Bank Dividend Policy during the Financial Crisis 2007-2009: an Empirical Analysis

In the finance literature investment opportunity is a crucial determinant to explain dividend policy. In order to measure the investment opportunity I use the ratio between the market price per share and the book value per share. The market value of equity measures the present value of all future cash flows to equity holders, from both assets in place and future investment opportunities, whereas the book value of equity represents the accumulated value generated from existing assets only.
Therefore, the market to book ratio measures the mix of cash flows from assets in place and future investment opportunities. A company with more investment opportunity should sell for a higher market to book ratio, as it has a greater anticipated cash flow from its invested capital. Thus a company may limit dividends as a way to conserve cash to take those opportunities. Moreover firms with greater growth opportunity will need to keep dividend payouts lower in order to avoid costs of external financing. Gugler (2003) finds that firms with low investment opportunities pay higher dividends, independently of who controls the corporation.

Higher dividends can also be effective in order to deal with the corporate free cash flow problem. Managers cannot be controlled perfectly so they can have the incentive to satisfy their own interests instead of interest of the shareholders. Once managers have satisfied all obligation contracted by the company with funds generated by operations, can use the remaining flows from the treasury for their own benefit (Jensen, 1986).
Thus managers with substantial free cash flow could invest it at below the cost of capital or waste it on organizational inefficiencies rather than distribute it to shareholders. The use of dividend policy as a way of reducing free cash flow is justified by the existence of alternatives for the control of managers’ decisions. In countries with a financial system oriented to the market, the control of managerial behavior is possible through capital markets.

Instead in these countries oriented to bank model, the bank debt can be view as an alternative to dividend policy in order to reduce the conflict of interests between managers and shareholders.
Companies with few investment opportunities can limit the management’s temptation to overinvest by paying out a larger portion of earnings. So we would expect higher dividends in stable, low-growth industries than in high-growth companies that have lots of investment opportunities and so profitable uses of their capital.

The negative relation between growth opportunity and dividend yield finds support in the empirical studies of Barclay, Smith, and Watts (1995) and Dickens, Ross, Michael, Casey, and Newman (2002). Furthermore this relation is reinforced by two contracting cost arguments. First, the new issue market helps to control conflict among management, shareholders and debt holders by providing more effective monitoring of management.

By paying higher dividends, firms must access the new issue market more frequently. This monitoring benefit of the new issue market is greater for companies with few growth opportunities than for companies with many growth options, because the latter, even if they do pay no dividends, they still are likely to access the new issue market frequently. Second, the corporations with more growth opportunity can tolerate more constraints on dividend payments, before that the benefits, in terms of control the underinvestment problem, generated by conflicting incentives of shareholders and debt holders, are offset by the costs.

Thus banks with greater investment opportunities should conserve cash to fund those opportunities and, therefore, pay fewer dividends.