Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation. This blog is currently suspended.

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

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Thu, 10 Dec 2020

Bankruptcy hardball and bank dividends

When I read the recent BIS working paper Low price-to-book ratios and bank dividend payout policies by Leonardo Gambacorta, Tommaso Oliviero and Hyun Song Shin, I was immediately reminded of the paper Bankruptcy hardball (Ellias and Stark (2020), Calif. L. Rev., 108, p.745) though that is not how Gambacorta, Oliviero and Shin analyse the issue.

Ellias and Stark documented the tendency of distressed firms to declare dividends or otherwise move assets out of reach of the creditors for the benefit of shareholders. This strategy which they called bankruptcy hardball is most closely associated with private equity owners.

As I reflected on the Gambacorta, Oliviero and Shin paper, it struck me that what makes bankruptcy hardball attractive is the high level of leverage rather than private equity ownership. If the assets are worth 100 and debt is 80% of assets (so that equity is 20%), then shifting 10 of assets to the shareholders reduces the value of debt only by 12.5% but increases the value of the shareholders by 50%. If debt is 90% of assets, then the same shift of 10 would be only a 11% loss to lenders but a 100% gain to shareholders. Since private equity is characterized by high leverage, the incentives are much greater in their case. On the verge of bankruptcy, it is true that the leverage would shoot up for all companies (as the equity becomes close to worthless), and it might appear that every firm can play hardball. However, the tactics are more likely to survive legal challenges when they are implemented at a time when the company appears to be solvent, and ideally years before a bankruptcy filing. So the greatest opportunity to play hardball is for those companies that have high levels of leverage in normal times when they are still notionally solvent but possibly distressed.

Apart from firms owned by private equity, there is another example of a business with high levels of leverage in normal times - banking. Banks typically operate with leverage levels that exceed that of typical private equity owned businesses. One would therefore expect banks to also play the hardball game - pay large dividends when they are distressed but still notionally solvent. And that is what Gambacorta, Oliviero and Shin find.

Their key finding is that banks with low Price to Book ratio (the ratio of the market price of the share to the book value per share) tend to pay higher dividends and this tendency becomes even more pronounced when the Price to Book ratio drops below 0.7. Price to Book has been associated with financial distress in the finance literature since the original papers by Fama and French. But the link is even stronger in banking where a low price to book ratio is often driven by the market’s belief that the asset quality of the bank is a lot worse than the accounting statements indicate. In other words, while for non financial companies, a low price to book reflects low profitability, for banks, it often indicates that book equity is overstated (due to hidden bad loans) and the capital adequacy of the bank is a lot worse than what the accounting statements suggest. Price to book is therefore an even more direct indicator of distress for banks than for non financial companies.

For a bank which is already highly levered and whose true leverage is even higher because of overvalued assets, dividends become an attractive device to transfer value to shareholders from creditors. The fact that the bank meets the capital adequacy standards set by the regulators (aided by overvaluation of assets) acts as a cover for the hardball tactic. The fact that many creditors (especially the depositors) are protected by deposit insurance means that creditor resistance is muted.

Gambacorta, Oliviero and Shin talk about the wider social benefits of curtailing dividends (increasing lending capacity), but there is a more direct corporate governance and prudential regulation argument for doing so. Regulators have already recognized the role of market discipline in regulating banks (Pillar 3 of the Basel framework). From this it is a short step to linking dividend and other capital distributions to a market signal (price to book ratio).

Posted at 17:46 on Thu, 10 Dec 2020     4 comments     permanent link

Comments...

Ritwik Priya wrote on Sat, 13 Feb 2021 02:50

Re: Bankruptcy hardball and bank dividends

Sir In my view it is very easy to forget with banks or dealers that they are actual firms with employees and opex, and not simply asset and liability vehicles. If we take the view that equity holders in an arms-length joint stock corporation are owners of residual claims, and not owners in any meaningful sense of propreitorship, the modern bank is the canonical corner case for that view.

P/B in banks therefore reflects: 1. A discount for complexity and quality of assets 2. A discount for all the embedded claims that employees have, particularly in a high-but-deferred compensation regime, which makes cost reduction or efficiency improvement hard. 3. A discount for all 'regulatory' claims - potential increases in countercyclical buffers, ability to stop dividends, variability in impact of future regulation on capital etc.

In other words, equity owners of a bank have to contend with and reserve for a number of 2nd order effects on the seniority of their claims, not merely on the value of the assets that these claims are over. In return, the regulators are usually willing to write fairly generous put options on the value of these assets.

A low P/B being correlated with high dividends should surprise no one then - the dividend stream is the only way an equity holder gets to extract any value at all from a firm that may have surplus book equity but which they don't meaningfully control in any sense.