Market Contestability and Payout Policy

Abstract

We analyze the impact of market contestability on payout policy by exploiting plausibly exogenous changes in interstate geographical restrictions on branch expansion of financial institutions. Leveraging branch-level data on bank deposits enables us to capture the exposure of each bank to state-level branching restrictions. We provide evidence of a negative impact of branching restrictions on payout ratios, which occurs only for banks with a low degree of market power, suggesting that competition is indeed driving our results. We test two potential channels: a “charter-value” channel, which predicts that contestability decreases charter values and leads to risk-shifting; and a “signaling” channel, which predicts that managers increase payout ratios to signal to the market that they do not expect a long-term decrease in profitability as a result of heightened market contestability. We do not find robust evidence that high-risk banks raise payout ratios more than low-risk banks when market contestability increases. Rather, we find support for the signaling hypothesis, in that market contestability boosts the probability of dividend increases, while share repurchases, which lack an ongoing commitment, do not increase. Moreover, the price reaction to dividend cuts is statistically significant only when market contestability is high, and unlisted banks (which cannot be punished by the stock market) do not react to changes in market contestability.

Keywords: dividends, competition, payout policy, share repurchases

JEL Classification: G35