How Bank Dividends Help Wall Street -- and Hurt Almost Everyone Else

The Federal Reserve's plan to let some big banks open the spigot on dividends is great news for their CEOs and other major investors in the companies. For everyone else -- notably taxpayers -- it's a troubling development.

The nation's 19 largest banks have been restricted in making payouts to shareholders since 2009, after the government rescued the institutions during the financial crisis. Bankers argue that many of these firms are now healthy enough to again issue dividends. They also claim that the dividend limits hurt banks' performance by hindering their ability to raise money, which in turn curbs lending and slows the U.S. economic recovery.

The Fed announced today that it will notify banks by March 21 if they will be permitted to resume and increase dividend payments. Some banks, including BB&T (BBT), JPMorgan Chase (JPM), Wells Fargo (WFC) and US Bancorp (USB), already seem to have gotten the green light -- all announced dividend boosts or share buybacks on Friday. The central bank said that economic conditions and the capital positions of financial institutions have improved enough to warrant the move.

Yet there's a very simple reason why this is a mistake. As a group of prominent economists recently explained in a letter to the Financial Times:

Paying dividends immediately reduces bank capital and the amount of money available to lend.... A dollar paid out to shareholders through either dividends or share repurchases is a dollar that would not be accessible to creditors in a situation of financial distress.

So long as big banks remain undercapitalized, as they are today, such financial distress remains a real possibility. In other words, allowing companies to return money to shareholders now raises the risk that taxpayers will have to bail them out in future.

The Fed hopes to mitigate that problem by requiring banks that pay dividends to grow their capital base. Dividends also will be limited to no more than 30 percent of expected earnings, although that's still a lot of capital potentially flying out the door.

Why bankers hate equity
Another reason to be wary of letting big banks pay dividends for now is that it encourages their use of leverage. As Stanford University economist Anat Admati notes, the average banks lives on borrowed money, funding more than 95 percent of their investments with debt and less than 5 percent with equity. By comparison, most publicly traded non-financial companies are 70 percent equity-financed; many highly profitable companies, such as Google (GOOG) and The Gap (GPS), are funded almost entirely through equity.

But bankers dislike equity. As we saw during the housing bubble, when Wall Street firms levered up big time, they'd much rather run their businesses on debt. Here's why, as Admati neatly sums up:

With more equity, banks have to "own" not only the upside but also more of the downside of the risks they take. They have to provide a cushion at their own expense to reduce the risk of default, rather than rely on insurers and eventually taxpayers to protect them and their creditors if things don't work out.

Trouble is, living on debt makes a company vulnerable to falling asset values. It's no different than people who got creamed after borrowing heavily against the rising value of their homes -- when real estate prices plunged, their debt soared. The danger with "systemically important" financial firms, of course, is that they're interconnected and implicitly backed by Uncle Sam. When they get in over their heads and suddenly have to shed debt, as happened in 2008, the whole economy feels the pain.

Big payday for CEOs

Who will benefit most from the Fed easing limits on bank dividends? Certainly bank executives, who are among the largest bank shareholders and much of whose compensation in in stock, will do well. JPMorgan chief executive Jamie Dimon could earn an estimated $6 million a year in dividend payments.

Other major Wall Street investors, such as hedge and pension funds, also will benefit. In his recent annual investor letter, for instance, Warren Buffett fairly crowed about the prospect of Wells Fargo, in which he owns a large stake, renewing dividend payments.

Good for him. But investors shouldn't reap these profits while banks -- institutions whose losses are effectively guaranteed by the U.S. government -- remain insufficiently capitalized. And what's the best way to ensure these companies are safe? For now, make them hold on to their earnings.

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Alain Sherter

Alain Sherter covers business and economic affairs for CBSNews.com.

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