Preferred Stock

Preferred stock is a form of equity in which investors’ claims are senior to those of common stockholders. As with common stock, preferred stock pays nondeductible dividends out of after-tax dollars. One significant difference is that corporate investors in preferred stock pay taxes on only 20 percent of dividends. For this reason, institutional investors dominate the market. New issues are effectively restricted to large, well-known banking organizations that are familiar to institutional investors, while smaller banks are excluded.

Since 1982 preferred stock has been an attractive source of primary capital for large banks. Most issues take the form of adjustable-rate perpetual stock. The dividend rate changes quarterly according to a Treasury yield formula. Investors earn a return equal to some spread above or below the highest of the 3-month Treasury bill rate and the 10 - or 20 -year constant maturity Treasury rates.

Investors are attracted to adjustable-rate preferred stock because they earn a yield that reflects the highest point on the Treasury yield curve under all market conditions. This removes guesswork as to whether short-term yields will move more or less than long-term yields and whether they will all move in the same direction. Unlike fixed-rate issues, these securities trade close to par and thus are more liquid. They effectively represent 3-month securities and have been sold to individuals as well as to corporations.

Preferred stock has the same disadvantages as common stock, but there are instances when it is more attractive. First, if a bank’s common stock is priced below book value and has a low price-to-earnings ratio, new equity issues dilute earnings. This earnings dilution is less with perpetual preferred stock than with common stock, so that the cost of common shares is relatively higher. Second, aggregate dividend payments on preferred stock will be less than dividends on common stock over time for any bank that regularly increases common stock dividends.

Common stock

Common stock is preferred by regulators as a source of external capital. It has no fixed maturity and thus represents a permanent source of funds. Dividend payments are also discretionary, so that common stock does not require fixed charges against earnings.

Common stock is not as attractive from the bank’s perspective due to its high cost. Because dividends are not tax-deductible, they must be paid out of after-tax earnings. They are also variable in the sense that shareholders expect per-share dividend rates to rise with increases in bank earnings. Transactions costs on new issues exceed comparable costs on debt, and shareholders are sensitive to earnings dilution and possible loss of control in ownership. Most firms wait until share prices are high and earnings performance is strong before selling stock.

Issuing common stock is frequently not a viable alternative for a bank that needs capital. If the current share price is far below book value, new issues dilute the ownership interests of existing shareholders. Stocks of the largest banks are traded in national markets with substantial liquidity. Bank managers attempt to increase share prices through strong earnings, consistent dividend policy, and adequate disclosure of performance to security analysts. Even with these efforts, however, stock prices often fall with adverse economic conditions or disfavor in the industry market.

Small bank stocks are traded over the counter, with far fewer annual transactions. Still, a market for new issues does exist within local communities. Banks can often sell new shares to existing stockholders or current customers. Share prices are less volatile but are sensitive to deviations in current versus historical earnings.