One of the unsolved and debated topics in economic literature is the dividend payout policy. Despite researchers’ effort to explain dividend behavior by developing numerous theories and factors, this puzzle is still unsolved. Dividend payout study began by Miller and Modigliani’s (1961) irrelevant theory. Further studies revealed market imperfections factors such as tax, agency cost, and asymmetric information, and enlightened dividend policy could be relevant to firm’s value. One of the factors that had its impact on dividend payout is liquidity, which makes dividend payment possible. The aim of this study is to examine the relation between bank dividend payout policy and liquidity.
In general, the dividend policy refers to decisions made by management regarding dividend payout to shareholders; and liquidity is a company’s available funds to cover dividend payouts, where firm’s with stronger liquidity or more access to found are more likely to pay more cash dividends. Pandey (2003) mentions that payment of dividends means cash outflow. So, the firm with higher liquidity has higher ability to pay dividends. Watson and Head (2007) studies showed that a firm may have high earnings but not adequate cash to pay dividends, so a firm with higher liquidity has higher ability to pay dividends. This captures the importance of liquidity impact on dividend policies. Although liquidity has an impact on dividend policies and its payout, it is also affected by dividend payout it turn. Insufficient cash or pressure on liquidity may lead management to follow a conservative dividend payout policy that may lead in unsatisfied shareholders and may damage the firm’s reputation in
market. Over the years researchers have employed numerous financial variables that have a possible impact on the dividend policy with the mixed finding. The importance of liquidity was lightened by scholars, regulators and governances after the financial crisis of 2007–08.
Dividend policy has attracted attention of many researchers ever since, such as Miller and Modigliani. The scholar’s aim is to explain that how the decisions in line with dividend are made, what are the related factors, and whether they influence firm’s value and so on. The irrelevant theory introduced by Miller and Modigliani (1961) that suggests dividend decision has no effect on firm’s value in perfect capital markets. Since real world market is imperfect and there are many factors that have their impact on dividend policy and firm’s value, therefore they led researchers to conduct more studies for this topic and developed a large number of theories, models and factors that affected dividend policy. Allen et al. (2000) states that the high dividends payout ratios have more effect on companies’ values. And on the contrary, De Angelo and De Angelo (2006) offers that lower dividend payout is preferable quoting from Black (1976).
Further studies of scholars introduced more theories for this very purpose, such as Bird-in-Hand by Gordon and Walter (1963), tax preference by Brennan (1970), Agency problem by Jensen and Meckling (1976), signaling theory by Aharony and Swary (1980), and transaction cost and residual theory by Mueller (1967). Furthermore, plenty of studies based on economy, industry, region, country law and social environment have been conducted to identify factors that affect dividend policy decision. These factors include size, tax, profitability, investment opportunity, and liquidity, or lower costs of chasing dividends that may have its impact on the rise or fall of dividends policy. For example, Fama and French (2001) studied the size, profitability and growth opportunities factors on dividend policy.
Meanwhile, study of bank dividend policies and its factors is not an old one in comparison.
Bank dividend policies are mostly based on signaling and agency theories. Casey and Dickens (2000) confirmed that dividend policy of bank is different from other institutions and industries. Scholars such as Filbeck and Mullineaux (1993), Collins et al. (1994) Boldin and Leggett (1995), Filbeck and Mullineaux (1999), Huda and Farah (2011), Marfo-Yiadom and Agyei (2011), Lee (2009), and McCann et al. (2012) have studied dividend policy of bank.
Banks represent one of the most important parts of the economy in our world. They serve as a trusted and secure place to keep found, transferring money, and providing the short-term or long-term financial facility for the business and individuals, and help them to manage the variety of risks. Banks transform credit risk and supply liquidity to the economy, using the short-term liquid deposit to finance long-term lending, and created liquidity by financing relatively illiquid assets with relatively liquid liabilities. (Diamond and Dybvig, 1983)
In the banking system, liquidity means the ability to fund all contractual financial obligations as of the maturity date. Berger and Bouwman (2008) described the asset’s liquidity as “how quickly, easily and costly is to convert the asset into cash”. The sources of bank liquidity are the cash holdings in currency, on account at the Federal Reserve or another central banks, or holding securities that can be sold quickly with minimal loss, such as government bills or commercial papers. The comparing of bank current assets and current liabilities creates the bank liquidity ratio. In the distress period, inadequate liquidity level, brings the high cost of funding resource and reduces bank profitability and may lead to insolvency. On the other hand, excessive liquidity will lower return on assets and reduce bank performance. However, a bank’s liquidity situation, particularly in a crisis, will be affected by
much more than just these reserves.
The subprime mortgage crisis demonstrated how the economy can suffer when the banks do not have sufficient safety margins of capital and liquidity. The most related reason for a bank’s drop off is a liquidity problem that makes it impossible to survive a ‘bank run’.
Banks can increase their liquidity in multiple ways such as shorten asset maturities, improve the average liquidity of assets, or cut their dividend payout and so on.
As the global financial crisis was the result of financial products of securitization and re-securitization based on sub-prime mortgage backed securities (MBS), collateralized debt obligations (CDOs) and CDO squared, which developed by banking sectors and credit rating agencies. When US investor’s lost their confidence in the value of sub-prime mortgages liquidity crisis occurred, and several banks such as American Home Mortgage, Bear Stearns, Lehman Brothers and the investment bank Merrill Lynch went insolvent or unable to meet minimum liquidity requirements. Therefore, government had to intervene with liquidity and credit facilities to prevent economy to collapse. Hence, bank liquidity had gained the attention of the Basel Committee on Banking Supervision (BCBS) and became a reason to set out new regulations and measurement on bank liquidity and dividend policy Basel Committee on Banking Supervision (2010a) to strengthen the global capital, liquidity, and risk assessment rules and enhance the resilience of the banking sector. Even though liquidity was one of the important cause of 2008 financial crisis, some banks instead of cutting or omitting dividend payout, consistently paid the dividend payout regardless of cash outflow and therefore weekend their liquidity buffers. Hence, to determinate the appropriate liquidity measurement, the existing and Basel Committee on Banking Supervision liquidity ratios are also being studied.
Seemingly, the bank has a crucial role in the modern financial system and economy by creating liquidity and transforming the risk. Therefore, having a healthy banking system that can optimize its performance in an economic crisis is vital. Basel Committee on Banking Supervision (BCBS) found the insufficient liquidity as one of the main reasons for 2007 financial crisis, where the key issue was that banks had built up excessive on and off-balance sheet leverage, and at the same time, many banks were not holding sufficient liquidity to cover their leverage. As a result, the banking system was unable to absorb the credit losses and large off-balance sheet exposures that was created in the banking system shadows.
Accordingly, Basel Committee on Banking Supervision sets of reform measures as Basel III which has its focus on the risk of “bank run”, requiring differing levels of reserves for different forms of bank deposits and other borrowings. The Basel III in the Principle 8 of the
“Sound Principles” focuses specifically on intraday liquidity risk and states that: “A bank should actively manage its intraday liquidity positions and risks to meet payment and settlement obligations on a timely basis under both normal and stressed conditions and thus contribute to the smooth functioning of payment and settlement systems.”
Basel Committee on Banking Supervision (BCBS) announced Basel III reform in September 2010 which should be fully implemented by 2019. In order to establish stronger capital and liquidity rules, Basel III proposals address increasing the quantity and quality of capital, expanding capital requirements for certain types of risks, introducing globally valid liquidity standards, and adjusting capital levels to reduce systemic risk in the global interconnected financial markets. Since the capital is not liquid and was not able to get liquidated during the crisis, therefore, cannot be used to bear losses, Basel Committee on Banking Supervision (2010a) sets two new liquidity measurement standards with a minimum
requirement of liquidity, so that they can be able to define liquidity risk that a bank is exposed to. These measurement are the liquidity coverage ratio (LCR) which is the measure of bank’s exposure to short-run liquidity risk, while the Net stable funding ratio (NSFR) is a measure of maturity mismatch aimed at promoting more medium and long-term funding Basel Committee on Banking Supervision (2010a). The short-term Liquidity Coverage Ratio (LCR) of Basel Committee on Banking Supervision (2010a) makes bank able to cover downgrading of credit rating, and partial loss of deposits, unsecured wholesale funding, and increasing significantly insecure funding and derivative calls on Off-balance sheet (OBS) exposures.
Basel Committee on Banking Supervision (2010b) extended the requirement based on which banks should hold sufficient high-quality liquid assets to manage and cover its total net cash outflows under a stress period over 30 days. This is used to get money quickly and needs to be repaid usually within one year. Basel Committee on Banking Supervision (2010b) cited that assets can be classified as high-quality when they are easily converted into cash with no loss of value or only little loss of value.
The metrics of these measuring shall be updated regularly to proper calculation of LCR and NSFR. Monitoring tools are the minimum amount of information that supervisors should use to decide liquidity risk exposure (Basel Committee on Banking Supervision, 2010a). The requirements and the time line of the implementation are shown in Table 1.
The implementation of Basel III might have both negative and positive effects on the banking industry and macro economy. The Basel III requires securing a higher level of capital and liquidity that could threaten the profitability of the banking industry by increasing the funding costs in the short term. It may also hamper the financial intermediary function by raising lending rates and reducing lending volumes, which could ultimately lead to slower
economic growth. However, over the medium to long term, it could promote economic growth by lowering the costs of funding capital and liquidity by reducing the chance of financial crises and enhancing the stability of overall banking industry.
Table 1. Requirements and implementation time of new elements in Basel III Countercyclical buffer Range of 0-2.5% constituting of
common equity dividend policy of the bank or not. The Basel III requires more liquidity coverage, therefore bank profitability may be affected. The change of banks profitability may affect the bank dividend policy. Since higher liquidity means having more liquid (current) assets which are less profitable than long term (fixed) assets that generate additional costs such as opportunity and maintenance cost that lower the bank profit. Although, increasing bank liquidity may
1. The LCR is partially implemented