Regulators Still Failing to Do Their Job

Here is more opposition to the Treasury's bailout proposal. Sebastian Mallaby also points out a regulatory failure that I've been concerned about for almost a year:

Raghuram Rajan and Luigi Zingales of the University of Chicago suggest ways to force the banks to raise capital without tapping the taxpayers. First, the government should tell banks to cancel all dividend payments. Banks don't do that on their own because it would signal weakness; if everyone knows the dividend has been canceled because of a government rule, the signaling issue would be removed. Second, the government should tell all healthy banks to issue new equity. Again, banks resist doing this because they don't want to signal weakness and they don't want to dilute existing shareholders. A government order could cut through these obstacles.

Why are government regulators allowing financial institutions to pay out dividends during a financial crisis? By paying out dividends, banks are reducing their capital at a time when they should be doing everything they can to preserve capital. I suggest three new regulatory rules, one temporary, two permanent: 1) All financial institutions must suspend dividend payments during this financial crisis. 2) Any time a regulated financial institution is unprofitable, it must suspend dividend payments until profitability is restored. 3) Regulated financial institutions may not pay out quarterly dividends that are greater than quarterly earnings.

If a bank is actually healthy, suspending dividend payments doesn't mean shareholders won't get their money. It just means they will have to wait for it. The money can simply be held on the books until the financial crisis or unprofitable period has passed, and then be paid out to shareholders as an extra-large dividend when the rough period has passed. If a bank is actually unhealthy, the retained capital reduces the probability of a bank failure, which would be a benefit to shareholders.

Allowing financial companies to pay out dividends to shareholders during a financial crisis is reckless, period. The Federal Reserve and other regulators are still failing to do their job competently.

Hat tip to Greg Mankiw.