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    ESRB Evaluates Effectiveness of Dividend-Based Prudential Regulation

    July 01, 2019

    ESRB published a working paper that investigates the effectiveness of dividend-based macro-prudential rules in complementing capital requirements to promote bank soundness and sustained lending. Available evidence on euro area bank dividends and earnings suggests there is a potential link between the payout policies and the adjustment mechanisms, through which bankers opt to meet their target regulatory capital ratios. This paper develops a Dynamic Stochastic General Equilibrium (DSGE) model that features a banking sector and certain financial frictions that account for this empirical phenomenon. Then, it defines a dividend-based regulatory scheme that is shown to be an effective macro-prudential complement to capital requirements.

    The paper presents empirical evidence on bank dividends and earnings in the euro area. It describes the basic model and identifies the transmission mechanism through which a dividend prudential target improves bank soundness and financial stability. Further it presents the extended model to improve the matching of the model to the data and develops a quantitative exercise to assess the welfare effects of the proposed policy and its interactions with regulatory capital ratios. Welfare-maximizing dividend-based macro-prudential rules are shown to have important properties:

    • They are effective in smoothing the financial and the business cycle by means of less volatile bank retained earnings
    • They induce welfare gains associated to a Basel III-type of capital regulation
    • They mainly operate through their cyclical component, ensuring that long-run dividend payouts remain unaffected
    • They are flexible enough so as to allow bank managers to optimally deviate from the target (conditional on the payment of a sanction)
    • They are associated to a sanctions regime that acts as an insurance scheme for the real economy

    The paper highlights that simplicity of the model is instrumental to clearly identify the transmission mechanism through which the proposed policy rule operates. Yet, it comes at the cost of abstracting from a number of considerations that potentially constitute promising avenues for future research. Modeling one or more of the market imperfections that may be behind bank dividend policies should be helpful to match the data by means of an improved micro foundation of the macro-economic model. Moreover, additional ingredients that are present in reality and that could possibly change some of the results have been omitted. The paper concludes that optimal coordination between this type of prudential regulation and other macroeconomic policies should be considered as well.

     

    Related Link: Working Paper (PDF)

     

    Keywords: Europe, EU, Banking, Securities, DSGE Model, Macro-Prudential Regulation, Capital Requirements, Dividend-Based Rules, Financial Stability, Basel III, ESRB

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