred Stock x 1000 /TA 0.0000 0.0000 0.0000 0.0000 0.0004 0.7629 Tier 1 Capital/TA 6.23 10.07 23.65 6.19 10.42 23.71 Adjusted Capital/TA 6.64 11.79 30.43 6.50 12.04 34.11 2005 Number of banks 1752 4192 Percent in rural locations 0.0000 0.6832 1.0000 0.0000 0.5270 1.0000 Percent state- chartered 0.0000 0.7637 1.0000 0.0000 0.7732 1.0000 Total Assets (TA in $000s) 7946 143671 2896153 6028 269002 2846117 Trust Preferred Stock x 1000 /TA 0.0000 0.0007 1.1727 0.0000 0.0006 0.9255 Tier 1 Capital/TA 6.08 9.89 22.96 6.07 10.40 24.18 Adjusted Capital/TA 6.78 11.67 52.33 6.36 12.16 80.58 32 Table 1 cont. S Corporation Banks C Corporation Banks Minimum Mean Maximum Minimum Mean Maximum 2006 Number of banks 1843 3942 Percent in rural locations 0.0000 0.6810 1.0000 0.0000 0.5259 1.0000 Percent state- chartered 0.0000 0.7701 1.0000 0.0000 0.7764 1.0000 Total Assets (TA in $000s) 8482 158462 2825566 5808 296181 2798781 Trust Preferred Stock x 1000 /TA 0.0000 0.0000 0.0000 0.0000 0.0000 0.0042 Tier 1 Capital/TA 6.21 10.13 24.81 6.19 10.61 25.24 Adjusted Capital/TA 6.78 11.96 93.38 6.56 12.27 46.56 2007 Number of banks 1932 3772 Percent in rural locations 0.0000 0.6806 1.0000 0.0000 0.5260 1.0000 Percent state- chartered 0.0000 0.7816 1.0000 0.0000 0.7914 1.0000 Total Assets (TA in $000s) 8717 173278 3461644 6583 312544 3431010 Trust Preferred Stock x 1000 /TA 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 Tier 1 Capital/TA 6.23 10.37 30.40 6.11 11.04 32.26 Adjusted Capital/TA 6.83 12.13 50.19 6.72 12.66 51.86 2008 Number of banks 2026 3585 Percent in rural locations 0.0000 0.6846 1.0000 0.0000 0.5180 1.0000 Percent state- chartered 0.0000 0.7764 1.0000 0.0000 0.7986 1.0000 Total Assets (TA in $000s) 8835 180477 3480952 6123 321061 3440854 Trust Preferred Stock x 1000 /TA 0.0000 0.0029 3.3070 0.0000 0.0071 4.2775 Tier 1 Capital/TA 5.54 10.28 26.37 5.34 10.72 27.69 Adjusted Capital/TA 5.86 11.98 37.27 5.47 12.22 38.32
33 Table 2 Means and t-tests for differences in means for S Corporation banks versus C Corporation banks from 1999 through 2008.
Variable S Corp. Bank (N = 15,637) C Corp. Banks (N = 44,360)
t-statistic for difference in means Wilcoxon z-stat. for median differences Mean Median Mean Median Profitability EBTROA (%) 1.4563 1.4727 1.2944 1.3342 25.70** 25.04** EBTROE (%) 15.0726 14.9521 13.2300 13.2124 25.46** 27.48** ROA (%) 1.4196 1.4297 0.9007 0.9399 90.34** 97.81** ROE (%) 14.6892 14.5353 9.1809 9.3156 87.03** 94.33** NIM 0.0438 0.0431 0.0421 0.0414 21.76** 22.78** Dividends/Pre-Tax Income 0.6703 0.6611 0.2829 0.2203 114.80** 121.58** Profit Growth (3 year) 0.1303 0.0990 0.0899 0.0674 8.71** 18.26**
Capital Ratios Equity/Total Assets (%) 10.0655 9.3745 10.3230 9.5531 -9.84** -8.19** Tier 1 Capital/Risk-wt. Assets (%) 14.9138 13.2210 15.3695 13.3231 8.01** -2.90** Adjusted Capital Ratio (%) 11.7700 10.9803 11.8856 11.0174 -3.55** -1.25 (Sub. Debt & Pref. Stock)/Assets 0.0108 0.0000 0.0224 0.0000 -6.93** -9.73** (Pref. Stock/Total Assets)*100 0.0020 0.0000 0.0139 0.0000 -11.90** -11.86** Asset Growth (3 year) 0.0759 0.0542 0.1046 0.0706 -29.94** -28.28** Sample size is bank-years. The adjusted capital ratio is Equity/(Assets Non-Int. Deposits); EBTROA is earnings before taxes and extraordinary items, divided by total assets; EBTROE is earnings before taxes and extraordinary items, divided by total equity; ROA is return on assets defined as after-tax income divided by total assets; NIM is net interest margin defined as (Interest Income Interest Expense)/Earning Assets; past-due loans are those with promised principal an/or interest payments over 90 days past due, scaled by total assets. * and ** signify significant at the five- and one-percent level, respectively.
34 Table 3 First-stage Probit Regression with S Corporation Equal to One in the Year of Conversion, Zero Otherwise from 1999 to 2008. Raw Data Standardized Data estimate p-value estimate Rank INTERCEPT -2.0995 <.0001 -8.5834 13 BUILTIN 0.0443 0.0144 2.4475 16 LOSSCF 1.3029 <.0001 70.4270 2 AMT -33.5348 <.0001 -9.2139 12 DIVIDEND 109.4233 <.0001 81.7019 1 YR00 0.3384 <.0001 9.7241 11 YR01 0.4352 <.0001 13.3908 10 YR02 0.5653 <.0001 17.8328 9 YR03 0.6433 <.0001 20.5527 8 YR04 0.6958 <.0001 22.3730 7 YR05 0.7564 <.0001 23.6375 6 YR06 0.8630 <.0001 25.3079 5 YR07 0.9146 <.0001 27.3832 4 YR08 0.9071 <.0001 28.9808 3 RURAL -0.0275 0.1040 -1.6272 17 AGE 0.0009 <.0001 4.5000 15 LNASSETS -0.0618 <.0001 -7.9231 14 The sample is size-constrained such that the C Corporation banks are no larger than the largest S Corporation bank in year t. Sample size is S Corporation = 15,637 and C Corporation. = 44,360 bank-years. BUILTIN is market less book value of investment securities, scaled by assets; LOSSCF is one if the prior three years losses are greater than this years profit, zero otherwise; AMT is the prior three years tax-exempt income scaled by assets; DIVIDEND is the proportion of dividends to pre-tax income; YRXX is an indicator equal to one in year XX and zero otherwise, with 1999 the omitted group; RURAL is an indicator variable equal to one if the bank is not in a MSA; AGE is bank age in years since charter; and LNASSETS is the log of total assets.
35 Table 4 Second Stage 2SLS regressions for performance and capital structure from 1999 through 2008. CAPRATIO(%) EBTROA (%) ROA (%) Variable estimate p-value estimate p-value estimate p-value Intercept 17.8927 <.0001 -1.2617 <.0001 -0.8329 <.0001 SUBS -0.8090 <.0001 0.4244 <.0001 0.7384 <.0001 YR00 0.4743 <.0001 -0.0234 0.0203 -0.0145 0.0665 YR01 0.5152 <.0001 -0.1473 <.0001 -0.1052 <.0001 YR02 0.9007 <.0001 -0.0571 <.0001 -0.0346 <.0001 YR03 0.9153 <.0001 -0.1816 <.0001 -0.1281 <.0001 YR04 1.1158 <.0001 -0.2618 <.0001 -0.1842 <.0001 YR05 1.2136 <.0001 -0.2743 <.0001 -0.1918 <.0001 YR06 1.5996 <.0001 -0.3375 <.0001 -0.2408 <.0001 YR07 1.9252 <.0001 -0.4689 <.0001 -0.3369 <.0001 YR08 1.8724 <.0001 -0.7179 <.0001 -0.5271 <.0001 PUBLIC 0.0214 0.7119 0.0105 0.3982 -0.0079 0.4164 RURAL -0.3193 <.0001 0.1999 <.0001 0.1587 <.0001 DENOVO 1.5932 <.0001 -0.4005 <.0001 -0.2747 <.0001 AGE 0.0019 <.0001 -0.0011 <.0001 -0.0007 <.0001 ASSETGRO -2.4545 <.0001 -0.4293 <.0001 -0.3388 <.0001 PROFGRO -0.0199 0.3123 0.1750 <.0001 0.1313 <.0001 LNASSETS -0.1636 <.0001 0.2007 <.0001 0.1446 <.0001 LLR2TA -25.8605 <.0001 -87.9204 <.0001 -67.2011 <.0001 AGLOANS 1.5077 <.0001 0.0816 0.0004 -0.0206 0.2561 CNILOANS 0.0767 0.5528 0.2458 <.0001 0.1641 <.0001 LOAN2DEP -0.9991 <.0001 0.7053 <.0001 0.4091 <.0001 DD2AST -9.5724 <.0001 1.3757 <.0001 0.9126 <.0001 OTHCOREAST -4.7499 <.0001 -0.0908 <.0001 -0.1260 <.0001 PURLIABAST -8.4046 <.0001 -0.6273 <.0001 -0.4407 <.0001 PREF2AST -0.4226 <.0001 -0.1468 <.0001 -0.0973 <.0001 SUBD2AST -0.3564 <.0001 0.0061 0.6137 0.0032 0.7369 LAMBDA 0.1581 <.0001 -0.2284 <.0001 -0.1991 <.0001 Adj. R 2 0.1836 0.3613 0.4334 The sample is size-constrained such that the C Corporation banks are no larger than the largest S Corporation bank in year t. Sample size is S Corporation = 15,637 and C Corporation. = 44,360 bank-years. YRXX is an indicator equal to one in year XX and zero otherwise; SUBS equals one if a bank elects S Corp. status and zero otherwise; CAPRATIO is equity divided by assets; LNASSETS is the log of total assets; PUBLIC is an indicator equal to one if the bank is publicly traded; RURAL is an indicator equal to one if the bank is not in a MSA; DENOVO equals one if the bank is less than five years old and zero otherwise; AGE is bank age in years; ASSETGRO is the growth in assets averaged over the last three years; PROFGRO is the growth in profit averaged over the last three years; LLR2TA is loan-loss reserves to total assets; AGLOANS is agriculture loans to total loans; CNILOANS is commercial and industrial loans to assets; COREDEPS are core deposits to total deposits; LOAN2DEP is total loans to total deposits. SAV2AST and DD2AST are savings and demand deposits respectively, scaled by assets. SD2AST is subordinated debt to assets, PREF2AST is preferred stock to total assets; and SMCD2AST is the amount of CDs less than $100,000 to assets. LAMBDA is the inverse Mills ratio from the first-stage Heckman (1979) correction probit model.
36 Table 5 Means, medians, and tests for differences in means and medians for S Corporation banks from 3 years before to 3 years after S Corporation conversion. Sample size is the number of banks in year -3 or+3. The adjusted capital ratio is Equity/(Assets Non-Interest bearing Deposits); EBTROA is earnings before taxes and extraordinary items, divided by total assets; EBTROE is earnings before taxes and extraordinary items, divided by total equity; ROA is return on assets defined as after-tax income divided by total assets; NIM is net interest margin defined as (Interest Income Interest Expense)/Earning Assets; past-due loans are those with promised principal an/or interest payments over 90 days past due, scaled by total assets. * and ** signify significant at the five- and one- percent level, respectively.
Before Conversion (N = 1,563) After Conversion (N = 1,563) After minus before After minus before
Variable
Mean
Median
Mean
Median t-statistic for difference in means Wilcoxon z-stat. for median differences Profitability EBTROA (%) 1.7189 1.7064 1.5576 1.5487 7.41** 7.42** EBTROE (%) 17.6473 17.0585 15.8325 15.6697 7.49** 7.09** ROA (%) 1.1888 1.1732 1.5257 1.5079 -18.23** -18.31** ROE (%) 12.1718 11.8558 15.5224 15.2599 -16.45** -16.17** NIM 0.0466 0.0457 0.0451 0.0443 4.98** 4.85** Dividends/Pre-Tax Income (%) 36.5086 31.0485 68.1923 66.8441 -27.26** -29.00** Profit Growth (3 year) 0.1029 0.0666 0.1218 0.0903 -1.31 -4.11**
Capital Ratios Equity/Total Assets (%) 10.2476 9.4730 10.2337 9.6029 0.14 -0.99 Tier 1 Cap./Risk-wt. Assets (%) 15.7951 13.9834 15.0261 13.4138 2.21* 2.02* Adjusted Capital Ratio (%) 11.7625 10.9604 11.8728 11.1383 -0.93 -1.78 Sub. Debt & Pref. Stock/Assets 0.0000 0.0000 0.0000 0.0000 0.63 0.38 (Pref. Stock/Total Assets)*100 0.0670 0.0000 0.0000 0.0000 1.68 2.65** Asset Growth (3 year) 0.0749 0.0542 0.0711 0.0570 1.23 -0.58 Sample size is the number of banks in year -3 or+3. The adjusted capital ratio is Equity/(Assets Non-Interest bearing Deposits); EBTROA is earnings before taxes and extraordinary items, divided by total assets; EBTROE is earnings before taxes and extraordinary items, divided by total equity; ROA is return on assets defined as after-tax income divided by total assets; NIM is net interest margin defined as (Interest Income Interest Expense)/Earning Assets; past-due loans are those with promised principal an/or interest payments over 90 days past due, scaled by total assets. * and ** signify significant at the five- and one-percent level, respectively.
37 Table 6 Means, medians, and tests for differences in means and medians for S Corporation banks from 3 years before to 3 years after S Corporation conversion adjusted by subtracting the yearly mean or median for all banks.
Before Conversion (N = 1,563) After Conversion (N = 1,563) After minus before After minus before
Variable
Mean
Median
Mean
Median t-statistic for difference in means Wilcoxon z-stat. for median differences
Profitability EBTROA (%)- t
0.1064 0.0899 0.1682 0.1514 2.90** 3.10** EBTROE (%)- t
0.8027 0.2415 1.7952 1.5588 4.19** 4.67** ROA (%)- t
0.0438 0.0337 0.4468 0.4253 22.21** 21.59** ROE (%)- t
0.2370 -0.0860 4.6411 4.3802 22.04** 21.05** NIM - t
0.0559 -0.0497 0.1944 0.1234 4.68** 5.44** Dividends/Pre-Tax Income (%)- t
0.0000 0.0000 -0.0001 -0.0001 -3.22** -47.99** (Pref. Stock/Total Assets)*100- t
-0.0010 -0.0025 -0.0001 -0.0001 -2.29* -46.14** Asset Growth (3 year %) - t
-0.0196 -0.0394 -0.0313 -0.0461 -3.85** -3.98** * and ** signify significant at the five- and one-percent level, respectively.
38
Figure 1: S Corporation banks from 1999 to 2008 as a proportion of all banks that have asset size equal to or less than the largest S Corporation bank for each year. All data are from the Call Reports at year end.