Tuesday, February 15, 2011

Banks Should Not Be Allowed to Pay Dividends Until They Are Much Better Capitalized

Text of Letter Published in Financial Times

View the letter as it appears in The Financial Times (subscription required to access).

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, Booth School of Business, University of Chicago
  • 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, Booth School of Business, University of Chicago
  • 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 of 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