Bank Capital and Dividend Externalities

Abstract

Dividend payouts erode equity capital and affect the relative value of claims on a bank. Through this channel, when banks have contingent claims on each other, one bank's capital policy affects the equity value and risk of default for other banks. When such externalities are strong, bank capital becomes a public good, whereby the private equilibrium features excessive dividends and inefficient recapitalization relative to the efficient policy that maximizes total banking sector equity. We relate these implications to the observed bank behaviour during the crisis of 2007-2009.