Moves by many banks to reintroduce or raise their dividends following the Federal Reserve’s stress tests suggests that the tests may have accidentally created an non-economic need for banks to pay higher dividends.
Shareholders now believe that the ability to pay a dividend is a sign of financial health—or at least a signal that regulators believe the bank is healthy—so they are willing to pay more for the shares. Banking executives understand the new “Fed Approved” signaling function of dividends, and so are eager to raise their dividends.
This signaling function, however, means that banks are likely to be over-incentivized to raise dividends. They will likely raise dividends beyond what would otherwise be justified in terms of optimizing their capital structure.
To put it slightly differently, the “Fed Approved” signal has the effect of lowering the cost of capital for firms that pay dividends—which means that an otherwise inefficiently high dividend payment is suddenly made efficient.
Since paying too high of dividend weakens the financial health of a growing firm, the ultimate effect of the stress test will be to weaken some of the firms that passed it.
This suggests that it would have been smarter not to link the stress tests to dividends in the first place.
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