One striking juxtaposition in equity returns this year is that utilities in the S&P 500 were the top performing sector in the year to date, with a positive return of more than 9 per cent, while financials were the worst, returning a minus figure of more than 21 per cent. In the UK utilities showed only a marginally positive return over the year, but the relative picture was broadly the same. Nothing more clearly illustrates how the banks’ transition from growth fuelled by leverage to more heavily regulated utility status entails a very nasty valuation adjustment. For longstanding bank investors, the pledge this week by George Osborne, the British chancellor, to implement most of the proposals of Sir John Vickers’ Independent Commission on Banking rubs salt in the wound.
Among investors’ more pressing concerns is the uncertainty that now prevails over bank dividends. At first sight this might seem odd. Although few people buy all the assumptions behind the famous Modigliani-Miller theorem that suggests investors should be indifferent to whether money stays in the company or is paid out, there are plenty of companies that pay no dividend but still enjoy high ratings. It is true that regulatory restraint on dividends transfers value from creditors to shareholders, in that less money will be there for creditors in a liquidation. But it does so at the cost of reducing the capital base, which is scarcely helpful to shareholders in a financial hurricane.
Charles Goodhart of the London School of Economics has argued, with colleagues, that paying dividends can be to the detriment of equity holders as well as debt holders. This is because a reduction in dividends allows banks greater access to debt markets when liabilities are due and can help remedy implosions in specific debt markets.
Yet investors clearly do worry about the pay-out. A constant refrain of fund managers in response to the Vickers commission has been that it is not helpful for dividends. And share prices respond sharply to unexpected announcements about dividends, witness the share price fall that followed news back in March that the Federal Reserve had scotched Bank of America’s plan to increase the pay-out after the bank stress tests. The question is why?
It is not necessarily irrational. There is, after all, a severe agency problem in banking whereby managers and employees have hogged a disproportionate share of the returns to the disadvantage of shareholders. A dividend payment reduces agency costs because it reduces the resources under managers’ control and increases discipline on them by forcing them to raise outside funds for new investment. This means that there is more market monitoring of their performance, since shareholders can veto the funding. And the pay-out is particularly valuable in mature industries like banking where the return on new investment by an ego-tripping management may be questionable.
Of course shareholders are happy to accept no dividends where management is attentive to their interests – the Warren Buffett case. But at the other extreme, an important lesson of investing in Japan, where dividends are threadbare, is that relying exclusively on capital gains to generate total return can be a snare and delusion. When the 1980s stock market bubble burst, the gains evaporated and what remained was a corporate sector run in the interests of managers and employees, yielding precious little cash to outsiders.
With banking today, there is both a governance problem and a regulatory restraint, against a deteriorating economic background. And nobody is quite sure how severe that restraint will be. The watchdogs are emitting some blood-curdling noises. Lord Turner of the UK Financial Services Authority pointed out on the publication of his report on RBS, for example, that if the Basel III capital adequacy regime had been in place, RBS would have been prevented from paying a dividend from 2005 onwards. We know that dividend decisions will now be scrutinised more closely, which in Britain includes FSA observers in the boardroom – a highly intrusive move that will, I suspect, mean that much board business is conducted elsewhere, leading to a new governance problem.
What investors need is reassurance that the period of restraint has a limit, the rentier’s equivalent of a sovereign debtor’s medium-term debt reduction strategy. Yet too much is still up in the air in the reorganisation of the financial architecture for this to be on offer. And even in relatively stable utilities regulatory risk is ever present. Monday’s fall in National Grid’s share price over declining visibility of dividend policy and capital structure before price control reviews next year makes the point. The bank dividend conundrum provides another reason why, as I argued before, the timing of a turnround in bank shares is a hopeless betting proposition.
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