System-wide measures on banks’ distributions – motivations and challenges

Prepared by Eleni Katsigianni, Kamil Klupa, Marcello Tumino and Balázs Zsámboki^[1]

This article provides an overview of the actions aimed at reducing or suspending banks’ distributions on a system-wide basis. It finds that such measures have a number of pros and cons which deserve further analysis. On the one hand, system-wide restrictions on distributions complement and enhance the effectiveness of other public support measures, including prudential relief measures, by ensuring that the “freed-up” capital is used for supporting the real economy and absorbing losses. Furthermore, system-wide measures simultaneously address adverse incentives to deleverage by removing the stigma effects associated with institution-specific restrictions. On the other hand, the implementation of system-wide restrictions on distributions presents several concomitant drawbacks and challenges. In particular, investors may be reluctant to invest in banks that are subject to restrictions which may hamper their ability to raise capital in the longer term. Other challenges include interference with the smooth functioning of the internal market and the possibility of the measures becoming less effective over time when introduced via soft-law instruments.

1 Introduction

The banking sector plays a key role in providing financial services to the real economy; it is therefore important to ensure that banks have the capacity to absorb losses and continue providing credit to viable corporations and households, even in times of crisis. To contain the enormous economic costs of the COVID-19 pandemic, a broad set of measures has been adopted at European Union (EU) and national levels. In this context, macroprudential authorities have taken a range of policy decisions, including the release of countercyclical capital buffers and the recalibration – or the revision of the implementation timeline – of other macroprudential buffers.^[2] These actions complemented various capital relief measures implemented by competent authorities, including the European Central Bank (ECB), that were aimed at supporting banks in serving the economy and addressing operational challenges under crisis conditions.^[3]

Providing capital relief and demonstrating immediate regulatory responsiveness should not undermine confidence in the financial system. The introduction of capital relief measures therefore came with an expectation that banks would use the positive effects of these measures to support the economy rather than increasing their distributions, which could undermine banks’ resilience during the later stages of the crisis or the recovery period.

Reducing or suspending discretionary distributions can mitigate a reduction in banks’ own funds during crisis periods when capital is needed to absorb losses and to maintain lending to the real economy. These distributions may consist of dividends, buy-backs of ordinary shares and payments of variable remuneration (i.e. bonuses), as well as discretionary coupon payments on Additional Tier 1 (AT1) instruments, such as contingent convertible bonds. Banks discretionary decisions on distributions can be complemented by temporary policy measures aimed at limiting the outflow of earnings and capital from the banking sector, thereby reducing the risk of failures of financial institutions in the face of potentially large and difficult-to-quantify losses. Such policy measures thus contribute to the ability of the banking system to continue supporting the economy through a period of stress (Dautovic et al. (2021)). These restrictions are also aimed at reducing the risk that shareholders and managers might distribute capital for their own benefit in the form of dividends or bonuses, in particular during times in which banks are benefitting from extraordinary public support measures.

This article discusses the pros and cons for limiting banks’ distributions on a system-wide basis. It outlines the extent to which the relevant authorities can impose restrictions on distributions under the current framework, and it also takes stock of the actions taken so far at EU and national levels. It presents arguments potentially in favour of applying restrictions at a system-wide level as well as the possible associated drawbacks and implementation challenges, with a focus on the EU perspective. In this regard, it partially builds on recent publications by the ECB and the European Systemic Risk Board (ESRB).

2 Current framework

The Capital Requirements Directive (CRD)^[4] provides for restrictions on profit and capital distributions at the level of individual institutions. On the one hand, such restrictions automatically apply to banks that breach their combined buffer requirement (CBR).^[5] On the other hand, the competent authorities may impose discretionary restrictions on distributions to shareholders, on interest payments to holders of AT1 instruments and on variable remuneration if they identify specific risks for individual institutions.^[6] To introduce such restrictions, the competent authorities should (i) have evidence that an individual institution is either already in breach of regulatory requirements or likely to be within the next 12 months, or (ii) have identified specific shortcomings with regard to the institution’s management and risk coverage during the Supervisory Review and Evaluation Process (SREP).

The EU Single Rulebook does not include a specific tool that can be used to impose legally binding restrictions on distributions in a system-wide manner. In most jurisdictions, the national authorities have various “soft powers”, including the power to issue recommendations to financial institutions falling within their remit. Similarly, at the EU level, the ESRB has the power to issue recommendations to a broad range of addressees.^[7] Recommendations are usually non-binding and their effectiveness stems from moral suasion and the “act or explain” mechanism^[8], under which addressees should act in compliance with them or provide adequate justification for their inaction. Such recommendations can be used to ask banks to refrain from discretionary distributions in view of emerging systemic risks. However, it must be noted that the domestic legal frameworks of some jurisdictions do provide relevant authorities with the power to introduce legally binding measures that restrict distributions.^[9] Such uncoordinated approaches may contribute to the fragmentation of the Single Market.

3 Recent system-wide measures related to distributions at national and EU levels

Non-binding system-wide requests asking financial institutions to limit discretionary pay-outs have been widely used at both EU and national levels. There are a number of examples of such requests being made both within and outside the EU (see ESRB (2020)), mostly through recommendations and communications, with authorities calling for a reduction in discretionary distributions^[10] or suspending them altogether.^[11] Some of these actions concern not only banks but also other financial institutions that are critical to the smooth functioning of the economy (e.g. insurance companies).^[12] Initially, authorities in the EU requested financial institutions to refrain in general from any distributions aimed at remunerating shareholders, but subsequently modified this approach by allowing for distributions up to a prudent threshold.

On 27 March 2020 the ECB issued a recommendation calling for banks to refrain from dividend distributions and share buy-backs.^[13] The recommendation was addressed to significant institutions (SIs) directly supervised by the ECB and national competent authorities (NCAs) that supervise less significant institutions (LSIs).^[14] On 27 July 2020 the ECB extended the recommendation until 1 January 2021.^[15] On 15 December 2020 the ECB issued a revised recommendation asking those institutions to refrain from dividends payments and share buy-backs, or to limit them to no more than 15% of the accumulated profit for the financial years 2019 and 2020 or to no more than 20 basis points in terms of the Common Equity Tier 1 (CET1) ratio, whichever is lower.^[16] The ECB recommendation generally applies at the consolidated level for significant groups, with a view to supporting the smooth functioning of the internal market and, in particular, the free flow of capital within significant groups.

The ESRB complemented actions by the ECB, the European Banking Authority (EBA)^[17] and the European Insurance and Occupational Pensions Authority (EIOPA)^[18] by issuing a recommendation addressed to the relevant authorities in the EU, in an attempt to establish a uniform approach to restrictions on pay-outs across the EU and across different segments of the financial sector. In May 2020^[19] the ESRB recommended that the relevant authorities request certain financial institutions to refrain from undertaking any of the following actions: (a) making dividend distributions, (b) buying back ordinary shares, and (c) creating an obligation to pay variable remuneration to material risk takers, which has the effect of reducing the quantity or quality of own funds at the EU group level and, where appropriate, at the sub-consolidated or individual level. In December 2020, the recommendation was amended and extended until 30 September 2021.^[20] The ESRB narrowed the scope of addressees^[21] and recommended that the relevant authorities continue to request financial institutions to refrain from pay-outs, unless extreme caution was applied and subject to a conservative threshold set by the competent authorities. The ESRB will consider the need to amend, extend or allow the recommendation to lapse prior to 30 September 2021.

While national authorities have requested financial institutions to refrain from distributions mainly through recommendations, in a limited number of cases this has been done through legally binding measures. Such measures to restrict certain forms of distributions have been adopted for macroprudential purposes in Bulgaria^[22], Croatia^{[23] [24]} and Slovenia^[25]. Initially, in all three jurisdictions, banks were requested to refrain from profit distributions. In February 2021 Banka Slovenije (Bank of Slovenia) adjusted its regulation to exceptionally allow banks to make distributions, provided that the cumulative profit in the first quarter of 2021 was positive and subject to specified caps.^[26] The national measures of the three countries concerned were applied at individual level to all banks established in their respective jurisdictions, i.e. also to subsidiaries of banks established in the EU.

4 Motivations for reducing or suspending banks’ distributions on a system-wide basis

At times of crisis, when access to capital markets is limited, limiting pay-outs can contribute to banks’ internal capital accumulation. ESRB (2020) provides a number of arguments in favour of such system-wide suspensions of distributions, such as supporting the critical function of banks in economic recovery, avoiding risk-shifting, mitigating procyclicality and avoiding stigma effects. This article complements these arguments and elaborates on three main issues, notably (i) complementing other prudential actions that encompass lower capital requirements, (ii) removing adverse incentives to lending created by institution-specific restrictions on distributions which may lead to deleveraging at system level, and (iii) addressing the uncertainty around the severity and length of the crisis.

System-wide restrictions on distributions complement and enhance the effectiveness of other prudential measures by helping to ensure that capital is used for supporting the real economy and absorbing losses rather than for making discretionary pay-outs. During the COVID-19 crisis, relevant authorities embarked on a wide set of micro- and macroprudential actions (such as the temporary possibility to operate below the Pillar 2 Guidance (P2G) and the release or reduction of capital buffers) that increased banks’ flexibility as regards capital management^[27] and complemented the extraordinary public support measures deployed by governments. Since all banks benefit from the additional capital headroom this creates, authorities may consider implementing temporary measures that restrict discretionary payments for the whole banking sector, thereby ensuring that capital is used to absorb shocks and to support lending to the real economy. According to Gardó et al. (2020), following the ECB recommendation, SIs kept around €27.5 billion in retained earnings, equivalent to about 1.8% of shareholders’ equity and 35% of total profits. It is estimated that these retained earnings could absorb an additional non-performing-loan (NPL) increase of around €60 billion. Furthermore, early evidence so far suggests that banks which refrained from distributions in direct response to relevant recommendations increased their lending more in comparison to other banks and increased their loss absorption capacity through the build-up of provisions (Dautovic et al. (2021)).

Requesting banks on a system-wide basis to refrain from making distributions may mitigate some of the adverse incentives towards lending that could potentially be created by institution-specific restrictions. Under the current framework, restrictions on distributions are automatically imposed on individual institutions if they breach the CBR or may be imposed if supervisory authorities identify certain risks that require institution-specific measures. However, in such cases the suspension of distributions could be perceived by the market as signalling the financial weakness of specific institutions. Banks may therefore aim to maintain, or even increase, their capital ratios in stress periods (Andreeva et al. (2020)) and be incentivised − in particular − to restrict the provision of credit or deleverage (Behn et al. (2020)). Against this background, suspending distributions on a system-wide basis could mitigate the risk of collective deleveraging associated with institution-specific measures.

Uncertainty regarding the severity and length of crises, especially at the onset of an exogenous shock such as the COVID-19 crisis, may make banks’ capital projections less reliable. Difficulties in measuring expected and unexpected losses in crisis periods arise at the level of each bank. Allowing discretionary pay-outs before the scale of the shock is properly determined might expose banks to credit risk materialising in the future. This can also lead to reputational consequences, if banks which benefited from extraordinary public support measures and made distributions face capital shortages eventually. Therefore, under conditions of exceptional systemic uncertainty, it may be warranted to temporarily move away from ordinary assessment of individual banks’ distribution plans and, instead, request all banks to limit or suspend discretionary distributions until more reliable projections of banks’ capital trajectories can be re-established. Such precautionary policy actions can also strengthen the resilience of, and trust in, the financial system as a whole.

5 Drawbacks of system-wide measures aimed at limiting or suspending distributions

The implementation of broad-based restrictions on distributions may negatively affect banks’ valuations and the allocation of resources. Early evidence (Andreeva et al. (2021)) suggests that the introduction of system-wide restrictions can create uncertainty over future distributions, which can have an adverse impact on bank valuations. It is estimated that ECB recommendations on dividend distributions from March 2020 onwards resulted in bank share prices falling on average by 7%. Other analyses point to an average fall of 10% in stock prices for large banks in the euro area and the United Kingdom in the wake of communications on this matter from the ECB and the Bank of England (Hardy (2021)). Furthermore, as highlighted by Gardó et al. (2020), investors may be less likely to invest in capital instruments that are subject to such restrictions. In consequence, the ability of banks to raise additional capital in the longer term could be reduced, or their cost of capital could increase. System-wide restrictions on distributions might also affect investors who rely on a steady stream of dividend income. While under normal circumstances these investors would be able to sell their shares and thus receive equivalent income, this could be hindered in periods of severe crisis (ESRB (2020)). Considering that banks compete for investment in international markets, the imposition of system-wide restrictions in some jurisdictions could make it more difficult for banks in those jurisdictions to raise capital externally relative to banks in jurisdictions where such restrictions had not been imposed.

Furthermore, the implementation of system-wide restrictions on distributions poses several challenges to the authorities in terms of harmonisation and consistency, since this instrument is not part of the Single Rulebook. Key challenges include: (i) the level of application (group, sub-consolidated or individual level) and (ii) the enforceability of the measure (binding or non-binding instruments).

Given the presence of cross-border banking groups, any decision on the application level for such restrictions should avoid impeding the smooth functioning of the internal market. On the one hand, the application of restrictions on distributions by home authorities at the highest level of consolidation is more in line with the principle of free movement of capital within the EU. Such an approach may allow for avoiding ring-fencing along national lines and may help EU banking groups to efficiently allocate their capital, thereby also supporting progress in the integration of the European banking market.^[28] On the other hand, national authorities in host countries may consider the cross-border payment of dividends by subsidiaries to non-domestic parent companies to be in conflict with other national prudential and public support measures. In a banking union with a single supervisor, such considerations can be properly addressed.

Regarding enforceability, the Single Rulebook does not include a specific power to impose legally binding system-wide restrictions on distributions. In the absence of such an instrument, efforts to establish a harmonised approach to distribution restrictions at EU level run the risk of being ineffective because of the non-binding nature of the tools currently in place (e.g. recommendations). Thus far, financial institutions have demonstrated a general level of compliance with the recommendations calling for restrictions on distributions that were introduced as an exceptional and temporary measure. However, if such measures were extended further, they might become less effective due to the lack of tangible enforcement mechanisms.

6 Conclusions

The implementation of system-wide restrictions on distributions has a number of pros and cons which deserve further analysis. Banks are a critical sector of the economy, so there is a need to maintain a sufficiently high level and quality of capitalisation in order to maintain loss-absorbing capacity and continue supporting the real economy during extraordinary circumstances, particularly when banks are benefiting from various public support measures. System-wide requests to limit distributions complement and enhance the effectiveness of other public support measures, including prudential relief measures, by ensuring that the “freed-up” capital is used for supporting the real economy and absorbing losses rather than for making discretionary pay-outs, while simultaneously addressing adverse incentives to deleverage by removing the stigma effects associated with institution-specific restrictions. Nonetheless, the implementation of system-wide restrictions on distributions presents several concomitant drawbacks and challenges. Investors may be reluctant to invest in banks which are subject to restrictions and, in consequence, the ability of banks to raise capital in the longer term could be impaired. Other challenges include its interference with the smooth functioning of the internal market and the soft legal nature of instruments establishing restrictions, which might become less effective over time.

References

Andreeva, D., Bochmann, P., Mosthaf, J., Schneider, J. (2021), “Evaluating the impact of dividend restrictions on euro area banks’ valuations”, Macroprudential Bulletin, Issue 13, European Central Bank, Frankfurt am Main.

Andreeva, D., Bochmann, P., Couaillier, C. (2020), “Financial market pressure as an impediment to the usability of regulatory capital buffers”, Macroprudential Bulletin, Issue 11, European Central Bank, Frankfurt am Main.

Behn, M., Rancoita, E., Rodriguez d’Acri, C. (2020), “Macroprudential capital buffers – objectives and usability”, Macroprudential Bulletin, Issue 11, European Central Bank, Frankfurt am Main.

Dautovic, E., Ponte Marques, A., Reghezza, A., Rodriguez d´Acri, C., Vila, D., Wildmann, N. (2021), “Evaluating the benefits of euro area dividend restrictions on lending and provisioning”, Macroprudential Bulletin, Issue 13, European Central Bank, Frankfurt am Main.

European Central Bank (2020), Financial Stability Review, Frankfurt am Main, May.

Gardó, S., Grodzicki, M. and Wendelborn, J. (2020), “Dividend payouts and share buybacks of global banks”, Financial Stability Review, European Central Bank, Frankfurt am Main, May.

Hardy, B. (2021), “Covid-19 bank dividend payout restrictions: effects and trade-offs”, BIS Bulletin, No 38, Bank for International Settlements, Basel.

European Systemic Risk Board (2020), “System-wide restraints on dividend payments, share buybacks and other pay-outs”, Frankfurt am Main, June.