* Costs to rise under stricter supervision by Federal Reserve
* S&P warns of "operational risk" * Shares fall 5.2 percent
(Adds S&P comment, trading volumes, more background)
By Sharanya Hrishikesh and Ashutosh Pandey
Oct 10 (Reuters) - H&R Block Inc , the biggest U.S. tax preparer, said it is exploring strategic alternatives for its small banking operation to avoid a looming sharp rise in costs associated with the introduction of stricter supervision under the Dodd-Frank Act.
H&R Block, like other companies with small banking units, is under pressure to get out of the banking business to escape costly oversight by the U.S. Federal Reserve. Among the biggest exits, MetLife Inc agreed last year to sell its deposit business to General Electric Capital .
H&R Block Bank, which mainly provides banking services to the company's tax clients, had cash balances of $341 million as of July 31.
Continuing as a bank holding company under Fed supervision would restrict capital allocation decisions including share buybacks and acquisitions, H&R Block said in a regulatory filing. "Such regulatory constraints are inconsistent with our strategic plans, operational needs and growth objectives."
H&R Block's shares fell more than 5 percent in heavy trading, however, as investors worried that the loss of the bank would hurt revenue and detract from the company's ability to attract customers to its core tax preparation business.
Ratings agency Standard & Poor's warned of "operational risks", saying it was unclear how the company would provide services such as lines of credit without its bank.
"We believe these products ... not only contribute revenues, but also help attract customers to the company's core tax business," the agency said. S&P said it was expanding the scope of its negative ratings outlook on the company.
Morningstar analyst Vishnu Lekraj, who expects the company to sell the bank rather than launch an IPO or wind it down, said shedding the business would be "pretty positive" for the company, given the increased capital requirements.
But he too expressed concern about the company's ability to offer financial services to customers after 2013.
"I expect that there will be an agreement between (H&R Block) and whoever buys the banking operations. That entity will provide them the funding for any financial products they may need for a certain period at least," Lekraj said.
H&R Block, which has engaged Goldman Sachs to advise on strategic alternatives for the bank, said it did not expect any material impact on its earnings for fiscal 2013.
The company is facing stiff competition in its tax preparation business from do-it-yourself tax filing services such as Intuit Inc's TurboTax software, and it has been on a cost cutting drive for most of this year.
It has cut jobs, shut offices and overhauled its management to focus on its fast-growing digital tax preparation business.
Kansas City, Missouri-based H&R Block reported a net loss of $107 million for the first quarter ended July 31. Revenue in its core tax services segment fell 1 percent to $90 million.
H&R Block shares were trading at $16.70 at midday on the New York Stock Exchange.
(Reporting by Sharanya Hrishikesh and Ashutosh Pandey in Bangalore; Editing by Ted Kerr)
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Keywords: H&RBLOCK STRATEGICALTERNATIVES/