Basel III could be the last straw for countless S corporation banks as they mull their futures.

Banks would be required by Basel III to hold a certain level of capital; failure to do so could result in a prohibition against paying dividends to shareholders. Dividends are critical to those investors, who rely on the payments to cover tax obligations if the bank is profitable.

For that reason, S Corp banks believe they face a greater burden under Basel III than C corporations, where the company is taxed for its profit. Concerns also exist that the proposed rules could force more S Corps to delay growth plans or opt to sell themselves.

"Community banks are slowly being euthanized," says E. David Locke, chairman and chief executive of McFarland State Bank in Wisconsin. Basel III "is just another example. There is an unintended consequence with this rule."

Basel III will require banks to have a common equity Tier 1 capital ratio of 4.5% plus a 2.5% capital conservation buffer. Banks that fall below 7% can have their ability to deploy capital, like paying dividends or bonuses, limited. S Corp shareholders are responsible for paying their share of the company's profits on their personal tax returns.

Shareholders would have to pay those taxes out of pocket if a profitable S Corp is barred from paying dividends to cover their costs. That burden could discourage some people from investing in S Corps, industry experts say.

First Fidelity Bank in Oklahoma City would "maybe be forced to sell" if it is barred from paying tax-distribution dividends, says Lee Symcox, the $1.4 billion-asset bank's president and chief executive. He says his family, which has been involved with First Fidelity for decades, has "reinvested all of the money back into the bank so we don't have a lot of cash reserves that we can pull from."

"When the IRS comes knocking on your door, you don't have a lot of options," Symcox says.

S Corp banks often struggle to raise capital because of their small size and restrictions on the number and type of shareholders they can have, says Chip MacDonald, a lawyer at Jones Day. "In today's world, access to capital is just as important as having the capital," he says.

Some banks are delaying acquisitions to bulk up capital reserves so they won't dip below the capital conservative buffer, says Bob Wray, president and chief executive of Capital Corporation, which offers consulting and investment banking services.

"S Corp banks don't want to be put in a position where they run into problems with not being able to make tax distributions to shareholders," Wray says. "Some that have been buyers in the past have expressly stated that they will wait to build capital."

First Fidelity may alter how it pays dividends so shareholders can build up larger cash reserves in case the bank is unable to pay dividends in the future, Symcox says. This step "just slows growth for community banks" and could "impact the availability of loans in a community," he says.

If the rule is implemented, more S Corps could choose to switch to a C Corp structure. But this could also cause more banks to consider selling, says Patrick Kennedy Jr., president of the Subchapter S Bank Association. The C Corp structure "isn't an effective structure for a closely held bank since you are basically double taxed and you're competing against credit unions that aren't taxed at all," he says.

Bank trade groups want regulators to tweak the rule to let S Corp banks pay dividends to shareholders to cover taxes equivalent to the taxes paid by C Corp banks, says Bob Davis, an executive vice president at the American Bankers Association. Absent this fix, S Corps will be treated differently than other banks and will actually hoard much more capital.

"This is a failure of the agencies to understand how one of their institutional structures operates," Davis says. "We aren't asking for an unlimited way to pay dividends out."

Generally, regulators are focused on "evaluating the capital levels and safety and soundness of the banking organization," the Federal Reserve Board and the Office of the Comptroller of the Currency said in their final rule. S Corps will still be able to pay limited dividends if they fall within a certain level of the capital conservation buffer.

Still, S Corp banks, like other smaller institutions, are discouraged by higher compliance costs, observers say. The roughly 2,200 S Corp banks tend to be smaller banks and, as a result, have been hit hard by rising regulatory costs, says George Scharpf, president and chief executive of Amboy Bank, a unit of Amboy Bancorp. in Old Bridge, N.J. It often seems as though regulation meant for bigger banks is trickling down to smaller institutions, he says.

"Banks are looking to spread that cost over larger companies," Scharpf says. Added regulation "is a reason why smaller banks will move to consolidation."

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