Bankruptcy hardball and bank dividends
When I read the recent BIS working paper Low price-to-book ratios and bank dividend payout policies by Leonardo Gambacorta, Tommaso Oliviero and Hyun Song Shin, I was immediately reminded of the paper Bankruptcy hardball (Ellias and Stark (2020), Calif. L. Rev., 108, p.745) though that is not how Gambacorta, Oliviero and Shin analyse the issue.
Ellias and Stark documented the tendency of distressed firms to declare dividends or otherwise move assets out of reach of the creditors for the benefit of shareholders. This strategy which they called bankruptcy hardball is most closely associated with private equity owners.
As I reflected on the Gambacorta, Oliviero and Shin paper, it struck me that what makes bankruptcy hardball attractive is the high level of leverage rather than private equity ownership. If the assets are worth 100 and debt is 80% of assets (so that equity is 20%), then shifting 10 of assets to the shareholders reduces the value of debt only by 12.5% but increases the value of the shareholders by 50%. If debt is 90% of assets, then the same shift of 10 would be only a 11% loss to lenders but a 100% gain to shareholders. Since private equity is characterized by high leverage, the incentives are much greater in their case. On the verge of bankruptcy, it is true that the leverage would shoot up for all companies (as the equity becomes close to worthless), and it might appear that every firm can play hardball. However, the tactics are more likely to survive legal challenges when they are implemented at a time when the company appears to be solvent, and ideally years before a bankruptcy filing. So the greatest opportunity to play hardball is for those companies that have high levels of leverage in normal times when they are still notionally solvent but possibly distressed.
Apart from firms owned by private equity, there is another example of a business with high levels of leverage in normal times - banking. Banks typically operate with leverage levels that exceed that of typical private equity owned businesses. One would therefore expect banks to also play the hardball game - pay large dividends when they are distressed but still notionally solvent. And that is what Gambacorta, Oliviero and Shin find.
Their key finding is that banks with low Price to Book ratio (the ratio of the market price of the share to the book value per share) tend to pay higher dividends and this tendency becomes even more pronounced when the Price to Book ratio drops below 0.7. Price to Book has been associated with financial distress in the finance literature since the original papers by Fama and French. But the link is even stronger in banking where a low price to book ratio is often driven by the market’s belief that the asset quality of the bank is a lot worse than the accounting statements indicate. In other words, while for non financial companies, a low price to book reflects low profitability, for banks, it often indicates that book equity is overstated (due to hidden bad loans) and the capital adequacy of the bank is a lot worse than what the accounting statements suggest. Price to book is therefore an even more direct indicator of distress for banks than for non financial companies.
For a bank which is already highly levered and whose true leverage is even higher because of overvalued assets, dividends become an attractive device to transfer value to shareholders from creditors. The fact that the bank meets the capital adequacy standards set by the regulators (aided by overvaluation of assets) acts as a cover for the hardball tactic. The fact that many creditors (especially the depositors) are protected by deposit insurance means that creditor resistance is muted.
Gambacorta, Oliviero and Shin talk about the wider social benefits of curtailing dividends (increasing lending capacity), but there is a more direct corporate governance and prudential regulation argument for doing so. Regulators have already recognized the role of market discipline in regulating banks (Pillar 3 of the Basel framework). From this it is a short step to linking dividend and other capital distributions to a market signal (price to book ratio).
Posted at 5:46 pm IST on Thu, 10 Dec 2020 permanent link
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