Background and Incentives

Recently, regulators and investors pay more attention to commercial bank dividend payout, especially since the year 2007 over the financial crisis. In fact, Boldin and Leggett (1995) have disputed that retained earnings were the primary cash resource of the U.S. banks after the financial crisis. If banks want to come out of the crisis, they need higher capital ratios, and stronger profitability was able to expand lending more.

People trust that banks will have the money when they go to get it because banking is a business providing financial services to consumers, businesses, and governments. The subprime mortgage crisis happened in the United States in the year 2007. It continues to progress as the world financial crisis. In this crisis, too much reliance on off-balance sheet operations of banks operating problems has emerged, like Bear Stearns, Lehman Brothers and the investment bank Merrill Lynch went bankrupt. The government subsidized some large banks during 2008 financial crisis because of the issue of too big to fail.

People began to think about the importance of banking supervision, internal auditing, market disciplines, and vulnerability and negative externality problems in the financial system when the world might face the financial crisis again especially in the global market. Basel III is a program of significantly revise existing capital adequacy framework was announced by the Basel Committee on Banking Supervision (BCBS) in September 2010 and fully implemented in 2019. BCBS and Financial Stability Board (FSB) also defined and specified targeted Global Systemically Important Banks (G-SIBs) to prevent those large banks from failures. G-SIBs are likely to be imposed higher

supervision and capital adequacy standard than ordinary banks. Those strings are expected to avoid the occurrence of the systemic risk of global financial markets. The Federal Reserve Act also ask banks to keep their money in reserve with a certain percentage, so that they would not be a shortage when everyone is going to withdraw their money at the same time. Moreover, Federal Reserve included the list of Domestic Systematically Important Banks (D-SIBs), which are those banks not being big enough for G-SIBs status but still with high sufficiently domestic systemically importance making them subject to the most stringent annual Stress Test (USA-ST)¹.

In fact, Basel III is a regulatory structure on bank capital adequacy, stress testing, and market liquidity risk. The banking regulatory requirements also significantly improved capital adequacy requirements; reduce the "too big to fail" systemic risk which brings moral hazard; strict with the capital deduction limit; enhancing risk coverage; requiring banks to increase capital buffers; provide liquidity coverage monitoring indicators to strengthen liquidity management. Comparison with Basel II, there are several changes in the definition of capital², minimum capital requirements, risk coverage, and leverage ratio and liquidity measures. Table 1 shown that the capital requirements (as % risk weighted assets) of Basel III and Basel II. First of all, the minimum Common Equity Tier 1 (CET1) as a percentage of the risk-weighted asset will increase from 2% to 4.5%. Create buffers in good times that can absorb shocks in periods of stress. There are two types of buffers are introduced. First is Capital Conservation Buffer (CCB) additional 2.5%, bringing the total capital adequacy ratio to 10.5%. This capital buffer can be used to conserve a bank’s capital. When bank did not meet the buffer requirement, automatic safeguards apply to limit the amount of

1 Any banks in the US with more than $50 billion in assets must take the annual Stress Test (USA-ST).

This test is an examination of what would happen to a bank if it ran into trouble.

2 Only Tier 1 and Tier 2 capital remain. Tier 3 disappeared.

dividend and bonus payments it can make. Second is a countercyclical buffer to limit excessive credit expansion. The buffer will vary between 0% and 2.5% of CET1. The leverage ratio computed as Tier 1 capital divided by the total of on and off-balance assets less intangible assets, was capped at 3%.

Table 1: Basel III Capital Requirement (as % risk weighted assets)

Basel III Basel II

D Capital Conservation Buffer (CCB) 2.50 None

F Minimum CET 1 + CCB 7.00 2.00

G Minimum Total Capital + CCB 10.50 8.00

H Countercyclical buffer 0 – 2.50 None

I Leverage ratio 3.00 None

Note: “A” item is Tier 1 capital and Tier 2 capital; “B” item isCET1 and additional Tier 1; “C” item is CET1 includes qualifying common stock and related surplus net of treasury stock, retained earning, accumulated other comprehensive income, plus or minus regulatory deduction or adjustments as appropriate, and qualifying CET1 minority interest

Source: Subbarao (2012)

Banks are giving time to implement these changes. The Basel Committee has outlined phase-in arrangements in Table 2 below. The minimum common equity and Tier 1 capital ratios will be increasing over two years beginning in January 2013, and fully increases taking effect in January 2015. Then, followed by a three-year phase-in starting in January 2016 of the capital conservation buffer, with full 2.5% buffer requirement taking in January 2019. This buffer must consist mostly of tangible common equity. According to Basel III, regulators should forbid banks from

distributing earnings, dividend payments, and salary bonus payments when banks have depleted their capital buffers. The capital conservation buffer would increase in increments of 0.625% annually on January 2016, until rising to 2.5% by January 1, 2019. Also, the deduction from Tier 1 capital of excess minority investments in financial institutions, mortgage servicing rights, and certain deferred tax assets will be phase-in over a five-year period in 20% increments beginning in 2014 to emphasize the quality of capital

It is possible that banks will be more or less profitable in the future due in part of these regulations. This study focuses on the effect of increasing capital adequacy. There are several ways to increase the capital base. First, banks can issue new equity raising the capital. When banks issue the new capital from external resources, the cost of funding will high. There was quite expensive and more difficult for banks to raise the new capital, especially the banks have poor performance and lower levels of capital. The rate of return will decrease at the moment when banks need to encourage enhanced investment to rebuild and restore capital buffers.Other ways, banks might decide by a reduction of credit supply (Hyun and Rhee, 2011). However, policy makers do not like a reduction credit availability in an economic crisis because there are fears that an adverse effect on bank lending could hurt the economy activity in the further. It also will affect the daily operation of banks, directly influence the performance of banks and then indirectly affect the dividend policy.

Table 2: Timeline of Basel III Capital Phase-in Arrangement (in percentages)

Phases 2013 2014 2015 2016 2017 2018 2019

Leverage ratio Parallel run 1 Jan 2013 – I Jan 2017

Disclosure starts 1 Jan 2015

Migration to Pillar 1

Minimum common equity capital ratio (row 1) 3.5 4.0 4.5 4.5 4.5 4.5 4.5

Minimum Tier 1 capital 4.5 5.5 6.0 6.0 6.0 6.0 6.0

Minimum total (Tier 1 + Tier 2) Capital (row 3) 8.0 8.0 8.0 8.0 8.0 8.0

Capital conservation buffer (row 4) 0.625 1.25 1.875 2.5

Minimum common equity plus capital

conservation buffer (sum of row 1 & row 4) 3.5 4.0 4.5 5.125 5.75 6.375 7.0

Minimum total capital plus conservation buffer

(sum of row 3 & row 4) 8.0 8.0 8.625 9.25 9.875 10.5

Phase-in of deductions from CET 1* 20 40 60 80 100 100

Capital instruments that no longer qualify as

non-core Tier 1 capital or Tier 2 capital Phased out over 10-year horizon beginning 2013

*Including for deferred tax assets, mortgage serving rights and financials.

Source: Bank for International Settlements

The last ways for banks to improve their capital is by the retention of profits and reduce or even omitting dividend payments. Lower dividends payout can contribute to banks' ability to use retained earnings to build capital. The Bank of China (Hong Kong) was flagged cut the dividend payout ratio from 60 per cent to 70 per cent previously to the recent year 2014 would be 40 per cent to 60 per cent, because of increased capital requirements from Hong Kong Monetary Authority and the Basel III international standard. While based on the ways above to increase capital base and improve capital quality, what the choice of US commercial banks? No matter what ways, it will bring effect to dividend payout. This study is to discuss the dividend payout policy being affected by the new capital requirement of Basel III.

Boldin and Leggett (1995) have argued that the dividend policy of the bank holding company is a signal of their quality and retained earnings is the primary source for the bank industry to raise capital. However, Bessler and Nohel (1996) have shown that U.S bank managers were unwilling to cut the dividend in the 1980s even with suffering losses is because they are afraid that investors and financial analysts discontinue the relationship when negative information is released. More recently, Basse et al. (2014) have shown that dividend signaling and dividend smoothing are not relevant economic phenomena with the empirical evidence from the European banking industry. Also, Grullon et al. (2005) have shown that dividend policies were not strongly associate with performance.

Furthermore, Miller and Modigliani (1961) demonstrate that the dividend policy has no effect on the price of the company’s stock or its cost of capital. According to them, the dividend policy is irrelevant if the company’s capital investments and debt policy were regular. Thus, the dividend payments can just be financed by a combination of excess retained earnings and new equity financing if required. While, the government

capital regulation may also affect the payout policy of banks (Bessler and Nohel, 1996).

Banks would consider cutting or omitting the dividend to improve its financial strength and to meet regulatory capital requirements of the government. However, the dividend policy depends on macroeconomic conditions affect the capital requirement.

Typically, when making a dividend decision, the company tends to balance the needs of future investments and the profit expectation of shareholders. There is a tradeoff to make the dividend policy and the future investment plan. Al-Twaijry (2007) indicated that the dividend policy is affected by the patterns of the past dividends payment trend, the stability of earnings, and the current and expected future earnings.

High growth firms will not pay a significant amount of bonus from their income to shareholders because they need profits to expand their business or sustain business growth.

Given this divisive discussion about dividend policy, the study collects and analyze the relationship between capital requirement regulation and bank’s dividend payout. The study split the sample into two group. One group identified as US commercial banks under the list of G-SIB & D-SIB and another group as other US commercial banks.

Basel III will be implementation on 31 March 2019, before that, there have phase-in arrangements parallel run start 1 January 2013 – 1 January 2017 and disclosure starts 1 January 2015, the study split into several periods following the arrangements.