In my recent blog post, Too Big To Fail (And Offend), I argued that the politics of banking were such that the bite of the Murray inquiry would be less menacing than its bark, consistent with the experience of financial sector reforms in other countries since the financial crisis.
One of the reasons I suggested that the government would be reluctant to lift capital requirements substantially was due to their concern that the banks would cut back their dividends, which account for almost one-third of total dividends paid by the ASX200 companies. In dollar terms, this translates into a chunky $20 billion paid out to bank shareholders in the past year alone. Any government would be concerned about being blamed for banks cutting back on dividends by self funded retirees and self managed super funds loaded up on high yielding bank shares.
Well, I was wrong on the 'negative' link between bank capital and dividends. Charles Hyde from Macquarie University has kindly pointed out that forcing banks to finance their loan books with more shareholder equity or loss absorbing capital does not mean that banks need to cut back on dividends. Contrary to conventional wisdom, bank capital is not an asset; it does not sit idly in a bank's vaults, unlike reserve requirements. Rather, it is a liability, which together with customer deposits and wholesale debt, is used to finance a bank's loans.
The key function that a bank performs is maturity transformation. It carefully manages its liabilities which are liquid with a short duration, and its loans which are illiquid and typically have long duration. If a bank uses more shareholders equity in its liability mix, in no way is it forced to cut back on loans or dividends. On the contrary, it can use those additional funds to lend to the household, business and government sectors. Unfortunately, the terminology used is confusing; capital regulation is a regulation of a bank's liabilities, not its loans or assets.
The causal link between bank capital and dividends might actually run in reverse; that is, more capital enables a bank to pay shareholders sustainably higher dividends. A bank that holds more loss absorbing capital is more resilient to a decline in the value of its loans, possibly brought about by an economic downturn. Though the economic cycle, insiders of safe banks should therefore have more confidence to pay higher dividends than banks with less shareholder equity.
The chart below provides strong empirical support for the proposition that safer banks actually more dividends. There is a statistically robust and positive linear relationship between the dividends to assets ratio on the vertical axis and the leverage ratio on the horizontal axis (ratio of common shareholder equity to assets) for the largest 100 global banks.
The strong and positive linear relationship is not just unique to the most recent annual estimates used; the regression line was very similar when I re-estimated the relationship using annual estimates from three years ago (not shown here).
It is interesting to note that the four Australian major banks all lie well above the regression line. This might reflect their focus on commercial banking operations, which have been associated with higher profitability and lower cost to income ratios than offshore banks. Moreover, Australia's status as one of the few countries in the world with a full imputation system encourages companies to pay dividends. The regression based on annual estimates from three years ago also shows that Australia's banks were well above the line then too, lending support to the view that higher profitability and imputation have contributed to their higher dividend payout rates.
Total Loss Absorbing Capacity
In a welcome development, the Financial Stability Board recently announced that it is seeking consultation for a common international standard for Total Loss Absorbing Capacity amongst global systemically important banks, which demonstrates a greater willingness to tackle the problem of too big to fail. But if the pace of reforms since the crisis is any guide, the move to a common global standard will be glacial and probably too lenient.
Despite the compelling empirical evidence that higher capital requirements = higher dividends, the politics of banking still favour the major banks, thanks to their size, profitability and concentrated industry structure. Although the Murray inquiry might be emboldened by the aggressive language used by the Financial Stability Board in its determination to tackle too big to fail, I still expect the inquiry's bite (and the government's response) to be far less menacing than its bark.