Finance: Research, Policy and Anecdotes

Important disclaimer: I am a member of the Advisory Scientific Committee of the ESRB. However, the views expressed below are exclusively mine and do not necessarily reflect the official stance of the ESRB or its member institutions.

Over the past two months, I chaired a workstream at the European Systemic Risk Board on pay-out restrictions, with the General Board adopting a Recommendation on 27 May to this effect. This recommendation was published on 8 June. The bottom line is to restrict voluntary payments by banks, insurers and CCPs that reduce own funds, including dividends, buy-back of shares and variable compensation to material risk-takers. The ultimate aim is to have sufficient levels of capital and loss absorbing capacity remaining in the financial institutions to mitigate the impact of the current crisis and thereby contribute to a smoother recovery for the pan-European economy as a whole. As the recommended actions fall under the jurisdictions of many different authorities, the Recommendation is addressed to relevant competent or supervisory authorities and, designated or macroprudential authorities.

While such restrictions intervene in ownership and management rights, there are strong arguments for such restrictions in times of crisis. First, banks constitute a critical sector for economic recovery and therefore there is the need to maintain sufficiently high capitalisation. Second, governments have provided capital relief to banks (e.g., EUR120 billion for significant institutions under direct ECB supervision) and have indirectly supported them through support payments to enterprises and households (who otherwise might have defaulted on loans) and credit guarantees; voluntary pay-outs would partly off-set the effect of these measures. Third, banks behave in a procyclical manner in their lending, showing a propensity to build reserves against credit losses and reduce lending during recessions. High capital buffers can to a degree mitigate this tendency towards deleveraging, which in turn calls for suspension of pay-outs to not off-set the effect of high capital buffers. Finally, if banks use dividend payments as a signal of strength to the market then any bank not doing so will fear being stigmatised, which speaks in favour of coordinated and mandatory action to restrict pay-outs.

There are certainly arguments against imposing such restrictions: charities, foundations, pension funds and retail investors often depend on steady dividend income; the prohibition of pay-outs might limit resource reallocation that might be needed during the recovery stage; and banning dividend payments can undermine banks’ relationships with investors and thus potentially restrict future access to market funding. These arguments certainly speak for only temporary restrictions.

The ESRB Recommendation comes after several recommendations issued by EBA, SSM and EIOPA in late March/early April, but there are several notable developments since then. First, this recommendation is a broader one, across several segments of the financial system, including banks, investment firms, insurance companies (which will certainly get under similar stress as banks and play a critical role in financial markets) and CCPs (while they are not directly involved in real sector funding, their critical role in financial market transactions makes their reliance important for banks’ and insurance companies’ hedging activities). 

Second, the recommendation refers to all voluntary pay-outs that have the effect of reducing the quality or quantity of own funds, including dividends, share buy-backs and variable remuneration to material risk-takers (staff members whose professional activities have material impact on the institutions' risk profile) and thus goes beyond previous recommendations. There is a proportionality clause in the recommendation and – obviously – where financial institutions have a legal obligation to pay, they have to do so.

Third, the restrictions apply until the end of 2020, rather than 1 October 2020, as under the SSM recommendation. It can be extended.

While the recommendation primarily targets pay-out restrictions on the consolidated level, one tricky issue has been restrictions on the sub-consolidated level. On the one hand, the recommendation calls for restrictions on the consolidated level, but on the sub-consolidated level if the parent bank is outside the EU. While ideally there would be cooperation on the global level, this has not happened, so we need to primarily take care of the European financial system.  On the other hand, several Central and Eastern European countries have imposed restrictions on subsidiaries of EU cross-border banks for financial stability concerns. There are strong arguments on either side. On the one hand, regulatory risk-sharing is incomplete in the EU (including within the euro area) and the financial stability mandate of national macro-prudential authorities focuses on local financial systems and economies. On the other hand, the Single Market principle of free movement capital speaks against imposing restrictions on the subsidiary level. The Recommendation therefore advocates that the relevant authorities enter a dialogue when considering imposing pay-out restrictions on subsidiaries of EU financial institutions. Compared to the last crisis, there are quite some fora available for this dialogue, including colleges, the Vienna Initiative and the Nordic-Baltic Macroprudential Forum.

It is important to stress that this recomendation constitutes “soft law”. The ESRB has no legal powers to enforce compliance; rather ESRB Recommendations are ‘comply or explain’. This means that an addressee could decide to explain in case it had good reasons for not complying. I am aware that there will be indeed some authorities who will decide to not comply, but I think it is still important to send this broad message in favour of capital preservation at times of very high uncertainty and possibly future distress!

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