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Home > Bank Resources > Bank Resources Publications > SRC Insights > 2002 > Fourth Quarter

SRC Insights: Fourth Quarter 2002

To Pay or Not to Pay: Section 60 Dividend Calculations

by Salome J. Tinker, CPA

Salome J. Tinker is a Senior Financial Analyst with the Accounting Policy Section of the Federal Reserve Board's Division of Banking Supervision and Regulation in Washington, D.C.

The views expressed in this article are the author's and do not necessarily represent official positions of the Board of Governors of the Federal Reserve System.

Dividend payments to shareholders play an important role in a society with a free market economy. Prospective shareholders will not invest in a corporation unless they expect to receive an adequate return on their investment. Dividend payments to shareholders typically send a positive statement to shareholders that the company is doing well. An institution that historically pays dividends may make a management decision to pay dividends over its retained net profits during down times, if deemed temporary in nature, as to not send mixed signals to its shareholders. However, as dividend payments reduce capital levels, the capital adequacy of banking organizations is a major concern of the Federal Reserve System and the other banking agencies, which strive to maintain the overall safety and soundness of the banking system.

In order to ensure that dividend payments are reasonable, limitations have been put in place to monitor and control the outflow of capital. Three methods are: the prompt corrective action (PCA) guidelines, which control capital levels from a balance sheet perspective; ¹ the section 60 dividend payment limitation, which limits the outflow of capital from the income statement perspective; and the section 56 dividend payment limitation, which establishes restrictions on dividends based on bank's undivided profits. ² These three methods work in tandem, each playing a key factor in monitoring banks' safety and soundness by ensuring that adequate capital levels are maintained. This article focuses on the computation of the section 60 dividend limitations.

From time to time Federal Reserve staff receives questions from examiners on a bank's calculation of its section 60 statutory dividend limitation. Usually the questions pertain to a bank's estimation of allowable dividends available, without Federal Reserve approval, when the dividends are expected to be greater than the net income for the current and/or previous year(s). For state member banks, Regulation H provides for a simplified computation of the section 60 limitation. Regulatory approval is required if the dividend would exceed the bank's retained net income for the current and prior two years or if the dividend would not be made from the bank's undivided profits.³ This article clarifies the existing Federal Reserve regulations on the payment of dividends by state member banks and provides an additional tool for analyzing whether prior Federal Reserve approval is required.

The dividend computation worksheet is found in the Commercial Bank Examination Manual (CBEM), which was revised in 2002. ⁴ The revision was made in accordance with Regulation H current guidelines, and not based on any new guidance.⁵ The purpose of the revision was to clarify the existing guidance and provide examiners with a revised worksheet for assessing whether an institution can pay dividends without prior Federal Reserve approval. The previous computation did not clearly provide for dividend adjustments that were carried back in previous years. As a result, new line items were inserted to clarify that prior year's net income and adjustments should be considered when calculating the current year's retained net profits available for dividend distribution.

The following example illustrates how to determine whether prior Federal Reserve approval is needed for a dividend distribution. ⁶ Assume XYZ institution has the following earnings and dividend activity for two years:

In 2001, XYZ net income dropped to $6 million. However, XYZ wanted to declare an $11 million dividend. Under section 60, $6 million of the $11 million dividend would be allowable based on the current year's net income. XYZ must then determine whether the excess $5 million can be paid (or carried back) based on the prior two years retained earnings. Since the guidance states that the institution should carry the excess first to the earlier year and then to the immediately preceding year, the institution carries back $4 million of excess to 1999, thereby depleting all of 1999's retained net profit. XYZ then carries back the remaining $1 million to 2000, leaving $1.1 million in retained earnings that the institution's management could still utilize for dividend payments in 2002. In this scenario, the institution would not need prior Federal Reserve approval to pay this dividend.

The following table summarizes how a bank would determine whether Federal Reserve approval would be needed for this dividend and the amount of retained earnings available from prior years for potential dividends in 2002:

The 2001 section 60 worksheet computation is below:

Assume that in 2002, XYZ institution reports $3 million in earnings and wants to pay a $4 million dividend. Could the institution pay this dividend without prior Federal Reserve approval?

The following table summarizes how a bank would determine whether Federal Reserve approval would be needed for this dividend and the amount of retained earnings available for potential dividends in 2003 from prior years:

At first glance, the answer may appear to be "yes, Federal Reserve approval is required" because XYZ institution paid dividends in excess of retained net profits in 2001. However according to the calculation, XYZ can still pay the $4 million in dividends without prior Federal Reserve approval. The sum of $4,100,00 current and prior year's earnings—$3 million from the current year plus $1.1 million from 2000 retained net profits—is still available for XYZ to distribute. In making the determination, XYZ's management and Federal Reserve examiners should be mindful of the previous two years' calculations and the order in which any adjustments were made. Remember the dividends in excess of retained net profits for 2002 should be first applied to the earlier year, which is 2000. The fact that 2001 had zero retained earnings does not enter the calculation because there were enough profits in 2000 to absorb the excess of dividends over current net income. The section 60 worksheet for 2002 would be calculated as follows:

In addition to the 2002 adjustment made, an additional adjustment was required for retained net profits in 2000. ⁷ Although XYZ still has a balance of $100,000 in 2000, it could no longer utilize this amount after 2002 since the two-year carryback period would have passed. Consequently, Federal Reserve approval would be needed both in 2003 and 2004 if XYZ wanted to pay dividends in excess of net profits because adjusted net profits for 2001 and 2002 are $0.

To reiterate, the changes made to the CBEM did not occur because of any recently issued guidance by the Federal Reserve, but rather to clarify existing guidance. When regulatory approval is required for dividend payments under section 60, institutions should submit the request to the appropriate Reserve Bank for approval. Both examiners and bank management should remember that the section 60 dividend worksheet is a tool that helps examiners assess the safety and soundness of banking institutions and should be used in conjunction with the PCA guidelines and section 56 limitations.

• ¹ Section 208.4 of Regulation H prohibits the payment of dividends when a bank is deemed to be undercapitalized or when the payment of the dividend would make the bank undercapitalized in accordance with the PCA framework. An organization that is undercapitalized in accordance with the PCA framework must cease the payment of dividends for as long as it is deemed to be undercapitalized. PCA guidance is also provided in section 4070, "Dividends," of the Commercial Bank Examination Manual (CBEM).
• ² Bank's undivided profits are adjusted for any surplus transferred, with prior regulatory approval, back to undivided profits and the excess, if any, of statutory bad debts over the allowance for loan and lease losses. Dividends paid in excess of the section 56 limitation must receive prior Federal Reserve approval and approval of at least two-thirds of the shares of each class of stock outstanding, pursuant to 12 USC 59. The section 56 computation worksheet is also provided in section 4070.3 of the Comercial Bank Examination Manual (CBEM).
• ³ Section 208.5(2)(c) of Regulation H states, "A member bank may not declare or pay a dividend if the total of all dividends declared during the calendar year, including the proposed dividend, exceeds the sum of the bank's net income (as reportable in the Reports of Condition and Income) during the current calendar year and the retained net income of the prior two calendar years, unless the dividend has been approved by the Board."
• Section 208.5(3) of Regulation H states, "In the case of dividends in excess of net income for the year, a bank generally is not required to carry forward negative amounts resulting from such excess. Instead, the bank may attribute the excess to the prior two years, attributing the excess first to the earlier year and then to the immediately preceding year. If the excess is greater than the bank's previously undistributed net income for the preceding two years, prior Federal Reserve approval is required and a negative amount would be carried forward in future dividend computations."
• ⁴ The Commercial Bank Examination Manual
• ⁵ In 1990, the Federal Reserve Board amended its regulations on the payment of dividends by state member banks. The objective was to simplify and clarify the computation of certain limitations on the payments of dividends included in 12 USC section 56 and 60. Section 208.5 of Regulation H was later revised in 1998, which provided further clarification on deficits that result from dividends declared in excess of net income. The change was incorporated based on an interpretation made in an OCC letter dated December 22, 1997, and published as Interpretative Letter # 816.
• ⁶ The following dollar amounts in this example are used to illustrate various outcomes for the sake of this article. Occurrences experienced by a bank of this magnitude would be unusual and infrequent in nature.
• ⁷ If XYZ recorded a net loss of $100,000 in 2002, but wanted to pay dividends of $1,000,000, the $100,000 loss and the $1,000,000 dividend could be carried back to 2000, leaving an adjusted retained net profit balance of $0.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.