A de facto ban on bank dividends is still in place despite fact many eurozone lenders are now in position to distribute profits. 

G Gabbi 2

The economists Franco Modigliani and Merton Miller are famous for their theorem which argues that the value of a company is not ultimately dependent on its dividend policy. 

According to them, in a perfect world with no taxes, transaction or bankruptcy cost, the dividend policy does not affect either the share price or the company’s capital structure.

Yet in recent months we have seen many banks criticise European regulators for ordering eurozone banks back in March to cease all dividends this year.

This European Central Bank (ECB) recommendation serves two purposes: to strengthen bank capital and absorb the losses that will materialise as a result of Covid-19; and encourage more support for companies in the real economy.

In other words, the economic impact of the pandemic crisis will manifest in a recession with inevitable deterioration in credit quality.

Distributing part of last year’s profit today would make the risk that is inevitably generated by the supply and demand shocks unsustainable.

Technically, this decision is an extended application of the conservation buffer that already limits the distribution of dividends of relatively under-capitalised banking intermediaries, but also combines a macro-prudential view that is guarded by the counter-cyclical buffer.

[Various] factors explain why bank executives are stressing the importance of being able to distribute part of their profits.

The change in dividend policy is not a peculiarity of the banking system. In response to the Covid-19 crisis, 45 companies in the S&P 500 and 281 in the FTSE All Country World index suspended the dividend distribution and many others revised downwards their policies to preserve liquidity, reduce leverage, protect reputation or access public funds in the event of difficulties. Also, the London Stock Exchange soon after the beginning of the pandemic had relaxed its dividend procedure timetable.

Regulatory intervention

But the case of the banking sector is different. It is the only case of regulatory intervention that affects an entire sector. The recommendation of supervisors has come at a time when, despite the general crisis, banks are in a favourable position to distribute dividends.

What are the factors that justify banks’ willingness to return to distributing their profits?

Firstly, the results from the final two quarters of the year seem to be particularly positive, thanks to an increase in revenues from services and capital gains on securities. Financial markets recorded unexpected positive performances in November, supported by promising statements from pharmaceutical companies involved in the development of the Covid-19 vaccine and the start of the vaccination campaign, at least in the UK.

Secondly, many banks have seen a decrease in credit provisions, thanks to recent securitisation operations and guarantee schemes adopted in some European countries on loans to support companies affected by pandemic containment policies. The non-performing loans ratio of large euro banks declined from 3.56% (second quarter 2019) to 2.94% (second quarter 2020).

Finally, there was an increase in capitalisation and liquidity: in particular, the common equity Tier 1 (CET1) ratio increased from 14.3% (second quarter 2019) to 14.8% (second quarter 2020), and the liquidity coverage ratio in the same period moved from 146.7% to 165.4%.

Uninvestable assets?

But there are other factors that explain why bank executives are stressing the importance of being able to distribute part of their profits. Particularly striking was the statement by Société Générale chairman Lorenzo Bini Smaghi (former member of the ECB’s executive board) who criticised the dividend regulators’ recommendation because it would make banks “uninvestable” and could backfire on them.

Why banks should become uninvestable assets?

Because the dividend distribution policy, contrary to the Modigliani and Miller hypothesis, strongly influences the cost of capital. It happens because in their perfect world there are no mandatory capital and liquidity ratios, there is no constraint on leverage, there is no corporate governance (such as that of foundations and other institutional investors) that in some cases prefers cash to capital gain, nor could one imagine the negative rates we have today. And when all these elements combine, dividends are an attractive solution for many investors. Not to mention that the banking sector has historically been generous in the distribution of dividends.

There are also unintended consequences that could go in the opposite direction to the one envisaged by the authorities: reducing the attractiveness of equity investments in the banking sector and thus conditioning its capitalisation; lowering the creditworthiness of shareholders who could be negatively affected by the pandemic; increasing credit spreads due to the higher cost of equity capital; and shrinking the disbursement capacity of institutional investors who have bank dividends as an important source of financial income. Moreover, as practices across jurisdictions differ widely in scope and severity, this may affect the level playing field.

Consideration must certainly be given to the likelihood that impaired loans will increase in the coming months and banks need to use stress test metrics on credit portfolios. But for all the reasons described, a return to flexibility and autonomy of banks can be seen as positive for the industry; a key element in restarting the financial system and its role in supporting the real economy. Because we definitely do not live in a perfect world.

Giampaolo Gabbi is professor of risk management practice at the SDA Bocconi School of Management in Milan.

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