Measuring Commercial Bank Profitability: Proceed With Caution

Abstract

The Federal tax code creates challenges for comparing the profit rates of different banks on a consistent basis. The earnings of banks that elect to operate under Subchapter S of the Federal tax code are not subject to the Federal corporate income tax, but S-bank shareholders are taxed on their pro rata share of the entire earnings of the bank. The number of banks electing Subchapter S tax treatment has increased rapidly, especially among small banks. Using estimates of the Federal corporate income tax that S-banks would pay if they were subject to the tax, this article shows that differences in the tax treatment of S-banks and other banks has a large impact on measures of U.S. banking system profitability. Further, the article shows that adjustment of S-bank earnings by estimates of Federal income taxes to make them comparable with the earnings of other banks can markedly affect conclusions of studies that use net income as a measure of performance. Finally, the article shows that S-banks tend to out-earn their peers even if S-bank earnings are reduced by estimated Federal taxes, and that S-banks also tend to have higher earnings rates than their peers in the year before they elect S-bank status.