February 15, 2011

Sir,

Mr. Isaac ("Banks should be allowed to pay out dividends", February 9) supports higher capital requirements, but argues that preventing profitable banks from paying "reasonable" dividends impedes bank lending and economic growth. We disagree.

Paying dividends immediately reduces bank capital and the amount of money available to lend. Mr. Isaac claims that if banks don't pay dividends now, they will have trouble raising capital later. But to raise capital it is not necessary that a company has paid dividends in its recent history. For example, a year after it went public, Google raised over $2 billion of new equity, even though it had not paid any dividends.

A dollar paid out to shareholders through either dividends or share repurchases is a dollar that would not be accessible to creditors in a situation of financial distress. For this reason, and to prevent the shifting of value from debt holders to equity holders, debt covenants typically restrict dividend payments when leverage is high. Debt covenants may be less restrictive in banking because most bank creditors are explicitly or implicitly insured, and thus are less concerned with dividend payments that reduce their security.

But taxpayers should be concerned when banks pay dividends and remain thinly capitalized, because, as we have seen, taxpayers are the ones who are likely to end up covering the banks' liabilities in a crisis. Moreover, everyone suffers from the consequences of the greater systemic risk associated with highly leveraged banks.

Mr. Isaac suggests that the fastest way to meet capital requirements is for banks to raise significant amounts in new equity. We strongly support recapitalization with new equity. However, the U.S. banks that want to pay dividends have not announced plans to raise new equity, and regulators are not forcing them to do so. Moreover, retaining earnings is generally viewed as the least costly way to raise funds and build capital, as it avoids the transactions costs associated with new equity issuance.

The fact remains that if banks retain earnings rather than pay them out, there is less need or urgency for them to raise new capital. With more retained earnings, banks would have more funds immediately available to lend, which would promote growth. Once banks are safely capitalized, which would require them to have significantly more equity on their balance sheets than they currently have, paying dividends would be appropriate.

SIGNATORIES TO THE LETTER IN THE FINANCIAL TIMES

Anat R. Admati George C. Parker Professor of Finance and Economics Stanford Graduate School of Business

Franklin Allen Nippon Life Professor of Finance Professor of Economics Co-Director, Financial Institutions Center The Wharton School, University of Pennsylvania

Richard Brealey Emeritus Professor of Finance London Business School

Michael Brennan Professor Emeritus, Finance Anderson School of Management, UCLA

Markus K. Brunnermeier Edwards S. Sanford Professor of Economics Princeton University

John H. Cochrane AQR Capital Management Professor of Finance University of Chicago Booth School of Business

Peter M. DeMarzo Mizuho Financial Group Professor of Finance Stanford Graduate School of Business

Eugene F. Fama Roger R. McCormick Distinguished Service Professor of Finance University of Chicago Booth School of Business

Michael Fishman Norman Strunk Professor of Financial Institutions Kellogg School of Management, Northwestern University

Charles Goodhart Professor, Financial Markets Group London School of Economics

Martin F. Hellwig Director Max Planck Institute for Research on Collective Goods, Bonn

Stewart C. Myers Robert C. Merton Professor of Financial Economics Sloan School of Management, MIT

Paul Pfleiderer C.O.G. Miller Distinguished Professor of Finance Stanford Graduate School of Business

Jean Charles Rochet SFI Professor of Banking Swiss Banking Institute, University of Zurich

Stephen A. Ross Franco Modigliani Professor of Financial Economics Sloan School of Management, MIT

Chester S. Spatt, Pamela R. and Kenneth B. Dunn Professor of Finance; Director, Center for Financial Markets Tepper School of Business, Carnegie Mellon University

Anjan Thakor John E. Simon Professor of Finance Olin School of Business, Washington University