Fiscal Cliff Could Invoke More Special Dividends from Banks

Investors in a number of banks may get a little something extra in their stockings this holiday season as bankers look to return capital ahead of an expected spike in the dividend tax rate.

Some cash-rich banks are paying out special dividends in coming weeks, particularly those that are struggling to put capital to work for loan growth or acquisitions. Concerns that taxes on dividends could rise — an aftershock of the fast-approaching fiscal cliff — are providing added incentive for one-time payouts.

Banks are struggling to make money on new originations, says Jeffrey Harp, the president of Trinity Bank in Fort Worth, Texas. “You might as well give [the capital back] to shareholders rather than do something stupid with it like buying a branch or bank at a premium that makes no sense over the long term.”

Trinity recently said it would pay an extra $1 a share dividend next month that would be separate from its regular dividend of 20 cents. The $179.3 million-asset bank is growing and profitable, but Harp says it has accumulated more capital than it needs. Uncertainty over future tax rates contributed to the timing.
 
“We might as well do it now when we know what the tax rates are,” Harp says. “Next year, I don’t know what the rates will be but they’re going to be higher.”

If Congress fails to avoid the fiscal cliff, taxes will substantially increase across all corporate sectors and individuals, based on their tax bracket.

Under current statutes, the highest tax rate on ordinary income can increase to 39.6% from 35%, according to Bloomberg. The capital gains tax could rise to 23.8% from 15%.

“That’s a big deal as far as capital planning goes” for both banks and investors, says John Corbett, the president and chief executive of the $2.4 billion-asset CenterState Bank of Florida in Winter Haven.

Accountants largely agree that tax rates will climb, but there is no consensus among tax professionals on the amount of increase.

“Generally, everybody expects rates to go up next year,” says Janet Rapp, a managing partner at Orlando, Fla., accounting firm GellerRagans. Tax rates “will still be lower than ordinary but it will go back up to 20%” or more.

Banks with excessive capital, in particular, should consider issuing special dividends to attract and retain investors, industry observers say.
 
“Banking is such a low-yielding world, and there are so many institutions as well as individuals that need current income” says Jeff Davis, the managing director of the financial institutions group at Mercer Capital. “A special dividend may help keep some investors around.”

The median dividend payout ratio for community banks, or the percentage of earnings paid as dividends, was 26.4 during the third quarter, according to Sandler O’Neill & Partners. The ratio has increased slightly in recent quarters but is down 40% from three years earlier.

By and large, banks are continuing to hold onto more capital than they need because of concerns about higher capital required proposed by the Federal Reserve Board, says Frank Schiraldi, an analyst at Sandler O’Neill. “Banks certainly have greater dividend-paying capacity given the strength of current capital levels,” he says.

Longer-term capital concerns should limit the number of banks that announce special dividends, Schiraldi says, who believes that share repurchase programs are a better way to return capital.

“No one wants to get too aggressive on capital return until final regulatory capital rules are known for certain,” he says. Bankers “tend to believe that they don’t get credit for special dividends and so it is generally not a popular way to return capital.”

Still, Davis says the Fed may be more lenient with smaller banks in light of potential tax increases and a lack of reinvestment opportunities.

“My assumption is the Fed will show, perhaps, a little more flexibility with the small banks assuming the special dividend is not excessively large,” he says. “I suspect there’s going to be a decided minority of banks that pleasantly surprise shareholders by paying a special dividend” before the end of the year.