Suspending dividend payments would not only benefit the financial system but also bank shareholders

Banks’ quarterly earnings have been published and as expected the results are not pretty:  Provisions reflecting anticipated credit losses have increased dramatically, values of investment portfolios have dropped and only the frenetic trading activity of the last weeks has somewhat compensated this bleak picture.

Nevertheless, banks insist on maintaining dividend payments. This makes the US the only major economy where banks still pay dividends.  In Europe regulators have asked banks to suspend dividend payments during the ongoing crisis, and banks have duly obliged. US banks have made some concessions, such as refraining from share buybacks in Q2, but so far they have strongly resisted cutting dividends.

Why exactly banks refuse to temporarily suspend dividends during the time of the crisis is not clear. Some banks and commentators have framed the discussion in familiar class-war categories by opposing shareholders to workers and the society. Depending on which side of the argument you adhere to, dividend cuts would endanger the livelihood of poor retirees or force greedy shareholders to pay their fair share of the losses caused by the current crisis.

But this discussion is entirely misguided: We know that there is no direct relationship between dividend payments and shareholder returns. Every time a dividend is paid out the price of a share drops by exactly the same amount, leaving the overall shareholder wealth constant. As Nobel Price winning economist Franco Modigliani and Merton Miller have demonstrated, if a company’ operational strategy remains unchanged, dividend policy will not impact shareholder returns. If a bank does not pay a dividend, the poor retiree as well as he greedy capitalist can simply generate a home-made dividend by selling a small part of their shares, and obtain the same cash flow.

Information effects can sometimes make things more complicated, but these effects entirely depend on the context and can go either way: For example, a bank will see its share price go up, if it can convincingly explain to shareholders that the current crisis opens up a large number of profitable opportunities and it therefore prefers reinvesting profits rather than paying a dividend. 

While the effect of high dividend pay-outs on shareholder returns are not clear, the effect on shareholder risk is obvious and well documented: Banks with higher payout ratios have lower equity and therefore a lower buffer to absorb shocks, such as the one we are experiencing now. The scatterplot below illustrates that banks with high payout ratios in 2019 were among the worst performers in the current market crash.

Importantly, this endangers not only the bank and its shareholders, but the entire financial system. In the same way that irresponsible behaviour of non-symptomatic Covid 19 superspreaders creates a problem for all those who are being infected, high-risk balance sheets by financial institutions do not only endanger the bank itself and its shareholders, but also the health of other more responsible market participants.  If a bank fails, the risk can spread throughout the financial system and create a shock that overwhelms the capacities of regulators and central banks.

Governments waited too long to strengthen the health system against the virus storm and we are now paying a price for that; a financial storm, of significant severity, is likely to come and now is the time to anticipate it, strengthen the financial system and make sure that irresponsible behaviour by individual players is curtailed.