Bank stocks have been flat for 12 months. Additionally, they are substantially down from their precrisis highs, despite improving operating performance. Crisis-related dividend cuts have reduced industry payout ratios to a fifth of previous levels.
Understandably, frustrated bankers are exploring dividend policy changes to improve stock prices. Simply restoring or increasing dividends is unlikely to improve valuations.
Dividends should be viewed within a capital-allocation setting, incorporating conflicting stakeholder expectations. Regulators, while allowing dividends, favor higher earnings retention to improve capital levels, especially in a higher-risk, post-crisis economy. Shareholders have shifted their focus from capital preservation to return on capital. Absent attractive investment opportunities, they will favor higher distributions.
Surprisingly, dividends impact the distribution of value, but not the overall value of a bank. Value is increased only by improving cash earnings. Berkshire Hathaway provides a clear example of this. It has neither paid a dividend nor repurchased its stock over the past 40 years, yet it has produced exceptional shareholder returns. Dividends, however, can provide a valuation floor for certain low-growth banks. These include the regulatory constrained large institutions. Dividend policy needs to consider cash needs, expected cash flows, what could go wrong and the need for financial slack to withstand and capitalize on unexpected developments.
Value is created from a bank's investment opportunities and strategy. Banks with potentially large capital needs, organic or merger and acquisition growth, should have low payouts. High dividend levels constrain growth capacity, which is the major source of value creation. Obviously, not all banks can or should grow. Nonetheless, the decision to pay dividends should be subordinate to the strategic investment plan, and consistent with a bank's growth profile and risk appetite. Thus, dividends should be paid only after concluding available cash flow cannot be profitably reinvested under the current or revised strategy.
The next component to dividend policy is cash earnings generation. Strong expected cash generation supports higher payout ratios. Cash earnings available for dividends are usually defined as earnings less a capital charge. The charge is equal to the product of the annual change in risk-adjusted asset times and target capital ratio. It represents the capital needed to support asset expansion. Cash earnings stability is also important to avoid confusing, erratic dividends. Consequently, dividends should be set on a through-the-cycle basis. Incorporation of post-crisis business model changes will weigh on stability considerations.
Capital adequacy is the final dividend policy consideration. Strong capital structures can support higher dividend levels. Banks should consider building an additional capital buffer to maintain flexibility. Just-in-time capital structures ignore the need to withstand and capitalize on "the swans." The well-known black swans include the occurrence of unexpected adverse events like the great recession of 2008-9. Surviving thinly capitalized banks were forced to take unpleasant actions including dilutive capital raises and fire-sale asset dispositions. The ill-timed spring 2007 dividend increases of the then-"overcapitalized" National City, Washington Mutual and Wachovia demonstrate the potential fatal consequences of a distribution policy mismatched to an institution's cyclical risk profile.
Equally important are the less-well-known white swan opportunities, which only highly capitalized companies can execute upon. These include the ability to make attractively priced consolidating acquisitions of weakened or failed competitors. This may be especially important for stronger regional banks given Dodd-Frank Act growth restrictions placed the largest systemically important institutions.
Establishing an appropriate dividend policy is a critical job for banks as they exit the capital-preservation mode of the crisis. Senior managers must resist the temptation to implement a follow-the-herd dividend policy just because they can. Risk-adjusted earnings from investments, not dividends, are the key to higher bank stock prices.
