Bailing out Shareholders

For much of the 1990s the Japanese government shoveled resources into troubled banks while the banks shoveled dividends to shareholders. The most important result was a lost decade of economic growth, as under-capitalized banks failed to lend. An additional important result was the government deficit grew while bank shareholders benefited from government largesse.

The Paulson plan replicates this error, shoveling hundreds of billions at banks while permitting them to pay a substantial fraction of that bailout directly to shareholders. David Schoarfstein and Jeremy Stein andxx jones also point out that $250 million of the bailout will go directly to dividends for bank CEOs. These dividends constitute a massive reward for past poor decisions and an incentive for future misbehavior. More broadly, bank dividends decapitalize the banking system that the government is trying to recapitalize.

No bank or other financial institutions wants to declare itself so cash-strapped that it cannot pay its dividend. In addition, if the bank is near bankruptcy, shareholders benefit at the expense of creditors if the bank pays dividends prior to going under.

Unfortunately, as we have all read about at length in recent weeks, few are willing to lend if most of the possible borrowers are under-capitalized -- it is too likely they will go bankrupt. Thus, each bank's decision to pay dividends imposes a negative externality on both its own bondholders and on investors and the economy more broadly.

Ironially, bank shareholders would almost surely benefit from a moratorium on dividends, as each bank would be more able to resume lending. Obama should push for such a change. Suspending dividends is a no-brainer for banks and others receiving aid from the federal government. In the short run, I recommend this requirement for all financial institutions.