Unlike the Global Financial Crisis, the current crisis did not start in the financial sector. As most sectors in the economy, however, the financial sector will be negatively affected by the crisis, through loan and income losses (Mann 2020, Perotti 2020). At the same time, the financial sector is central in efforts to mitigate the crisis and speed up the recovery (Beck 2020). Specifically, banks can play a key role in maintaining liquidity support for firms during the lockdown phase, as has become obvious from the drawdown of credit lines over the past months (Acharya and Steffen 2020). Banks play an important role as a conduit for fiscal support measures for firms and households and serve as a critical transmission channel for monetary policy. Central counterparties (CCPs) support hedging activities by financial market participants, more important than ever in these highly uncertain times.
Given this important role and the risks to which the financial sector is exposed, governments and regulators across the globe have taken decisive actions early on, including providing capital relief, liquidity support and loan guarantees (Baldwin and Weder di Maruro 2020).1 These actions seek to limit losses and encourage the financial sector to keep supporting the real economy. The goal of maintaining sufficient levels of capital and loss-absorbing capacity is also the reason why regulators across Europe have encouraged banks and insurance corporations to refrain from voluntary pay-outs (e.g. dividends, bonuses and share buybacks aimed at remunerating shareholders).
On 27 May, the European Systemic Risk Board (ESRB) decided to reinforce and complement these recommendations with a broader recommendation.2 Compared to previous recommendations, the ESRB covers a larger array of financial institutions, including banks, investment firms, insurance companies and CCPs. Unlike previous recommendations, the ESRB refers to all voluntary pay-outs that have the effect of reducing the quality or quantity of own funds, including dividends, share buy-backs and variable remuneration to material risk-takers (staff members whose professional activities have material impact on the institutions' risk profile) and thus goes beyond previous recommendations. And unlike some recommendations issued by other European regulators, the recommended restrictions apply until the end of 2020. They can also be extended further.
The economic arguments
While such restrictions intervene in ownership and management rights, there are strong arguments for them in times of crisis.
Arguments in favour of restrictions
- Banks constitute a critical sector for economic recovery, so there is a need to maintain a sufficiently high capitalisation. There are good reasons why such a decision cannot be left to shareholders themselves: the direct effect of pay-outs on the resolvability of banks, the severe externalities in the event of a bank’s failure, and the fiscal and other measures put in place by authorities during the COVID-19 crisis which limit losses for banks’ shareholders and could encourage more risk-taking than optimal from society’s viewpoint.
- With governments using various means to support companies during the lockdown, shareholders and senior management should not shift capital allocation for the benefit of their own personal wealth. In the case of banks, regulators have provided significant capital relief (€120 billion for significant institutions under direct ECB supervision), which would be partly offset by pay-outs.
- Mitigating procyclicality. Banks behave in a procyclical manner in their lending. During recessions and times of crisis, banks show a propensity to build reserves against credit losses and reduce lending, with this reduction in lending being caused by an increase in information asymmetries between borrowers and lenders and a reduction in collateral values (e.g. Bernanke et al. 1999). Other sources of procyclical behaviour are accounting standards (Laeven and Majnoni 2003) and capital regulation requiring higher risk weights (Brei and Gambacorta 2016). High capital buffers can partly mitigate this tendency towards deleveraging. This in turn suggests that pay-outs should be suspended so as not to offset the effect of using these capital buffers.
- Avoiding stigma and a race to the bottom: If banks use dividend payments as a signal of strength to the market, then any bank not paying dividends will fear being stigmatised. This is another argument in favour of coordinated and mandatory action to restrict pay-outs (Bernanke 2009).
Arguments against restrictions
- Charities, foundations, pension funds and retail investors often depend on steady dividend income. While in a complete market shareholders would be able to sell their shares and thus receive equivalent income, this is a suboptimal strategy in the current volatile times.
- The prohibition of pay-outs could limit resource reallocation that might be needed during the recovery stage. This represents an argument in favour of limiting the period for which restrictions are applied.
- Banning dividend payments may undermine the relationship between a bank and its investors. This could potentially restrict the bank’s future access to market funding. Capital instruments subject to the restrictions might become less attractive to investors, particularly compared with instruments of entities in jurisdictions that do not impose such restrictions. In turn, this could reduce the ability of the affected banks to raise additional capital, or it could increase their cost of capital. This represents another argument in favour of limiting the period for which a restriction on pay-outs is in place.
To assess the impact of system-wide restrictions on dividends, we considered the stock market reaction on Monday 30 March 2020 to the ECB recommendation published on Friday 27 March 2020 addressed only to significant institutions directly under the supervision of the ECB. Their share prices suffered only a limited additional fall (of around 80 basis points) compared with the fall in the share prices of European banks not supervised by the ECB, although effects on individual institutions varied. Larger banks tended to be more affected by the dividend restrictions. Stock prices of euro area global systemically important institutions (G-SIIs) dropped by 280 basis points more than the stock prices of non-euro area G-SIIs. Banks’ own announcements also seem to have had an impact on their stock prices. Over a relatively short time frame (one day), large banks that announced dividend cancellations tended to underperform the broader banking index (EURO STOXX Banks) by between 161 and 539 basis points. The greater impact of individual bank announcements clearly points to the stigma effect outlined above. This would suggest a need for coordinated action rather than relying on individual bank initiatives.
Looking beyond banks
While the above arguments relate primarily to banks, (re-)insurers are also likely to suffer losses from the COVID-19 crisis. The COVID-19 pandemic has caused significant losses in financial markets, including steep falls in stock markets, across-the-board spread widening and swap-rate tightening. COVID-19 could be seen as a ‘triple-hit’ scenario, combining market shocks in the form of an increase in risk premia and a decrease in the risk-free rate affecting both sides of insurers’ balance sheets and additional insurance-specific shocks. Given the important role of insurance and reinsurance companies in financial markets (European insurance companies hold around €10 trillion in assets), and the expected severity of the financial crisis following the COVID-19 pandemic, which is potentially comparable to stress test scenarios applied in recent European stress tests, it is important to maintain own funds and capital buffers to safeguard the resilience of the insurance sector. In light of these concerns, the ESRB decided to include (re-)insurers in its recommendation on restricting pay-outs.
CCPs now play a key role in clearing financial market transactions and are a major segment of the financial sector. It is therefore important that they maintain adequate prefunded own resources in addition to initial margins and default funds. As in the case of banks and (re)insurance companies, investor rights have to be weighed against financial stability concerns. In addition, it is important to note that while CCPs are not directly involved in real-sector funding, their critical role in financial market transactions means that banks and insurance companies rely on them for their hedging activities.
The Single Market
The recommendation calls for restrictions on the consolidated level, but on the sub-consolidated level if the parent bank is outside the EU. Ideally there would be cooperation on the global level. As this has not happened, the ESRB saw the need to primarily take care of the European financial system. Therefore, the recommendation primarily targets pay-out restrictions at the EU consolidated level. One tricky issue has been restrictions at the sub-consolidated and individual level within the EU, several Central and Eastern European countries already having imposed restrictions on subsidiaries of EU cross-border banks for financial stability concerns.
There are strong arguments on either side. On the one hand, regulatory risk-sharing is incomplete in the EU (including within the euro area), and the financial stability mandate of national macro-prudential authorities must focus on local financial systems and economies. On the other hand, the Single Market principle of free movement of capital speaks against imposing restrictions, in particular at the subsidiary level, i.e. within EU cross-border groups. Furthermore, the ESRB has a specific mandate to contribute to the functioning of the EU internal market. That argues against imposing pay-out restrictions on subsidiaries of EU financial institutions. Compared to the last crisis, there are several fora available for dialogue on these issues, including supervisory colleges, the Vienna Initiative and the Nordic-Baltic Macroprudential Forum.
On a final note…
It is important to stress that this recommendation constitutes ‘soft law’. The ESRB has no legal powers to enforce compliance; rather, ESRB Recommendations are ‘comply or explain’. This means that an addressee could decide to explain in case it had adequate justification for not taking action. We are aware that there will be indeed some authorities who will decide not to take action, but we believe it is very important to send this broad message in favour of capital preservation at a time of very high uncertainty and possible future distress.
Author’s note: Any views expressed are those of the authors and do not necessarily reflect the official stance of the ESRB, its member institutions, or any institution to which the authors may be affiliated.
Acharya, V and S Steffen (2020) “’Stress Tests’ for Banks as Liquidity Insurers in a Time of COVID”, VoxEU.org, 22 March.
Baldwin, R and B Weder di Mauro (2020), Mitigating the COVID Economic Crisis: Act Fast and Do Whatever it Takes, a VoxEU.org eBook, CEPR Press.
Beck, T (2020), “Finance in the Times of COVID-19: What Next?”, in R Baldwin and B Weder di Mauro (eds), Mitigating the COVID Economic Crisis: Act Fast and Do Whatever it Takes, a VoxEU.org eBook, CEPR Press
Bernanke, B S (2009) “The Federal Reserve’s Balance Sheet: An Update”, speech at the Federal Reserve Board Conference on Key Developments in Monetary Policy.
Bernanke, B S, M Gertler and S Gilchrist (1999), “The Financial Accelerator in a Quantitative Business Cycle Framework”, in J B Taylor and M Woodford (eds.), Handbook of Macroeconomics, Elsevier, 1341-93.
Brei, M and L Gambacorta (2016), “Are bank capital ratios pro-cyclical? New evidence and policy”, Economic Policy 31: 357-403.
Laeven, L and G Majnoni (2003), “Loan loss provisioning and economic slowdowns: too much, too late?”, Journal of Financial Intermediation 12: 178-197.
Mann, C (2020), “Real and financial lenses to assess the economic consequences of COVID-19”, in R Baldwin and B Weder di Mauro (eds), Economics in the Time of COVID-19, a VoxEU eBook, CEPR Press.
Perotti, E (2020), “The Coronavirus shock to financial stability”, VoxEU.org, 27 March.
1 See, among others, here and here.
 For the recommendation, see here; for the background report, see here.