September 2021 issue contents
Rethinking Capital Regulation: The Case for a Dividend Prudential Target

Manuel A. Muñoz
European Central Bank


Recent empirical studies have documented two remarkable patterns shown by euro-area banks in the aftermath of the Great Recession: (i) their tendency to boost capital ratios by shrinking assets (contraction in loan supply), and (ii) their reluctance to cut back on dividends (fall in retained earnings). First, I provide evidence of a potential link between these two trends. When shocks hit their profits, banks tend to adjust retained earnings to smooth dividends. This generates bank equity and credit supply volatility. Then I develop a DSGE model that incorporates this mechanism to study the transmission and effects of a novel macroprudential policy rule-that I shall call dividend prudential target (DPT)-aimed at complementing existing capital regulation by tackling this issue. Welfare-maximizing DPTs are effective (more than the CCyB) in smoothing the financial and the business cycle (by means of less volatile retained earnings) and induce significant welfare gains associated with a Basel III type of capital regulation through various channels.

JEL Code: E44, E61, G21, G28, G35.

Full article (PDF, 64 pages, 6577 kb)
Online appendix (PDF, 16 pages, 141 kb)