Rethinking Capital Regulation: The Case for Dividend Prudential Target

Abstract

The paper investigates the effectiveness of dividend-based macro-prudential rules in complementing capital requirements to promote bank soundness and sustained lending over the cycle. First, some evidence on bank dividends and earnings in the euro area is presented. When shocks hit their profits, banks adjust retained earnings to smooth dividends. This generates bank equity and credit supply volatility. Then, a DSGE model with key financial frictions and a banking sector is developed to assess the virtues of what shall be called dividend prudential targets. Welfare-maximizing dividend-based macroprudential rules are shown to have important proper-ties: (i) they are effective in smoothing the financial cycle by means of less volatile bank retained earnings, (ii) they induce welfare gains associated to a Basel III-type of capital regulation, (iii) they mainly operate through their cyclical component, en-suring that long-run dividend payouts remain unaffected, (iv) they are flexible enough so as to allow bank managers to optimally deviate from the target, and (v) they act as an insurance scheme for the real economy.

Keywords: macroprudential regulation, capital requirements, dividend prudential target, financial stability, bank dividends

JEL Classification: E44, E61, G21, G28, G35