Should Banks Be Allowed to Pay Dividends?

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by Viral Acharya

In "Banks should be allowed to pay out dividends", published as Comment in FT on February 10, 2011, William Isaac, former chairman of FDIC and chairman of LECG Global Financial Services, makes the point that paying out dividends will enable banks to raise more capital in future, and easily so, which in turn would help promote growth. The author also agrees with the need to have greater capital in the system. Hence, it is somewhat difficult to understand the author's blanket assertion that banks should be allowed to pay out dividends. There are at least two difficulties with the author's position.
One, isn't a better way to proceed to engage in a "stress test" under which bank portfolios are subjected to reasonably extreme but plausible losses and ensure that - even after dividends they wish to pay - they have adequate capital to cover their liabilities and yet have a comfortable cushion to avoid loss of intermediation? This is what the Federal Reserve system plans to do and it appears to strike the right balance between the need to preserve capital in the system for sake of financial stability and the need to ensure that capital markets receive right signals from firms about their quality through payment of cash dividends.

Second, the idea that banks can pay dividends simply because they have now repaid TARP injections deserves some more thought. In parallel with TARP, the government back-stopped a large number of other parts of financial sector and markets, is still continuing to run the Fannie and the Freddie as "bad banks" incurring significant losses in the process, and providing a substantial lender-of-last-resort role through various forms of interventions of the Federal Reserve. Some of these have clearly benefited the economy, including the financial firms whose capitalization has improved since a complete collapse of the housing market has been averted. Assessing the economic attractiveness of banks paying dividends based solely on their balance-sheet strength - and even worse, just on their ability to repay TARP - ignores the most important lesson of the crisis: that we should strive for regulating systemic risk of the financial sector, not the individual risk of financial firms.

I agree with the author that a steady increase in rebuilding of the capital base of financial firms, rather than in an abrupt manner, has some benefits (and that Basel risk-weights are inherently flawed). But this too seems to call for dividend preservation for those firms vulnerable to systemic stress (rather than based on their Basel risk-weighted assets).

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The Dodd-Frank Act, signed into law in July 2010, represented the most significant and controversial overhaul of the U.S. financial regulatory system since the Great Depression. Forty NYU Stern faculty, including editors Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson, and Ingo Walter, provide a definitive analysis of the Act, expose key flaws and propose solutions to inform the rules’ adoption by regulators, in a new book, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (Wiley, November 2010).

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Previously, many of these faculty developed 18 independent policy papers offering market-focused solutions to the financial crisis, which were published in a book, Restoring Financial Stability: How to Repair a Failed System (Wiley, March 2009).

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