Dividends: ECB recommendations prove effective
18 August 2021
The extreme uncertainty caused by the onset of the coronavirus (COVID-19) pandemic made it difficult to predict the implications for individuals and economies alike. The unprecedented nature of the crisis raised questions about banks’ ability to accurately estimate its potential impact on their balance sheets. Because of the uncertainty, banks and supervisors were unable to properly assess how banks’ capital positions would develop. As European and national authorities started to implement wide-ranging support measures, including some aimed at protecting bank balance sheets, ECB Banking Supervision recommended that banks suspend dividends in 2020 and subsequently limit them until September 2021, with the aim of bolstering banks’ capacity to absorb losses and support lending to businesses and households. These recommendations were similar to measures taken by other supervisory authorities, such as the US Federal Reserve System and the UK Prudential Regulation Authority.
Inviting all banks to suspend dividends was the only prudent course of action, but it was a difficult decision. Some banks criticised the blanket approach and argued that it did not properly take into account the specific characteristics of individual banks and their business models and, as a result, would send negative signals to equity investors. Despite this criticism, banks generally understood the objectives of the ECB’s recommendation, namely to maintain the safety and soundness of credit institutions in a period of stress and uncertainty. More than one year later, ECB Banking Supervision is pleased with how banks have followed the recommendations on dividends. As a result, €28 billion of dividends were kept on banks’ books in 2020 and continued to act as a capital buffer. Following the ECB’s recommendation of December 2020, banks under the ECB’s supervision decided to pay out dividends totalling around €10 billion in the first months of 2021, less than one-third of the amount banks typically pay out in a normal financial year. Analyses suggest that the ECB’s dividend policy has been effective: banks that altered their dividend distribution plans increased provisions by 5.5% and lending to the real economy by 2.4% relative to banks that left their distribution plans unchanged (either because they had already distributed dividends before the recommendation, or because they had not intended to in the first place).
As uncertainty has gradually decreased and macroeconomic projections have improved, the ECB has now decided to return to its standard supervisory practice of engaging with banks on a case-by-case basis. Banks’ management bodies are responsible for deciding on dividend distribution plans. When assessing these plans, supervisors will take into account how much capital banks can possibly generate out of their profits, the quality of their capital planning framework (including how they ensure that underlying macroeconomic assumptions used in capital planning are reliable), and the potential impact of a deterioration in the quality of exposures, including under adverse scenarios. Supervisors will also use stress test results to identify vulnerabilities in banks’ risk profiles, which will in turn inform their assessment of distribution plans.
The ECB’s decision to revert to its standard practice does not mean that the uncertainty around the evolution of the pandemic and its economic impact has disappeared. But the macroeconomic outlook has improved and supervisors are now in a better position to assess banks’ capital projections. In fact, the ECB has enhanced the way it scrutinises banks’ capital plans in relation to the challenges posed by the COVID-19 pandemic. Supervisors will place even greater focus on the adequacy of banks’ credit risk processes to ensure that weak practices do not result in increased loan losses or a build-up of non-performing loans once public support measures are lifted. The ECB has clearly set out its expectations in this area: banks need to conduct in-depth analyses that inform the classification of assets under the prudential and accounting frameworks according to their credit quality, and they need to recognise any signs of deterioration in a timely manner. Supervisors will duly consider these elements in their assessment of capital plans and will engage with banks as part of the standard supervisory dialogue. This will take place before banks finalise their capital distribution plans in the fourth quarter of 2021. Preliminary data suggest that banks are not planning significant catch-up distributions, with overall pay-out plans remaining prudent and generally below pre-crisis levels. Supervisors will have an in-depth dialogue with those banks whose medium-term capital positions appear weak based on their capital projections and risk profile. This could be due to poor provisioning practices – which are likely to lead to an underestimation of losses in the capital plans – or low profitability – which is likely to lead to a reduced capacity to build capital organically.
While the ECB’s recommendations were successful overall, the limits on dividend payments had consequences for the integrated operations of banking groups within the banking union. The ECB recommendations were applicable at the consolidated level so that banking groups could continue to transfer resources internally to where they were most needed during the period of stress. Some limits at the local level could be considered, on a case-by-case basis, if a local subsidiary had insufficient capital headroom. However, in a few instances national authorities restricted intragroup distributions from local banks to parent companies located elsewhere in the EU, reflecting financial stability concerns at the national level. This demonstrates the need to better integrate supervisory approaches and macroprudential policies to ensure a balance between financial stability concerns and preserving market integration within the banking union.
Banks, for their part, should remain vigilant, as the crisis continues to present challenges for their balance sheets and capital positions. The ECB encourages banks to be conservative and prudent, which means they should duly consider lingering concerns about a potential backlog of borrower defaults – particularly in sectors hit hard by the crisis – when making decisions about the appropriate level of credit loss provisions. In particular, banks should not release any additionally booked provisions (so-called management overlays) too early. Prudence is key to achieving ECB Banking Supervision’s overarching goal: ensuring that banks can absorb losses and continue lending to businesses and households, even in an ongoing crisis situation.