Analysis
By Scander Bentchikou, analyst-manager at Lazard Frères Gestion, a specialist in the banking sector
The restrictions on bank dividends, which have been in force since March 2020, are expected to end this summer. For banks and their shareholders, this is a relief. The measure, supposed to protect banks from the crisis, has done more harm than good.
Technically, the banking sector’s dividends made a big comeback in spring 2021. However, the amounts paid remained well below their 2019 levels, given the still numerous restrictions. The return to normal will have to wait for the results of the banking stress tests, published on 31 July by the European Banking Authority. If they prove to be conclusive for most institutions, as expected, the ECB will finally be able to remove the restrictions that have applied since the start of the health crisis.
The suppression of dividends, an awkward warning signal
On 27 March 2020, the European Central Bank “recommended” that eurozone banks suspend the payment of their dividends, even when they had been announced for a long time. The aim? Preserve their capital to protect their solvency in the event of a deep economic crisis. At the time, the ECB believed that the Covid-19 pandemic would lead to a collapse in bank capital.
The massive financial support provided to companies and individuals during the crisis prevented the much-feared wave of defaults. Regulatory capital levels managed to remain broadly stable throughout 2020. On the other hand, the ban on dividends had a real effect on the share prices of banks. After their initial fall in February-March, they accelerated their decline until May 2020, or even until the autumn, despite the market upturn.
The suppression of dividends was a worrying signal of distress for the sector. In a banking environment that is highly regulated to deal with the worst crises, the adoption of this unexpected and unprecedented measure gave the impression that regulators had lost confidence in their own prudential rules. As the central bank has information about the banks that the market does not have, investors may have feared the worst. By shouting fire, the central bank’s firefighters sowed panic, even though the fire did not actually take place.
Negative long-term consequences
The consequences of this episode are not neutral for the banking sector. Investors became aware that their dividend could be suspended without notice in the event of economic concerns. Fearing the repetition of similar measures in future market turmoil, they will now tend to increase the discount applied to bank stocks to take this latent risk into account.
Far from being a simple matter of frustration among shareholders, the subject hides a more serious problem, the cost of capital and of its access for credit institutions.
The sector’s ability to raise capital under good conditions could be reduced. In order to protect banks in the short term, the ECB reduced their ability to finance themselves under good conditions. This, while banks are already faced with profitability problems linked to low interest rates, changes in banking practices (digitization) and competition from fintechs, which have led them to announce a series of restructurings (branch closures, staff cuts).
The results of the dividend suppressions are therefore very mixed, especially as the retention of capital for the benefit of the banks has proved to be very symbolic. The annual dividends of the European banking sector represent 0.5% to 0.6% of regulatory capital (less than 5% of bank equity). Their suppression would therefore have had only a small impact on the preservation of bank reserves in the event of a “severe” crisis.
A practice that should be banned in order to manage future crises better
The lifting of restrictions now seems like to have been achieved by the end of July and credit institutions will soon be able to return to their pre-crisis yields, which are multi-year in some cases. A significant increase in dividends and share buybacks within the banking sector should be expected to offset the prolonged lack of shareholder returns. This trend should be a significant catalyst in the coming months for the sector as a whole in Europe.
Yet we must in fact hope that this “return to normal” will be accompanied by a return to regulatory stability. Banking regulation is a question of predictability and proportionality, quite the contrary of the suddenness of the announcements of March 2020. The European Parliament is now considering whether legislation is needed to provide a legal framework for this practice. However, the ECB seems to have become aware of the pitfalls of this policy, according to a letter dated 18 May 2021 sent to two MEPs by Andrea Enria, Chairman of the ECB’s Supervisory Board:
“The benefits of a dividend restriction must be carefully evaluated against its disadvantages. (…) In the light of this experience, I do not see a clear and pressing need to provide the supervisory authorities with the power to impose general and legally binding restrictions on dividends (…). Such a process would be contrary to other important legislative initiatives aimed at complementing the banking union architecture.”
A firm commitment from the ECB to eschew this practice in the future would be welcome to restore investor confidence in the banking sector in the medium term.
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Article written on 02 July 2021. The information provided is not intended to constitute investment advice and is intended for information purposes only. The data used in this document is used in good faith, but no guarantee can be given as to its accuracy. All data contained in this document, unless otherwise indicated, comes from Lazard. Past performance is not a reliable indicator of future performance. The opinions expressed in this document are subject to change.
