Kristalina Georgieva, Managing Director of the IMF, in an article published last week in the Financial Times, has called for banks to collectively suspend dividend payouts and share buy-backs. The rationale is that this will strengthen banks’ capital and liquidity positions, allowing them to be in a better position to disburse fresh loans. The article notes that the 30 global systemically important banks distributed cUS$250bn to shareholders last year as dividends or share buy-backs.
We argue that this is a blunt instrument to achieve such a policy goal, and that policymaker attention would be better directed elsewhere. There are several problems with the proposal: it unfairly punishes investors in better-run companies; it weakens market oversight as a governance tool; it raises the banking sector’s cost of capital. We think there are alternative courses of action that would better achieve the desired outcome of improved credit disbursement without stymieing value creation in private sector banks.
7 major problems with the IMF proposal
1. It’s unrealistic
Some governments are continuing to deny the existence of Covid-19. There is no agreement on even basic policy measures (eg is wearing masks helpful or not for the general public?). In this context, any global agreement on bank dividend restrictions seems highly unlikely. However, even if you aim your policy goals high, you should at least point in the right direction.
2. Capital isn’t always the issue
Taking just one area of our coverage universe, we think some banks in Africa would be able to write-off over one-quarter of their loan books and still keep their tier 1 ratios above 12%. To force the shareholders of institutions such as these to forego dividend income appears unreasonable and unnecessary. These entities may not be lending for a whole host of other reasons (see below).
3. Regulation should focus on depositor protection, not credit expansion
The primary justification for the extra regulatory burden banks face relative to most other industries is to ensure that customer deposits are protected. Using bank regulation to achieve other policy goals could put at risk this core principle.
4. Collective action on dividends carries limited benefits
One justification for collective action is that it can prevent a contagion effect on otherwise healthy institutions. For example, if all banks contribute to a deposit insurance fund, there is less risk that depositor fears over the health of one bank would lead to widespread withdrawals from other institutions. In this case, the IMF’s goal is to ensure the supply of fresh credit to the economy; but, if one institution is unable to meet a new borrower’s needs, another one can still come forward, provided the opportunity makes economic sense (favourable risk/reward profile). There is no domino effect. (Note also that, in most markets, protections for existing borrowings have already been put in place – see below.)
5. Long-term borrower costs will rise
Bank equity investors are already providing considerable support to the global economy. In many markets, regulators have imposed requirements on banks to extend loan terms or reduce loan interest rates. Lower policy interest rates are also typically negative for banks’ margins.
As a result, bank shares have been among the weakest performers so far this year (the global financials sector has underperformed the global equity market by c9%). If equity investors are further punished by losing any opportunity for dividend income, we think the industry's long-term cost of capital could rise, which would over time be passed on to borrowers.
6. Individual banks and countries have already taken action on dividends
Given the heightened uncertainty, many banks have already announced the suspension of near-term dividend payments. We note that some countries have already imposed restrictions on dividend distributions. For markets like Vietnam and Bangladesh, we think this makes sense; bank capital was already constrained following years of credit-growth promotion. In others, like Ghana, the rationale seems less sound; we think dividend restrictions could be a precursor to asking stronger banks to take over weaker institutions. Our objection to restrictions on dividend distributions is not prescriptive, but rather that it should be tailored to the situation of individual institutions and/or banking systems, rather than being a blanket global ban.
7. Restrictions on dividends will weaken market oversight
One of the key pillars of regulatory innovation in recent years has been to improve the transparency of disclosures so that investors can impose market discipline over banking institutions. A blanket ban on dividend distributions would reduce the incentives for investors to differentiate across institutions, thereby limiting the level of discipline imposed on weaker entities. Over the long-term, this would also result in less efficient capital allocation.
...And 11 Solutions
We don’t think there is a one-size-fits-all solution, but policymakers may wish to consider some of the following to achieve their goals. Some can be applied relatively easily in the short-term (indeed many governments have already taken action); we have presented these first. Others are structural changes that would take significant time to implement; one benefit of this crisis may be that it focuses policymaker attention on these areas, which seem to be ignored during growth phases of the economic cycle.
1. Credit guarantees
One way to encourage banks to extend new loans is for the government to enter into risk-sharing arrangements for qualifying loans.
2. Reduced risk-weightings for new loans
A two-tier risk-weighting system could be introduced to reward banks for extending additional credit. These reduced risk-weightings could encourage shareholders to support capital retention over dividend distribution, as the shareholder returns on new business would potentially be superior (lower capital intensity).
3. Enhancing banking system liquidity
Extensions to loan terms, and depositor withdrawals to meet their day-to-day/working capital cash needs, could lead to a reduction in the liquidity available to banks, in turn deterring them from extending new loans. Central banks can ameliorate these short-term issues by temporarily relaxing some of their liquidity rules or enhancing repo and other liquidity facilities. Again, we have seen such initiatives widely adopted in recent weeks.
4. Limiting the procyclicality of risk faced by bank sector investors
During economic downturns, bank investors face significant downside risk given the skewed pay-off profile of loans, and the geared nature of bank balance sheets. Measures that would limit the cyclicality of risk faced by bank investors have been introduced; many markets have a dynamic regulatory framework, with tighter regulations when economic growth is strong, and relaxing them during downturns. Over time, this could lower banks’ cost of capital. As shown in Figure 5, many liquidity and capital requirements have already been eased. Restrictions on dividends when investors need them most would, however, put a big dent in the credibility of these counter-cyclical initiatives.
5. Protecting supply chains and employment
Many governments have already instituted employment protection/support measures, as well as providing additional borrower protections, such as repayment moratoria. To the extent that these protect the commercial ecosystem from the short-term shock of Covid-19 lockdowns, we think the measures are well-targeted and effective. Lower economic risk will naturally encourage banks to feel comfortable about extending fresh loans to their customers.
6. Capital injections into existing institutions
Institutions with weak capital ratios could be given capital injections in exchange for certain behavioural changes (such as restricting dividend distributions for a certain period, and requirements relating to credit disbursement to target sectors, etc.). Management/board changes may be appropriate if their failings were responsible for the weak capital ratios
7. Creation of new state-owned banks
If policymakers feel that private sector banks are not directing credit to the right parts of the economy, one solution may be to create a new institution for that purpose. The key challenge here is that creating such an institution from scratch takes time. The purpose of the entity should also be narrowly defined, so that it does not end up competing with private sector institutions in mainstream credit disbursement. Directions for how the institution can be wound up once its purpose has been served should also be established.
8. Creation of state-sponsored vehicles to remove bad assets from bank balance sheets
The sharp slowdown the global economy is likely to suffer this year could generate a significant volume of impaired bank loans. As a result, banks may focus on managing these impaired assets rather than disbursing new loans. By removing bad assets from banks’ balance sheets, governments can ensure management teams are focused on finding profitable new lending opportunities.
9. Improved financial inclusion
In many of the markets we specialise in, banks are only lending to a small segment of the economy, such as large corporations and wealthy individuals. Helping to lower the cost of distribution and collection could have a much more profound impact on credit disbursement than dividend restrictions. Key initiatives include: creation of a comprehensive credit bureau; clearer legal bankruptcy frameworks (see below); accurate registries of real estate assets; and national ID schemes.
10. Stronger bankruptcy frameworks
Bankruptcy proceedings in many of the markets we cover can be protracted and expensive, particularly in markets with high discount rates/cost of capital (in many developing markets, it can take several years to enforce the terms of commercial contracts). In these situations, banks will factor likely low recoverability into their loan charges, pricing some borrowers out of the market.
11. Improved fiscal discipline
In some of the markets we cover, banks are the key funders of government budget deficits, via their purchases of government-issued securities. This, in turn, limits these banks ability/appetite to extend loans to the private sector. Improved revenue collection and a widening of the tax base, combined with improved spending discipline and reduction of subsidies, would free up bank balance sheets to extend credit to the private sector rather than purchasing government bonds. In many developing markets, a relatively small proportion of bank deposits are recycled as private-sector loans.