Pub. 13 2023-2024 Issue 3

Investment Subsidiaries Offer Solution For Municipal Securities

A large number of community banks have purchased General Market (GM)/Non-Bank-Qualified tax-exempt municipal securities for their investment portfolio over the past 5-10 years. General Market munis offer an attractive yield/spread over comparable Bank Qualified (BQ) munis, and up until recently, the historically low-cost-of-funds environment for banks mitigated the federal TEFRA penalty imposed on General Market munis. However, the significant increase in interest rates over the past year and a half makes the purchase of General Market munis much less attractive unless banks consider forming an investment subsidiary to hold them.


In the early 1980s, the U.S. Congress enacted the Tax Equity and Fiscal Responsibility Act (TEFRA), which levied a penalty on community banks seeking tax-free income through municipal bonds, limiting the amount of tax-free income earned on these investments. The federal government felt the banking industry was “double-dipping” — earning tax-free income on munis while enjoying a deductible business expense for interest paid on deposits funding these investments.

TEFRA Haircut Calculation is a function of 3 areas:

  1. TEFRA haircut (20% for BQ or 100% for GM)
  2. Federal tax rate
  3. Bank cost of funds

BQ TEFRA Haircut Formula: 20% (TEFRA disallowance) * 21% (tax rate) * 2.50% (cost of funds) = 0.11%

BQ TEFRA-Impact: (3.50% – 0.11%) / (1 – 21%) = 3.39% / 0.79% = 4.29% TEY
BQ Not Subject to TEFRA: 3.50% / (1 – .21%) = 3.50% / 0.79% = 4.43% TEY (+14 bps)

GM TEFRA Haircut Formula: 100% (TEFRA disallowance) * 21% (tax rate) * 2.50% (cost of funds) = 0.53%

GM TEFRA-Impact: (3.70% – 0.53%) / (1 – 21%) = 3.17% / .79% = 4.01% TEY
GM Not Subject to TEFRA: 3.70% / (1 – 21%) = 3.70% / 0.79% = 4.68% TEY (+67 bps)

General Market vs. Bank Qualified Municipal Bonds

To lessen the blow, Congress allowed a smaller penalty, or discount, to be applied for tax-exempt municipal bonds for a newly created subset of the muni market — BQ munis. BQ munis are for municipal bond issuers that issue no more than $10 million in tax-free bonds in any given calendar year. Congress set this qualification to provide a ready market for the “smallest issuers” in the muni marketplace, ensuring steady and permanent demand for those smaller towns and municipalities that qualified.

When TEFRA was enacted, a Bank Qualified muni issuer bringing $10 million to market was a considerable issue size, and these issuers made up approximately 30% of the entire municipal bond market. Today, the $10 million limit has not increased with inflation, so the Bank Qualified share of the entire tax-exempt muni market has declined to less than 5% of the total municipal bond market. Banks purchasing BQ bonds pay a premium to do so because only a limited number are issued. This premium has created a permanent yield advantage for General Market munis. The yield differential for comparable maturities and credit quality BQ munis vs. GM munis is generally 20-50 basis points.

Beyond a significantly better yield, the GM municipal market is superior to the BQ muni market in other aspects. The GM muni market is considerably larger, which creates greater liquidity and provides an opportunity to create a more diversified municipal portfolio since there is a much larger pool of municipalities that issue GM muni bonds. The larger pool also provides a significantly larger population of bonds with higher agency ratings. Also, GMs are not limited to the $10 million annual issuance limit that applies to BQs, giving banks the opportunity to purchase larger block sizes. Without this, most regional banks have avoided building large municipal bond portfolios. Finally, these bigger, more sophisticated municipalities with larger issues provide more complete, transparent and timely financial data to investors and ratings agencies.

This additional yield has enticed community banks to purchase GM munis over the past 10 years. During the same time period, banks have experienced a relatively low cost of funds, so banks have taken advantage of the steep municipal bond muni curve with less concern about how the TEFRA penalty could degrade their tax equivalent yield. Now, with the prospects of “higher for longer” interest rates, the penalty can meaningfully reduce a bank’s effective yield on new or existing GM municipal holdings.

An Investment Subsidiary Solution

In the current interest rate environment, banks are unable and unwilling to sell their GM munis and recognize losses. And as banks’ cost of funds continues to increase, the larger TEFRA penalty will greatly reduce the tax-equivalent yield on a bank’s GM muni portfolio. One solution is for a community bank to form a wholly-owned subsidiary to hold their GM municipals — a General Market Investment Subsidiary (GMI sub).

In 2007, the U.S. tax court ruled in PSB Holdings v. Commissioner of Internal Revenue that a bank investment subsidiary is not itself a “bank” and therefore is not subject to the TEFRA haircut for BQ or GM munis. This case resulted in banks with investment subs revisiting GM munis as a potential sector for investment. The court noted that, other than simply avoiding the TEFRA haircut, a bank must have a business purpose or reason for forming an investment sub, e.g., minimizing state taxes. The investment sub allows a bank to consolidate management of the investment portfolio, provide access to highly skilled investment officers (through the service provider it hired to manage its investment subsidiary) and provide greater purchasing power for portfolio services like custody and bond accounting.

Decision to Form a GMI Subsidiary

Banks have been utilizing investment subsidiaries for decades. In the current market environment, many banks may look to municipal bonds to enhance the yield of their portfolio. Banks with muni portfolios should evaluate forming an investment sub so that they can hold and build a GM muni portfolio. Interested community banks should always consult with their tax advisors and also with professionals experienced with forming and managing investment subs for banks.

Larry Wood is Executive Vice President — Financial Institutions Group for the KeyState Companies. He oversees KeyState’s Investment Advisory and Bank Investment Subsidiary group with over $16 billion in assets under management. Founded in 1991, KeyState manages tax-advantaged investment and insurance structures for over 120 financial institutions across the country. For more information, please contact Larry Wood at or visit

KeyState is not a tax advisor — please consult your bank’s tax advisor before proceeding with any strategy.

Picture of By the Colorado Bankers Association

By the Colorado Bankers Association