Rethinking capital regulation: the case for a dividend prudential target

By Manuel Muñoz

The paper investigates the effectiveness of dividend-based macroprudential rules in complementing capital requirements to promote bank soundness and sustained lending over the cycle. First, some evidence on bank dividends and earnings in the euro area is presented. When shocks hit their profits, banks adjust retained earnings to smooth dividends. This generates bank equity and credit supply volatility. Then, a DSGE model with key financial frictions and a banking sector is developed to assess the virtues of what shall be called dividend prudential targets. Welfare-maximizing dividend-based macroprudential rules are shown to have important properties: (i) they are effective in smoothing the financial and the business cycle by means of less volatile bank retained earnings, (ii) they induce welfare gains associated to a Basel III-type of capital regulation, (iii) they mainly operate through their cyclical component, ensuring that long-run dividend payouts remain unaffected, (iv) they are flexible enough so as to allow bank managers to optimally deviate from the target (conditional on the payment of a sanction), and (v) they are associated to a sanctions regime that acts as an insurance scheme for the real economy.

This paper suggests an intriguing policy, which is to use taxes and subsidies to prevent excessive retained earnings volatility in banks. Why do banks like to smooth dividends? Is it because they hate to reveal less than stellar results? If so, wouldn’t more volatile dividend create the potential for a run? That would not be good. This trade-off seems to be missing in this paper.

One Response to Rethinking capital regulation: the case for a dividend prudential target

  1. Manuel Muñoz says:

    Yes, incorporating additional assumptions such as bank outside equity financing in an environment in which bank owners can substitute their shares for alternative assets at a relatively low cost, could make the policy proposal less attractive. The model also omits ingredients which should make the regulatory scheme more appealing. For instance, imposing higher earnings retention during the lower phase of the cycle in a framework in which banks can default, should improve bank soundness and reduce financial fragility.
    The challenge for the regulator would be to design a regulatory scheme that gives incentives for bank owners to tolerate a higher degree of dividend volatility, based on their understanding that this policy does not substantially affect the amount of dividends they receive over the cycle, it improves bank soundness (it reduces bank equity volatility and should reduce the probability of bank failure), and is particularly effective in smoothing the credit cycle (it is more effective than the CCyB under the proposed calibration for the euro area economy).
    Although required penalties for this regulatory scheme to give the right incentives seem to be small (and could in practice be used to build an insurance fund ultimately aimed at reducing the probability of bank default), the supervisor could alternatively use the dividend prudential target (DPT) as a mere indicator that helps in giving prudential recommendations on payout policies to banks.
    Here is a policy note on this paper recently published by SUERF (The European Money and Finance Forum)

    Click to access f_b7ae8fecf15b8b6c3c69eceae636d203_6285_suerf.pdf

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