When Nobel laureate Merton Miller was asked whether capital structure matters for banks, he answered, "Yes and no."
In the real world, where bankers say FDIC stands for "Forever Demanding Increased Capital," the answer is an unambiguous and resounding: "Yes, capital structure does matter!"
Bank holding companies and other corporations have found a new way to play the capital-structure game that lets them have their cake and eat it, too. It permits them to issue equity-like instruments with tax-deductible dividends.
The ingredients in these sweet deals have generated a new set of acronyms to master: Mips, Quips, Toprs and Trups, (pronounced "troops"). These stand for monthly income preferred stock, quarterly income preferred stock, trust originated preferred securities, and trust-preferred stock, respectively.
To simplify the discussion we will call these hybrid instruments "capital securities" or, using the term bank regulators seem to favor, "trust-preferred."
These securities offer several advantages to bank holding companies:
Trust-preferred counts as Tier 1 capital for bank holding companies- but only up to a maximum of 25%, which could be reduced to 15% if Basel- based regulators have their way. In addition, rating agencies such as Moody's and Standard & Poor's count the securities as equity capital.
Based on an IRS ruling, the structure of a capital-securities offering makes the interest payments to a special-purpose subsidiary or vehicle tax- deductible to the parent.
The sole reason for the vehicle's existence is to issue the hybrid securities and channel the funds to the parent as a loan.
If a trust-preferred dividend payment is missed, investors cannot force the issuer into bankruptcy.
The payment of dividends by the subsidiary can be deferred for up to five years, provided the parent is not in default under the loan agreement.
The securities can be issued at a lower cost than common equity.
On balance, capital securities have the tax advantage of debt while counting toward the parent company's risk-based capital requirements but not creating the potential for bankruptcy from a missed dividend payment.
Exxon issued the first Mips in October 1993, but it wasn't until Oct. 21, 1996-when the Federal Reserve ruled that bank holding companies could count capital securities as Tier 1 capital-that banks jumped on the bandwagon.
Since then, banking companies, mainly the large ones, have raised more than $20 billion from such issues, conservatively estimated to be roughly one-half the total raised by all corporations.
During this period many banks also were buying back shares and, to a lesser extent, retiring notes and debentures or issuing trust-preferred instead of notes and debentures or ordinary preferred stock.
Given the benefits described above, bank holding companies' motivations for restructuring their capital positions are obvious. However, the 25% constraint on these securities' share of Tier 1 capital is an impediment that can kill the market for trust-preferred.
Moreover, if the Basel Committee has its way, capital securities will be limited to 15% of Tier 1 capital. This struggle between capital market innovations and bank regulators illustrates the persisting battle that shapes the financial services industry worldwide.
Alternatively, because the trust-preferred loophole permits the tax deductibility of "special dividends," one can view the use of these securities as a pure tax play.
However, if the IRS wants to reduce corporate tax rates across the board, it would be more efficient to simply cut the marginal tax rate. Of course, if the tax loophole were closed, that would kill the market for trust-preferred, except for grandfathered issues.
Large banking companies made extensive use of trust-preferred in 1996 and 1997, but the market dropped off substantially in 1998. Thousands of smaller banks lack any trust-preferred securities in their capital structures.
Why aren't they taking advantage of this innovative hybrid security?
Ignorance about the existence and potential advantages of this type of security.
The costs might exceed the benefits because security-issuance costs can be prohibitive for smaller banking organizations.
Institutional investors might not be interested in capital securities issued by banks without name recognition.
Smaller banking comnpanies could face discretionary capital requirements that discourage them from using innovative financial instruments that dilute the amount of pure equity in Tier 1 capital.
Ignorance and moral suasion obstacles notwithstanding, reduced security- issuance costs and access to retail investors might bring the market for trust-preferred to smaller banks.
Then they, too, could try to have their cake and eat it.