Dividends or Bank Stability?

story_images_dollars-funnelNow that the big U.S. banks – both money-centre banks and the investment banks now folded into bank-holding corporations to benefit from U.S. Federal Reserve Board facilities – are paying dividends, perhaps it’s time for a second look.

Dividends have long been a major – if not the major – part of stock appreciation for long-term investors, provided that they were reinvested. Lately – and lately means the past 20 years – stock buybacks have vied with dividends as a way to reward investors.

After all, it’s a choice between cutting investors in on the profits, or making their share holdings more profitable. Sometimes the latter is favoured because capital gains are taxed less heavily than dividends (although, at a formal level, there should be no difference; but that depends on the robustness of the tax system and its integration of corporate income taxation with personal income taxation).

Still, are higher dividends a good thing? Perhaps if it’s a private company that has been sitting on a cash hoard for want of consumer, or business to business, demand. If it’s banks, perhaps that’s not such a good thing, or so argues Simon Johnson, former chief economist at the IMF. In a New York Times blog he wrote:

“The bankers  … are officially released from the financial hospital ward that was set up for them in 2008. No matter that this was a very comfortable place, with few conditions relative to any other bailout in recent American or world history, there were still restrictions on what banks could do and bank executives chafed at these constraints.

“In particular, banks were required to build the equity in their business –- insolvency is avoided, after all, while there is positive equity in a business. When shareholder equity is exhausted, creditors face losses.

“You might think that the people who run banks have an incentive to keep equity at a high level, providing a cushion against future losses and effectively protecting creditors. And banking did operate in this fashion back when government was much smaller and effectively unable to save large financial institutions.

“But that was in the 19th century – when banks had capital levels in the range of 30 to 50 percent (and functioned fine). In the 20th century, the equity in banking has tended to decline relative to debt. This is what people mean when they say leverage has gone up.”

At little history isn’t bad. And now? “The Fed’s decision on dividends effectively lets the banks pay out shareholder equity, making the banks more highly leveraged.”

Sounds like a cue for bank skeptic Meredith Whitney.