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One reason that you’re in for seven lean years in the investment banking business is that bank capital requirements are going up due to Basel III, and “capital is expensive” in some loose sense, so banks will have less money to use to make loans and/or pay you. Some people think that this is mostly bull, because capital is not actually any more “expensive” than any other form of funding, though those people often actually don’t care that much about paying you so it may not be worth listening to them. In any case here is the abstract to an amusing new paper by Karlo Kauko of the Finnish central bank, because yes I make a point of being up to date on everything published by the Finnish central bank:
Bank managers often claim that equity is expensive relative to debt, which contradicts the Modigliani-Miller irrelevance theorem. … An opaque bank must signal its solvency by paying high and stable dividends in order to keep depositors tranquil. This signalling may require costly liquidations if the return on assets has been poor, but not paying the dividend might cause panic and trigger a run on the bank. The more equity has been issued, the more liquidations are needed during bad times to pay the expected dividend to each share.
Don’t worry if you don’t get that name dropping, it doesn’t matter. Also don’t worry too much about the paper itself, which is amusing but also sort of nuts.* The basic idea to come away with is that bank equity is where the bank puts all its hopes and dreams, and that, if banks are more or less reflections of hopes and dreams, the people who provide the real funding for the banks – repo counterparties and clearing banks and suchlike – are going to be inordinately influenced by reading equity tea leaves. Because what else are they going to read?
Complex banking organisations, where the true leverage cannot be accurately estimated by outsiders, are more likely to consider equity capital expensive. A bank with simple operations, a transparent balance sheet and no off-balance sheet risks cannot mimic high profitability by choosing an extreme leverage and paying a high and steady return on a tiny equity capital. Interestingly, minimising the capital base seems to have become more commonplace when banking has become more complicated. The true leverage of modern large and complex banking organisations can hardly be deduced from public information.
In Kauko’s story the way that banks signal to depositors – for which read “repo counterparties and suchlike” – that everything’s fine is by paying big, stable dividends on their equity. Surely if a bank is paying a healthy dividend, which after all it could cut off at any time, it won’t have any trouble paying off its debts, right? The problem is that this makes the dividend something like a real cash obligation for a bank in crisis: if it cuts the dividend, it will signal to lenders that they’re next, and they’ll all stampede for the exits. So equity is “expensive” in that it requires banks to fork over lots of cash for dividends.
This is to some degree news to regulators, who like equity precisely because it has no cash cost when banks really need to conserve cash – like I said, the banks can always cut the dividend. But it’s probably correct to say that (1) like a quarter of every bank earnings call these days is taken up with “so, when will the regulators let you raise your dividend or buy back more stock?” and (2) there is a pretty strong link in many people’s – investors’ and bankers’ – minds between “the regulator is letting us pay more dividends” and “we are probably not going to blow up all that soon.” So this seems like a good point:
The model has at least one obvious policy implication. If the public observes clear symptoms of a recession, it is reasonable to restrict banks’ dividend payments. If such a regulation is enforced and applies to all banks, dividend cuts tell nothing about the profitability of any particular institution, and bank solvencies could be enhanced with retained earnings without bank-specific adverse signalling effects.
In a way this happens now – bank regulators are keeping a closer eye on everyone’s dividends and buybacks than they were in 2007, even healthy-ish banks – but the blanket dividend restriction in a crisis is maybe a good idea, akin to making all the banks take TARP to avoid stigmatizing the banks who really needed it.
Like I said, this paper is sort of nuts and maybe doesn’t tell you exactly why bank capital is expensive or whatever. But I like the basic move, which is to remind us that with bank balance sheets so opaque, the short-term lenders who mostly fund banks will have to grasp at whatever imperfect indicators they can find – and that they will react to those imperfect indicators in ways that are weird and unintended. Things that should preserve capital and make a bank safer, like cutting its dividend, may have the opposite effect. Not sure that that means that more capital = more danger, but it’s at least a reminder that more capital doesn’t = no danger either.
* Because its core belief is that banks don’t like equity because it requires them to pay out more actual cash dollars in a crisis than alternative funding sources do, and that just can’t be right. The paper’s model breaks down bank funding into two things, dividend-paying equity and interest-bearing deposits, and more or less postulates that the “dividend is higher than any deposit rate the bank might offer, consistently with at least some casual empirical observations on banks’ dividend policies,” which, like, that’s just your opinion man, but banks in fact fund using a range of seniorities and tenors and pay a range of rates on their debt funding instruments and it strikes me as hardly set in stone that your blended interest expense will be less than your dividend; JPM’s is (crudely I get interest expense / total liabilities = 0.65%, div yield = 2.67%), but BAC’s isn’t (1.14% vs. 0.55%) and neither is GS’s (1.5% vs. 1.28%). And that’s in a pretty pretty low rate environment. Once you get away from the belief that equity has a higher cash cost for banks than debt, which is implicitly assumed and also, like, obvs wrong, you start to wonder about the results. I’m being a little unfair because yeah probably the average bank pays a higher dividend than it pays on its shortest-dated most run-sensitive funding, but I suspect that’s the wrong margin to look at. Whatever.