Why is Equity Capital Expensive for Opaque Banks?

Abstract

Bank managers often claim that equity is expensive relative to debt, which contradicts the Modigliani-Miller irrelevance theorem. This paper combines dividend signalling theories and the Diamond-Dybvig bank run model. 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.

What factors determine dividend smoothing by US and EU banks?

“…Another source of information asymmetry has been noted by Kauko (), who shows that dividends may be a welcome source of information for both debtholders and shareholders. Aivazian, Booth, and Cleary () find that firms that regularly access public debt (bond) markets are more likely to pay higher and smoother dividends than firms that rely exclusively on private debt.…”

Effect of Institutional Depositors on Banks' Dividend Policy: Evidence from Korea during the Global Financial Crisis*

“…Kauko (2012) suggested in a theoretical model that the dividend becomes a means to deliver information about profitability and liquidity to depositors. Kauko (2012) also argued banks would be likely to increase their dividends during a financial crisis since depositors become more sensitive to the bank's liquidity at this time.…”

“…Kauko (2012) suggested in a theoretical model that the dividend becomes a means to deliver information about profitability and liquidity to depositors. Kauko (2012) also argued banks would be likely to increase their dividends during a financial crisis since depositors become more sensitive to the bank's liquidity at this time. While Kauko (2012) assumed depositors' homogeneous information sensitivity, recent theoretical models and the results of empirical studies (Huang and Ratnovski, 2011; Oliveira et al ., 2015) have argued that institutional depositors, such as financial companies, tend to be more sensitive to information, such as dividend payments, than individual (small) depositors.…”

“…However, Forti and Schiozer (2015), Huang and Ratnovski (2011), Kauko (2012), and Oliveira et al . (2015) found that depositors become the recipients of a bank's management information, as shareholders do.…”

Bank dividend payout policy and debt seniority: Evidence from US Banks

“…The literature on the determinants of banks’ payout policy rarely accounts for the type of debtholders and how they may impact bank dividend policy. A handful of studies documents that banks distribute dividends to signal their financial health to bank debtholders, which is known in the literature as the signalling hypothesis (e.g., Kauko 2012; Forti and Schiozer, 2015). They argue that banks maintain dividend payments and they attempt to avoid the need to reduce dividends because external economic agents might perceive dividend cuts or omissions as distressingly negative signals.…”