The stock-market reaction to dividend cuts and omissions by commercial banks

ELSEVIER

Journal of Banking & Finance 20 (1996) 1485 15(18

Journalof BANKING & FINANCE

The stock-market reaction to dividend cuts and omissions by commercial banks Wolfgang Bessler a,*, Tom Nohel b ~ School of Management, Rensselaer Polytechnic Institute, Troy, NY 12180-3590, USA h School of Business Administration, Loyola Unil,ersi O, ~)["Chicago, Chicago. IL 60611, USA

Received 8 June 1994; accepted 23 November 1995

Abstract We postulate that the announcement effect of dividend reductions should be more severe for banks than for non-financial firms because bank customers may avoid financially weak institutions and discontinue the relationship when negative information is released. To test our hypothesis we investigate a total of 81 dividend reductions by 56 commercial banks listed on the NYSE, A M E X and NASDAQ for the period 1974-1991. We find significant abnormal returns of - 8.02% for the two-day event window and - 11.46% for a two-week period. These negative valuation effects are stronger than those reported in studies for dividend reductions of non-financial firms and for other negative bank announcements. We also explore the relationship between abnormal returns and specific bank characteristics cross-sectionally and find a stronger reaction for larger banks. JEL classtfication: G 14; G21 ; G35 Keywords." Banking; Financial markets; Asymmetric information; Dividend announcements: Valuation

effects

1. Introduction D i v i d e n d p o l i c y a n d the role t h a t d i v i d e n d a n n o u n c e m e n t s play in c o m m u n i c a t ing m a n a g e r s ' p r i v a t e i n f o r m a t i o n to s h a r e h o l d e r s h a s a t t r a c t e d a c o n s i d e r a b l e a m o u n t o f r e s e a r c h s i n c e the s e m i n a l p a p e r s o f M o d i g l i a n i a n d M i l l e r ( M o d i g l i a n i

* Corresponding author. Phone: (518) 276-2996; fax: (518) 276-8661; E-mail: [email protected]. 0378-4266/96/$15.00 Copyright © 1996 Elsevier Science B.V. All rights reserved. PII S03 7 8 - 4 2 6 6 ( 9 6 ) 0 0 0 0 4 - 0

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and Miller, 1958, Miller and Modigliani, 1961). Since then a number of dividend signaling models have been developed (e.g., Bhattacharya, 1979; Miller and Rock, 1985; Ambarish et al., 1987). These models describe how managers can optimally convey their private information to lesser-informed outside investors. The empirical evidence for non-financial firms suggests that dividend cuts and omissions reveal private information to investors. Typically dividend decreases result in negative valuation effects (e.g., Healy and Palepu, 1988; DeAngelo and DeAngelo, 1990; DeAngelo et al., 1992). However, in most of the preceding research, financial institutions are excluded with the argument that they are unique because they are highly regulated and highly leveraged, i If banks are unique, then it is reasonable to expect that bank stock prices react differently to announcements of negative information. This should be especially true because bank regulation, including deposit insurance, is aimed at minimizing the impact of negative information about banks on the financial system. The purpose of this study is to provide new evidence on the stock-market reaction to dividend cuts and omissions by commercial banks. In earlier studies, Keen (Keen, 1978, Keen, 1983) and Black et al. (1989) investigate the dividend policy of banks and the valuation effects of bank dividend decreases. Keen (1983) finds significant negative abnormal returns in weekly data for the period 1974-1977. Our approach is quite distinct from that in Keen in that we focus on the stock-market reaction immediately around the event by employing daily data instead of weekly data. Thus we are more concerned with the immediate stock-market reaction to the dividend announcement and less with the long-run valuation effects. Another significant difference is that we employ the standard market model instead of a two-factor model that includes a bank industry index (Keen, 1983). The reason for using the single-factor model instead of the multi-factor model in examining the effects of bank dividend announcements is rather important. Including a bank index seems inappropriate because it can be expected that the announcement of a dividend decrease by one bank will have an impact on the stock prices of other banks (contagion effect), thus biasing the return of the bank index. 2 In addition we employ a different test methodology (Boehmer et al., 1991) that allows for the possibility of event-induced variance. Furthermore, we extend the time period under consideration (1974-1991) substantially and by doing so increase the sample size to 81 announcements. This allows us to include periods that are characterized by both severe bank asset problems, e.g., LDC debt

I Most of the time banks are either treated separately in a particular study (e.g., Slovin et al., 1992), or they are the subject of a separate study (e.g., Horwitz et al., 1991). Banks are also excluded from recent studies of dividend policy under financial distress (DeAngelo and DeAngelo, 1990; DeAngeloet al., 1992). 2 Bessler and Nohel (1994) provide empirical evidence of intra-industry or contagion effects in bank stock returns (surrounding dividend cuts by money center banks) that are induced by bank dividend cuts. A comprehensive review of the literature on bank contagion effects is provided by Kaufman (1994).

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and real estate loans, and increases in equity standards in 1981 and 1988. Both are factors that should influence a b a n k ' s dividend policy. Finally, we relate the abnormal returns cross-sectionally to bank-specific variables in order to explain the magnitude of the abnormal returns. The study by Black et al. (1989) is restricted to N A S D A Q - l i s t e d banks. They find that these smaller banks experience substantial negative reactions to dividend cuts. Again, our approach is quite different in that we include larger banks listed on NYSE and A M E X and in that our sample contains the 1990-91 period in which many dividend cuts occurred. To test for the unique behavior of banks we study the stock-market reaction to dividend cuts and omissions by commercial banks for the 18-year period from 1974 to 1991. W e investigate 81 events of 56 banks (all banks in our sample are BHC but we will refer to them as banks) and our results indicate that, on average, banks experience significant negative excess returns of - 8.02% over the two-day window of days O and + 1 and - 11.46% over a two-week period from day - 8 to + 1. These negative excess returns are not only substantially larger in magnitude than those observed in similar studies for non-financial firms, but they are also more severe than those typically found for the release of other unfavorable information about financial institutions, such as debt-rating agency downgrades or the announcement of an LDC debt moratorium. Various bank characteristics are employed to explain the difference in magnitude of these abnormal returns. We find that several variables, such as bank asset size and the magnitude of the dividend cut, provide explanatory power for the banks' stock price decline. The rest of the paper is organized as follows. In Section 2 some relevant issues on dividend policy and bank behavior are explored. In Section 3 we present the methodology, data, and results. In Section 4 we test cross-sectionally the relationship between abnormal returns and various bank characteristics. Section 5 concludes the paper.

2. R e v i e w of s o m e relevant issues 2.1. Dividend policy o f non-financial firms In recent studies DeAngelo and DeAngelo (1990) and DeAngelo et al. (1992) investigate dividend adjustments of troubled NYSE firms and firms with losses, respectively. They report that firms cut their dividends in periods of financial distress and that there is usually a strong reluctance to omit dividends, especially when the firm has a long history of paying dividends. 3 Particularly striking is that

3 Linmer (1956, p. 99) reiterates this position when he reports "'that these elements of inertia and conservatism - and the belief on the part of many managements that most stockholders prefer a reasonably stable rate and that the market puts a premium on stability or gradual growth in rate - were strong enough that most management sought to avoid making changes in their dividend rates that might have to be reversed within a year or so".

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about half of the firms cut their dividends in the year of their first loss (after at least 10 years of profits). Moreover, dividend cuts are most often observed for firms with, in retrospect, persistent losses, whereas firms with transitory losses usually do not cut their dividends immediately. These results imply that the interaction of losses and subsequent dividend changes conveys some private information to outsiders about the managers' perception of the severity and duration of the problem. The willingness of non-financial firms to cut dividends following initial losses also suggests that, though a dividend cut may cause an immediate negative reaction from investors, it may not have a negative impact on the current business and the future business opportunities of the dividend-cutting firm; i.e., a dividend cut may not send an adverse signal to suppliers and customers to abandon their relationship with the firm. It is also interesting to note that dividend cuts and omissions have been employed strategically by managers to achieve wage concessions (DeAngelo and DeAngelo, 1991). Thus, evidence exists that dividend policy is employed to transmit signals to outsiders and that, even in situations where not intended, dividend changes reveal managers' private information to shareholders.

2.2. A r e banks special?

One explanation for the special treatment of financial institutions in capital market studies is that banks are usually perceived as quite different from nonfinancial firms. Whether banks are indeed special has been an issue of intense debate in the finance literature for some time. 4 The uniqueness of banks, on one hand, and the reason for their common neglect in corporate finance on the other hand, is substantiated by the fact that in perfect capital markets (the conventional paradigm in early finance models) banks would have no reason to exist (Fama, 1980). Furthermore, it is well known that a firm's dividend policy would be irrelevant in perfect capital markets (Miller and Modigliani, 1961). Consequently, the introduction of market imperfections in one way or another is a necessary condition to explain the existence of financial intermediaries as well as the relevance of dividend policy. Various market imperfections have been suggested in the literature to explain the existence of commercial banks and these market imperfections are important for understanding the functions and services that

4 Fama (1980) extends the Modigliani-Miller irrelevance argument to the financial system. He concludes that the structure of financial claims does not matter and banks would be similar to mutual funds under the assumption of perfect capital markets. In contrast to this view, it is evident that banks play a central role in credit markets because of their expertise in channeling savings of relatively uninformed depositors into loans that are information-intensive and particularly difficult to evaluate. See Bernanke (1993, pp. 51-55) for a review of these issues.

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financial intermediaries provide. 5 W i t h the introduction o f a s y m m e t r i c information, for instance, the irrelevance a r g u m e n t s o f M i l l e r and M o d i g l i a n i (1961) and F a m a (1980) no l o n g e r apply. A l t h o u g h a s y m m e t r i c information b e t w e e n borrowers and lenders is often e m p l o y e d to explain the existence o f banking firms, it is important to note that information asymmetries, and agency p r o b l e m s in general, exist not only b e t w e e n lenders and borrowers, but also b e t w e e n bank m a n a g e r s and bank stockholders, bank m a n a g e r s and depositors, as well as b e t w e e n bank managers and bank regulators. A s y m m e t r i c information b e t w e e n bank managers and shareholders require a m e a n s by which outside shareholders can reliably infer the b a n k ' s true financial status. D i v i d e n d a n n o u n c e m e n t s could be an effective and credible, though costly, m e t h o d o f p r o v i d i n g this information to investors. Naturally, d i v i d e n d policy w o u l d c o n v e y information to bank customers as well - not just to shareholders - assisting t h e m in u n c o v e r i n g the actual financial condition o f the bank. Likewise, if regulators ' f o r c e ' a bank to change its dividend, this will inevitably c o m m u n i c a t e private information about the b a n k ' s s o l v e n c y status d i s c o v e r e d through periodic examinations. 6 This m u l t i d i m e n s i o n a l aspect of the a s y m m e t r i c information p r o b l e m faced by banks and bank customers, shareholders, and e x a m i n e r s is an important factor in arguing that financial institutions are different. 7

2.3. Dit~idend policy o f commercial banks Since quarterly d i v i d e n d p a y m e n t s and e v e n yearly d i v i d e n d increases for banks in the U.S. h a v e been very c o m m o n for decades, stockholders may expect

5 Among the market imperfections suggested to explain the existence of banks are transactions costs (Benston and Smith, 1976) and asymmetric information (Leland and Pyle, 1977; Boyd and Prescott. 1986), which subsequently leads to delegated monitoring or asset services by banks (Diamond, 1984). 6 So far there exists no clear evidence of whether the stock market provides information to regulators or whether regulators provide information to the stock market. Berger et al. (1994) find evidence from Granger causality tests that changes in regulatory assessment of BHC conditions precede changes in market assessment and not the converse. They suggest that BHC inspections provide useful intormation to the market in that "regulators obtain information before the market, that this inlormation is subsequently revealed to the market (perhaps indirectly), and that this inlbrmation is useful to the market in assessing BHC condition". However, they also report that market information is more useful than regulatory information in predicting future BHC condition, as measured by balance sheet variables. 7 If banks and non-financial firms are indeed dissimilar, then this suggests that their dividend policies should be viewed differently. The difference between banks and industrial firms, from the perspective of asymmetric information, is suggested in a recent study by Slovin et al. (1992) who find that the information conveyed by seasoned equity offerings, another means by which investors inter manager's private information, resulted in a significant negative reaction, not only in the announcing bank's stock price, but also in the stock prices of non-announcing rival banks. Although industrial firms" stock prices reacted negatively to announcements of seasoned equity issues, there was, in contrast, no significant impact on the stock prices of non-announcing industrial firms when another firm in the same industry announced a new equity issue.

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quarterly dividends from those institutions that are viable and that currently are not faced with severe financial difficulties. In addition to their shareholders' anxiety, banks have to consider the assurance needs and confidence aspects of their customers. Quarterly a n n o u n c e m e n t s of stable or g r o w i n g dividends m a y therefore be utilized b y banks as a m e a n s for providing positive information about the b a n k ' s solvency to investors, customers, and regulators alike. Hence, dividend p a y m e n t s provide some assurance (information) about the f i r m ' s current success, and the continuity of a regular d i v i d e n d p a y m e n t over a long period of time strengthens confidence in m a n a g e m e n t . 8 The importance of d i v i d e n d p a y m e n t s as a positive signal in the b a n k i n g industry can be inferred from the fact that most banks c o n t i n u e d to distribute dividends during the 1980s despite suffering large losses in m a n y cases. This is in contrast to the behavior of n o n - f i n a n c i a l firms, which often cut dividends i m m e d i a t e l y w h e n losses occur and are expected to c o n t i n u e (see D e A n g e l o et al., 1992). Furthermore, banks often issued n e w equity while c o n t i n u i n g to pay out existing equity as dividends. For the dividend policy of banks this can create the following conflict: on one hand, b a n k customers m a y appreciate d i v i d e n d a n n o u n c e m e n t s as a signal of the b a n k ' s financial viability, while on the other hand, they are aware that dividend p a y m e n t s are a means of diverting the b a n k ' s equity to its shareholders, thus increasing their risk of financial loss (in the absence of deposit insurance and a too-big-to-fail policy). However, if a b a n k ' s performance has deteriorated and its capital position is so inadequate that dividends need to be reduced or even omitted, outsiders will likely perceive this as a strong and reliable signal that the b a n k is faced with serious financial difficulties. Because banks appear to cut dividends only as a measure of last resort, the release of this information can result not only in the usual negative stock-market reaction around the a n n o u n c e m e n t date, but even more importantly, it m a y adversely impact the b a n k ' s o n g o i n g and future business opportunities in that loan customers switch to rival banks or other sources of funding, deposits are withdrawn, and the b a n k ' s position in the inter-bank market is w e a k e n e d (in particular w h e n the d i v i d e n d cut is required by regulators). 9 In an efficient

8 Even Miller (1987, p. 46) concedes: "Perhaps the steady stream of dividend payments by the firm over long periods with no outside equity financing is, in part, at least simply a way of keeping the financing window open for future public flotations should they ever become necessary, by signaling that the firm's finances are under control". 9 Nadler (1977) provides a similar argument: "Dividend cuts.., are undertaken only when a bank has no alternative. A bank that cuts its dividend is giving a signal..., that it has trouble that will not go away soon. The result is that individual depositors start shying away from the bank...... and generally the bank's entire posture suffers". Bleakley (1991) supports the latter point when he reports that in a recent survey conducted by Greenwich Associates, more than one third of the 1,150 companies surveyed said that they had terminated or downgraded a banking relationship because of financial conditions of the bank, most of whom had established a formal policy for doing business with banks based on the bank's credit rating. The survey also reports that many companies increasingly look to foreign banks and insurance companies for their credit needs. The most affected banks appear to be the money center banks and other large banks with large corporate clients.

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market, this additional n e g a t i v e information also should be i m p o u n d e d into the stock price in the d i v i d e n d a n n o u n c e m e n t period, resulting in a m o r e negative reaction than for non-financial firms. In addition to the sudden w i t h d r a w a l o f deposits, banks that appear to have financial difficulties m a y e x p e c t a decline in their loan business because current and potential loan customers, especially the higher quality ones, may prefer to bank with a strong and viable institution. Several studies demonstrate the importance of the bank lending relationship for small and large firms and the positive and n e g a t i v e effects on bank customers s t e m m i n g from a n n o u n c e m e n t s affecting those banks with which the customers are associated. ~0 The empirical e v i d e n c e indicates that a continuing relationship with the s a m e bank is m e a n i n g f u l because reputational and informational capital has b e e n built up o v e r a lengthy b a n k c u s t o m e r relationship. Therefore, depositors and loan customers alike have many reasons to bank with a financially sound institution. The a n n o u n c e m e n t o f a cut or an o m i s s i o n of the regular quarterly d i v i d e n d m a y prompt t h e m to reconsider their relationship with the dividend-cutting bank.

2.4, Reaction o f bank stock prices to unfavorable information Several recent studies find e v i d e n c e that bank stock prices react negatively to the release of unfavorable information. In particular, the f o l l o w i n g events were studied: L D C debt moratoria, changes of a b a n k ' s debt rating, and issuance of seasoned equity. 11 The significant negative reaction on the a n n o u n c e m e n t date usually found in these studies suggests that investors very often are not fully aware of bank p r o b l e m s but instead are surprised by the release of negative information. Since information from bank e x a m i n a t i o n s is not m a d e publicly available, it is unclear h o w this information is c o n v e y e d to the market, that is to shareholders, bondholders, and bank customers. ~2 D i v i d e n d a n n o u n c e m e n t s (dividend cuts, in

~0 SIovin et al. (1993), for instance, study the impact of the failure of Continental Illinois on bank borrowers' stock prices and report that the impending demise of Continental Illinois Bank in 1984 had a negative impact on the stock price of firms that had major financial relationships with Continental, but that the news of the eventual 'bailout' caused a sharp stock price increase. The importance of the bank lending relationship is supported by James (1987) and Lummer and McConnell (1989), who provide evidence that the announcement of a new loan agreement produces a positive signal to the financial markets about the borrowing firms. In contrast, the announcement effect of a public offering of straight debt is negative. it See, for example, Bruner and Simms (1987), Musumeci and Sinkey (1990a), Musumeci and Sinkey, 1990b), Slovin and Jayanti (1993), Schweitzer et al. (1992), Polonchek et al. (1989). 12 The bank examination process is designed to uncover private information about a banks loan portfolio. Thus, a confirmation or a change in a bank's CAMEL rating following such an examination could reveal private information about a bank's loan quality. If the disclosure contains non-public information then this should result in an immediate stock market reaction. Berger and Davis (1994) examine the information content of bank examinations by analyzing the announcement effects of upgrades, downgrades and no-changes in the CAMEL rating for banks. Their empirical findings suggest that the reaction to upgrades and no-changes are relatively small. In contrast, CAMEL downgrades lead to a significant negative stock price effect, suggesting that CAME[+ downgrades reveal substantial negative information about banks discovered in bank examinations.

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the c a s e o f n e g a t i v e i n f o r m a t i o n ) e m e r g e t h e n as a c r e d i b l e a n d n a t u r a l o p t i o n to c o n v e y this i n f o r m a t i o n b e c a u s e t h e y c a n at the s a m e t i m e r e m e d y s o m e o f the a f o r e m e n t i o n e d i n h e r e n t a g e n c y p r o b l e m s . F o l l o w i n g the a r g u m e n t s in S e c t i o n 2.3 it a p p e a r s likely, t h o u g h u n d e r s t a n d a b l e , that b a n k m a n a g e r s are r e l u c t a n t to c o n v e y i n f o r m a t i o n a b o u t the b a n k ' s c u r r e n t or i m p e n d i n g f i n a n c i a l difficulties.

3. Methodology, data, and results 3.1. M e t h o d o l o g y S i n c e it is b e l i e v e d that a d i v i d e n d cut or o m i s s i o n c o n v e y s n e g a t i v e i n f o r m a tion to i n v e s t o r s r e g a r d i n g the b a n k ' s f i n a n c i a l c o n d i t i o n , it is e x p e c t e d that s u c h a n a n n o u n c e m e n t will r e s u l t in n e g a t i v e a b n o r m a l r e t u r n s for b a n k s a r o u n d the a n n o u n c e m e n t date. In a d d i t i o n , w e c o n j e c t u r e that t h e s t o c k p r i c e r e a c t i o n s to n e g a t i v e d i v i d e n d a n n o u n c e m e n t s s h o u l d b e m o r e s e v e r e for b a n k s t h a n for n o n - f i n a n c i a l firms. T h i s f o l l o w s f r o m o u r p r e v i o u s a r g u m e n t t h a t n e g a t i v e i n f o r m a t i o n a b o u t a b a n k ' s f i n a n c i a l c o n d i t i o n ( s o l v e n c y ) s h o u l d h a v e a direct n e g a t i v e i m p a c t o n its f u t u r e b u s i n e s s o p p o r t u n i t i e s . T o test the h y p o t h e s i s o f a n e g a t i v e v a l u a t i o n e f f e c t w e e m p l o y the m e t h o d o l o g y d e v e l o p e d in B o e h m e r et al. ( 1 9 9 1 ) 13 to test for the s i g n i f i c a n c e o f the a b n o r m a l r e t u r n s ( A R ) a n d c u m u l a t i v e a b n o r m a l r e t u r n s ( C A R ) . A b n o r m a l r e t u r n s are c a l c u l a t e d u s i n g the m a r k e t m o d e l a p p r o a c h . It is a s s u m e d t h a t the r e t u r n s are g e n e r a t e d a c c o r d i n g to the f o l l o w i n g 14 process:

~3 It has been previously documented that dividend announcements induce an increase in the variance of stock returns (see Kalay and Loewenstein, 1985; Nohel, 1992). The cross-sectional method described in Boehmer et al. (1991) accounts for the event-induced increase in variance in computing the significance of returns. 14 So far there is no clear evidence with respect to what constitutes the best approach for modeling and computing bank excess returns in event studies. It has been often suggested in the literature to model bank returns with a multi-factor model. Most authors include a variable to measure a bank's interest rate sensitivity. Although interest rates appear to provide some explanatory power (beyond the explanatory power of the market index) based on monthly data, we do not find an improvement by including such variables for an event study with daily data. Our findings are in accordance with results in the literature. Others have employed two-factor market models that include an industry index along with a market index (e.g., Keen, 1983). However, if contagion effects are present, then the contagion effects would contaminate our 'control' index of bank stocks by definition. Although the same argument could be waged against the use of the single-factor market model, the hypothesized contaminating effects are greatly diluted by choosing a broad market index due to the presence of firms from all other industries. To approach this problem nevertheless, we constructed multi-factor models with the following independent variables: (a) we used the spread between the one-year and thirty-year bond rates as a measure of interest rate risk exposure; (b) we used the spread between AAA and BAA bonds as a measure of default risk; (c) we used the FED Funds rate as a measure of a bank's liquidity risk. None of these variables and no combination of these variables provide any explanatory power when the market return is also included (see also Bessler and Nohel, 1994).

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ri., = ~J + /3jrm., + Ej.,

1493

( l)

where ri, t denotes the realized (observed) rate of return of security j on day t, r ..... denotes the return on the market portfolio (value weighted NYSE composite index) on day t, a and 13 are market model parameters estimated over a 100-day pre-event period from t = - 1 1 0 to - 1 1 , and Ej. t is the unexpected return of security j, which is assumed to have an expected value of zero and a variance of crj2. Abnormal returns ai. , for security j on day t are then given by ai., = rj.t -

( a.i +/3j

rm.,)"

(2)

To minimize the impact of heteroscedasticity of returns, the method of Boehmer et al. (1991) uses standardized abnormal returns given by A j,, = a j. , /s j

(3)

where s i = ,~i(l + I / T j + (rm. , - r.,)2/XfJ= t(rm,.~ - rm )2) and .~j is securities j ' s estimated standard deviation of abnormal returns from the estimation period (t ~ [ - 110, - 11]. The test statistic for significance of the standardized residuals is given in (4) below: j

(l/J)

Ai, , ,j = 1

(1/J(J-1))~

J

Aj,,-(1

-

(4)

.i = 1

where J is the total number of dividend cuts and omissions in the sample. Boehmer et al. (1991) find that the test statistic in (4) gives appropriate rejection rates under conditions of event-induced variance while simpler test statistics reject the null hypothesis too often by ignoring the event-induced variance. More details on the properties of the test statistic in (4) under various circumstances can be found in Boehmer et al. (1991). 3.2. D a t a The empirical analysis includes all banks that cut or omitted regular dividends between 1974 and 1991 and are listed on both the C O M P U S T A T and the CRSP N Y S E / A M E X or N A S D A Q tapes (In the following, the expression dit,idend cuts refers to both dividend cuts and dividend omissions). A total of 132 banks were listed on these tapes for the entire period. Of these 132 banks, 56 banks announced a total of 81 dividend cuts. Among those banks announcing dividend cuts there were 13 money center banks with 19 announcements (for this study a money center bank is defined as a bank that was listed as a money center bank in the Federal Reserve Bulletin of December 1981). In addition to the standard tape, the C O M P U S T A T research tape was used in order to cope with the usual survivorship bias problem encountered when using C O M P U S T A T data. It is particularly important for this study to avoid the survivorship problem, because dividend cuts

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often occur in periods of financial distress. Firms in financial distress are precisely those that are often 'dropped' by COMPUSTAT. The accounting data employed in this study are taken from various issues of Moody's Banking and Finance Manual. Of those banks announcing dividend cuts, the average asset size was $ 25.95 billion (with a range of $857 million to $217 billion), the average capital adequacy ratio (book value of equity / book value of assets) was 5.25% (with a range of

14-

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Fig. 1. Dividend cuts: (a) NYSE/AMEX & NASDAQ banks (1974-1991); (b) All banks & money center banks (1974-1991).

W. Bessler, T. Nohel / Journal of Banking & Finance 20 (1996) 1485-1508

1495

1.54% to 7.68%), and the average market-to-book ratio of equity was 0.533 (with a range of 0.152 to 1.350). Overall, for all 132 banks in our sample, the average asset size was $12.59 billion (with a range from $668.66 million to $230.64 billion), the average capital adequacy ratio was 5.8% (with a range of 1.43% to 12.22%) and the average market-to-book ratio of equity was 1.34 (with a range from.34 to 4.775). Clearly, the dividend-cutting banks were larger and much less profitable, based on market-to-book ratios. The distribution of events (grouped by the year of the announcement) is given in panels a and b of Fig. 1. It becomes immediately evident from these two figures that dividend cuts are extremely rare among banks, in particular among money center banks, until 1990. It appears that at the beginning of the 1990s a shift in dividend policy occurred that seems to have persuaded (or forced) bank managers to cut dividends. This policy change could be due to managerial decisions, e.g., deteriorating asset quality (real estate), but more likely is due to regulatory 15 pressure. Roughly two thirds (12) of the 19 dividend cuts announced by money center banks between 1974 and 1991 occurred in the last two years (1990 and 1991), but only one third (7) during the period 1974-1988. This last number is especially interesting when compared to the 16 equity issues of money center banks from 1975 to 1988 as reported in Slovin et al. (1992). From these observations it could be postulated that over the 1975-1988 period, banks favored equity issues over retained earnings (dividend cuts) as a means of improving their capital ratio. However, theoretically, the Miller and Rock (1985) model would suggest that an equity issue and a dividend cut should have the same impact on the 'net dividend' and thus the same impact on the stock price, while the pecking order theory of Myers and Majluf (1984) suggests a preference for retained earnings over outside equity. In other words, neither of these theories would suggest a preference for outside equity over retained earnings as a means of raising equity, in contrast to observed behavior. Alternatively, Easterbrook (1984) suggests that dividends can act as a means of subjecting a firm to monitoring by the capital market by forcing the firm to raise outside equity rather than relying on retained earnings as a source of capital, thereby reducing agency costs. Ambarish et al. (1987) suggest that some firms may choose to continue to distribute dividends, even when faced with the need to raise outside equity, as a means of boosting stock prices and thereby reducing offering

~5It is difficult to conceive of a sudden shift in managerial policy occurring nearly in unison across so many banks. However, because all the banks fall under the jurisdiction of the same regulatory agency (the FED), and because they are all bank holding companies, a shift in regulatory policy could explain the observed pattern of dividend cuts, especially in light of the increasing capital adequacy standards, i.e., the Basle Accord, FDICIA, etc.

1496

w. Bessler, T. Nohel / Journal of Banking & Finance 20 (1996) 1485-1508

dilution. 16 It could therefore be argued that the continuation of dividend payments, even in the event of capital needs, is an important signal that banks want to convey to the market and that this policy should be interpreted as such.

3.3. R e s u l t s

Our first hypothesis is that the announcement of a dividend cut conveys unfavorable information to the market and should subsequently lead to a negative stock-market reaction. This is tested by examining the abnormal return (mean return and standardized mean return) on and around the event date. Our results of the announcement period abnormal returns for all banks announcing dividend cuts are summarized in Table 1. On the event day banks experience, on average, a negative excess return of - 4 . 6 4 % and on the day following the announcement a negative excess return of - 3 . 3 8 % . Both values are significant at the 1% level. Thus, the result of a significant abnormal return of - 8 . 0 2 % for the traditional two-day event window of days 0 and + 1 supports the hypothesis that the market reacts adversely to a bank dividend cut. Over a two-week period the negative valuation effects sum to - 1 1 . 4 6 % . In the following discussion we contrast our results to findings in previous research on dividend decreases by non-financial firms and to the capital market reaction to the announcement of other unfavorable bank events. The conjecture that the negative reaction to a dividend cut by banks should be more severe than for non-financial firms is supported by our results. The abnormal return of - 8 . 0 2 % for all banks for the two-day announcement period is substantially higher than the negative abnormal returns found in other studies of dividend cuts for non-financial firms. Bajaj and Vijh (1990), for example, report for the period from 1962 to 1987 abnormal returns of - 1 . 7 7 % for a two day event window. We find further support for our hypothesis when we compare the relevant sub-sample of our events with the data used in Nohel (1992). The data used in Nohel includes a sample of 308 dividend cuts over the 1975-1990 period by industrial finns that all report R and D expenditure. This data does not include any bank dividend cuts. For this sample the average abnormal return for event days 0 and + 1 is - 3 . 0 3 % . When we concentrate our analysis only on larger firms similar in size to our bank sample (assets of more than $875,000,000) we find

16Yet another explanationis suggested by Choe et al. (1993) who show that firms tend to issue new equity in the growth phase of the businesscycle and avoid the use of outside equity during recessions. However, while this could explain the surge in dividend cuts in 1991 when perhaps firms shied away from issuing equity, in cannot explain the several cuts that occurred in the mid 1980s when the economy was growing. It also is not clear how much the results of Choe et al. (1993) apply to financial institutionsbecause the capital structure of banks is regulated and thus banks may not have the freedom to postpone an equity issue if they are facing capital adequacy problems.

W. Bessler, T. Nohel / Journal of Banking & Finance 20 (1996) 1485-1508

1497

Table 1 A n n o u n c e m e n t period excess returns (All banks ( N = 81)) Time

Excess ret.

Std. excess ret.

T-stat

-8

-0.26%

-0.1211

- 1.300

-0.26%

- 7 --6 5

- 0.76% -0.74% - 0.33%

- 0.2290 -0.2883 - 0.0002

- 2.438 * * -2.420 * * 0.001

- 1.02% - 1.76 - 2.09%

-4 --3 2 - I

-0.18% -0.50% - 0.34% - 11.33%

-0.0416 -0.2700 - 0.2393 - 0.2006

-0.329 -2.274 * * 1.595 - 1.251

-2.27% -2.77% - 3.11% - 3.44%

0 + l

-4.64% 3.38%

-2.0215 - 1.6717

-4.027 * * * -3.416 * * *

-8.08% - l 1.46%

+ 2 + 3 +4 -+-5 +6 -+-7

0.46% 0.27% -0.26% 0.17% -0.29% 0.46%

0.2528 0.0324 -0.1595 -0.0136 0.0183 - 0.2364

1.247 0.187 - 1.290 -0.104 0. I l l 1.417

11.00% - 10.73% - 1/).99% - 10.82% -11.11% - 11.57 %

~8

-0.59%

-0.2676

- 1.169

12.16%

" CAR[0, + 1] = - 8.02%, C A R [ - 8, + 1] = . . . . Significant at the 1% level. '~ * Significant at the 5% level.

abnormal

returns

e t al. ( 1 9 8 9 )

of

who

-

1.99%.

report

decreased

dividends

(although

compared

with our sample

11.46%.

17 F i n a l l y ,

two-day

Cumulative abnormal returns (CAR) ~'

our findings

abnormal

their findings

of 81). Moreover,

returns are based

support of

those of Polonchek

-7.87%

on only

for the relatively

for

banks

that

19 a n n o u n c e m e n t s short period

from

~7 When comparing our results for banks to similar studies for non-financial firms, there appears to be some concern that the stronger reaction for bank dividend cuts are observed because their dividend decrease tends to be much deeper. In fact, when banks cut dividends, the average decrease amounts to - 5 1 . 4 % of the current dividend, whereas for non-financial firms the average cut is - 3 2 . 4 % (see Nohel, 1992). To cope with this problem we compare the relative price decline per decrease in yield percentage point for banks and non-banks. For industrial firms our results indicate returns of - 3.5% for every 1% point decrease in dividend yield. In contrast, bank stocks decline on average by 15.87% lor every 1% point decrease in dividend yield. This result is obtained from regressing stock returns on dividend yield change and is based on 275 observations for non-financial finn dividend cuts and 28 comparable observations for bank dividend cuts. It is also interesting and important to note that the stock price reaction to a 1% dividend cut, e.g. from 5% to 4%, is similar to that of a 1% dividend ()mission.

1498

W. Bessler, T. Nohel / Journal of Banking & Finance 20 (1996) 1485-1508

1974 to 1977, Keen (1983) finds also two-week excess returns of - 1 5 % for banks. Another interesting and important outcome of our study is that the stock-market reaction to a bank dividend cut appears to be much more severe than the reaction to announcements of other unfavorable events for financial institutions. For instance, the negative reaction to a dividend decrease is larger in magnitude than that for the debt moratoria announcements of Mexico, Brazil and Bolivia. The most dramatic negative abnormal returns Bruner and Simms (1987, p. 51) find for the Mexican debt moratorium are - 1 . 9 3 1 % (high exposure group) for the event day and - 2 . 4 1 2 % (all banks) for a two-day window. For the Brazilian debt moratorium, Musumeci and Sinkey (1990a) report abnormal returns of - 3 . 5 0 % for money center banks and - 0 . 3 5 % for regional banks on the announcement day. For the same event, Karafiath et al. (1991) report a day 0 impact of - 2 . 1 7 % for high-exposure banks. Slovin and Jayanti (1993) find that the abnormal return for capital-deficient U.S. banks on the event date is - 2.64% for Mexico and - 1.94% for Bolivia. Schweitzer et al. (1992) investigate the capital market reaction when a rating agency announced that the debt of a bank would be downgraded. They report that during the two-day announcement period these banks have an average abnormal return of -1.484%, and over the period from day - 1 0 to + 1 of -4.314%. The issue of new equity resulted in abnormal returns of - 1 . 3 8 % for a two-day announcement period (Polonchek et al., 1989)). These negative reactions are much smaller in magnitude than the negative abnormal returns we find for the announcement of dividend decreases. Finally, our conjecture that banks should experience a sharper stock price decline than non-financial firms after announcing a dividend cut receives some support in the work of Schweitzer et al. (1992). They find that the negative reaction to the announcement of a debt downgrade is significantly stronger for banks than for non-financial firms. In short, the empirical evidence suggests that dividend cuts by banks are perceived by the market as negative information and subsequently result in immediate negative valuation effects. This negative market reaction is much stronger than that documented for other unfavorable bank events and is also stronger than that observed for dividend cuts by non-financial firms. Thus an unfavorable dividend announcement appears to convey information to the market that was not previously available. Given the potential negative impact on the bank's business, bank managers may develop the tendency to avoid releasing these negative signals as long as possible. Therefore, regulators and examiners need to monitor especially weak banks carefully and prevent equity distributions, for instance, in the form of dividend payments, in order to preserve the bank's capital. In addition, regulators may need to be in a position to convince or force managers to convey any negative information to the market. Whether this is the explanation for the observed increased frequency of dividend cuts since 1990 and whether or not such an approach of more disclosure constitutes optimal regulatory policy are questions beyond the scope of this paper.

W. Bessler, T. Nohel/ Journal of Banking & Finance 20 (1996) 1485-1508

1499

4. Cross-sectional analysis of announcement effects T o gain insight into the factors that d e t e r m i n e the m a g n i t u d e o f the individual bank stock reaction to a d i v i d e n d cut, we run a cross-sectional regression analysis of the a n n o u n c e m e n t period a b n o r m a l returns on a group o f both quantitative and qualitative explanatory variables. A n n o u n c e m e n t period abnormal returns, A i, are defined as the two-day abnormal returns o f days 0 and + 1. In the f o l l o w i n g section we report our estimation o f various cross-sectional regressions.

4.1. The importance o f certain bank characteristics Since a d i v i d e n d cut c o n v e y s n e g a t i v e information to the market regarding the b a n k ' s financial condition, it is h y p o t h e s i z e d that a larger d i v i d e n d decrease should result in a stronger n e g a t i v e valuation effect. O n e w o u l d also expect a stronger n e g a t i v e reaction for capital-deficient banks because this group has a higher risk o f failure than banks with sufficient capital. Finally, it is e x p e c t e d that the reaction to a d i v i d e n d cut by a larger bank should be stronger than the reaction to such an a n n o u n c e m e n t by a smaller bank. The rationale for this presumption is that larger banks are usually dealing with corporations and large clients w h o are c o n c e r n e d about bank p r o b l e m s and the likelihood o f a bank failure. ~s Alternatively, it can be argued that large banks are g i v e n m o r e l e e w a y by regulators and hence m a y h a v e a w i d e r range o f options. ~9 Thus, the regression model takes the f o l l o w i n g form:

A i = c~, + j 9 1 [ A D i v / P ] + ~2CAPADQ + ~ 3 L O G A S S E T S + e i

(5)

where A i is the t w o - d a y a n n o u n c e m e n t period excess return, A D i t , / P measures the impact o f the m a g n i t u d e of the d i v i d e n d change, 2o CAPADQ is a measure of capital a d e q u a c y (book value of e q u i t y / a s s e t ratio), LOGASSET is the logarithm

~s Thus, one can expect a highly sensitive reaction from large loan customers, on one hand, because they are the ones with the most to lose from a bank failure (as explained in Section 2.2). On the ~ther hand, uninsured depositors may also react by immediately withdrawing their funds, even in the presence of a 'too-big-to-fail' policy, because they are the least protected. Goldberg and Hudgins (1993) provide empirical evidence that S and Ls experienced an outflow of uninsured deposits when their financial position weakened. They conclude that financial strength affects the level of uninsured deposits in the expected direction. However, a larger reaction by larger banks would contradict other findings for non-financial firms as reported in the literature. The usual argument for a smaller reaction by larger companies is that these firms are more intensely followed by financial analysts, leaving little margin for surprises. ~9We thank an anonymous referee for suggesting this as an explanation for a potentially more severe reaction in the stock prices of larger banks. 20 Dividend cuts are usually discussed in terms of percentage decreases. However, since we have a number of dividend omissions in our sample and these would all represent - 100%, vve use changes in dividend yield instead.

1500

W. Bessler, T. Nohel /Journal of Banking & Finance 20 (1996) 1485-1508

Table 2

Estimates of the regressions in Eqs. (5)

AI =/30 +/31(ADIV/P)+/32CAPADQ +/33 LOGASSET + Ei /30

/31

/32

/33

R2

F-stat

N

0.357

14.23 * * *

81

0.176

16.89 * * *

81

0.177

16.94 * * *

81

***

0.278

30.47 * * *

81

* **

0.356

21.59 * * *

81

0.379

10.78 * * *

57

0.272

2 0 . 5 4 ** *

57

0.142

9.10 * * *

57

***

0.244

17.77 * * *

57

***

0.378

16.44 * * *

57

Full sample 6.174 * * * (3.723) 0.430 (0.359)

4.287 * * * (2.831)

0.323

-0.006

(0.228)

( - 2.24)

6.325 * * * (4.109)

2.306

-2,840

(1.440)

*** ( - 4.12)

4.675 * * *

-0.007

(2.856) 6.222 * * * (3.804)

**

( - 5.52) 4 . 3 9 4 ** *

-0.006

(3.073)

( - 4.67)

W i t h all c o n t a m i n a t e d s a m p l e p o i n t s e l i m i n a t e d 5.354 * * * (2.824) 1.394 (0.995)

6.451 * ** (3.147)

0.352

-0.005

(0.223)

(-

8.738 * * * (4.532)

1.212

-2.386

(0.634)

( - 3.02)

***

3.503 *

-0.006

(1.809) 5.417 * * * (2.914)

1.54)

( - 4.22) 6.593 * **

-0.004

(3.414)

( - 3.04)

* S i g n i f i c a n t at the 10% level.

* * Significant at the 5 % level. * * * S i g n i f i c a n t at the 1% level.

of the bank's total assets, and e i is an error term assumed to be distributed N(0, ~.2). All equations in Section 4 are estimated using weighted least squares to account for possible heteroskedasticity in the error term. As shown in Table 2, the coefficient /31 is positive and significant at the 1% level, supporting our hypothesis that a deeper dividend cut conveys a stronger negative signal. Our hypothesis that capital-deficient banks should experience a stronger negative reaction is not supported. The coefficient, /32 , is insignificantly different from zero unless L O G A S S E T is omitted from the regression. 21 In fact, if

LOGASSETS a n d CAPADQ. In fact, in our LOGASSETS and CAPADQ h a v e a c o r r e l a t i o n coefficient

21 T h e r e a p p e a r s to be s t r o n g m u l t i c o l l i n e a r i t y b e t w e e n s a m p l e o f 81

events,

the v a r i a b l e s

a p p r o a c h i n g 0.9 ( w h e n the v a r i a b l e s are scaled b y the a p p r o p r i a t e standard errors as part o f the w e i g h t e d least s q u a r e s procedure). H o w e v e r , asset size s e e m s to be the d o m i n a n t v a r i a b l e consistently

showing m o r e e x p l a n a t o r y p o w e r than c a p i t a l adequacy.

W. Bessler, T. Nohel / Journal of Banking & Finance 20 (1996) 1485-1508

1501

LOGASSET is omitted from the regression, /32, is significantly negative rather than positive. This is in contrast to other studies that find evidence that capital-deficient banks experience a stronger negative valuation effect at the occurrence of an unfavorable event. 22 Our results lead to the interpretation that a cut in dividends comes as more of a surprise for a more capital-sufficient bank than for a capital-deficient bank, leading to the observed larger reaction. Alternatively, it could be argued that information asymmetry is less severe for capital-deficient banks because such institutions are more closely monitored by regulators. 23 The coefficient, /33, which measures the impact of asset size on abnormal returns, is negative and highly significant indicating that announcements of dividend cuts by larger banks result in a larger negative valuation effect than do such announcements by smaller banks (remember, however, that even the smallest bank in our sample has assets of nearly $1 billion). This is consistent with the argument that larger banks are more likely to be affected by news of impending financial distress as they will have proportionately more uninsured, as well as commercial, customers. However, this outcome is in contrast to the general findings that dividend announcements of smaller firms are more informative than those of larger firms (e.g., Eddy and Siefert, 1988), Ghosh and Woolridge, 1988)). 24 Table 2 also shows these results to be consistent when those announcements with contaminating events (i.e., contemporaneous earnings announcements) are eliminated, reduc25 ing the sample size from 81 to 57 events. 4.2. The impact of the 1981 capital regulation In December 1981, bank regulators imposed stricter capital adequacy standards on banks. Polonchek et al. (1989) argue that because of this stricter regulation, various bank financial policies are constrained and therefore changes in those policies, particularly changes in capital structure, should be less informative after December 1981. They investigate the impact of the increased capital standards on the informativeness of the announcement effects of offerings of common stock, preferred stock, and debt, as well as dividend cuts. They find support lk~r their

22 Slovin and Jayanti (1993) study the impact of LDC debt moratoria on capital-sufficient and -deficient banks and find stronger reaction for the capital-deficient group. It should be noted, however, that an announcement of a moratorium of debt payments by an LDC is an announcement that comes from outside the U.S. banking system and affects all banks, whereas a dividend cut by a U.S. bank is a result of a policy decision on the part of the management of a particular bank. 2~ We thank an anonymous referee for suggesting this possibility. 24 This also is opposite the size effect found for the investors" reaction to the earnings announcements of non-financial firms as reported by Chari et al. (1988). -'5 All dividend and earnings announcement dates were double checked using the Wall Street Journal

Index.

1502

W. Bessler, T. Nohel / Journal of Banking & Finance 20 (1996) 1485-1508

hypothesis. To test this hypothesis for our data, we estimate the following regression: (6)

A i = ot o + f 1 1 P R E 1 9 8 1 D + e i

where Ag is the two-day abnormal return, P R E 1 9 8 1 D is a dummy variable equal to one when the dividend announcement date is prior to December 1981 and zero otherwise, and e i is an error term assumed to be distributed N(0, ~ 2). The results of the estimation are given in Table 3. The distinction between pre- and post-December 1981 is quite large and significant at the 1% level. As reported in Section 3, the two-day abnormal return for our entire sample is - 8 . 0 2 % . However, by separating the sample by date we find that in the later period the mean return decreases (in magnitude) to - 4 . 9 % , while in the earlier period the abnormal return is - 17.8%. Therefore, we certainly find support for the results of Polonchek et al. (1989). To gain additional insight into the effect of the 1981 change in capital adequacy standards, we estimate cross-sectional regressions using the same independent variables as in Section 4.1, but investigate separately announcements before and after the change in capital regulation. The results are reported in Table 4. It should be noted that the pre-December 1981 sample contains only 19 sample points, hence the results should be treated with caution. The relationship of these cross-sectional variables to the abnormal returns is consistent in sign in the periods both before and after the 1981 change in capital standards. However, the importance of the variables diminishes (the magnitude of the estimates decreases) after the implementation of the new capital standards. The diminished importance of C A P A D Q is not surprising because in the post 1981 period it is likely that even the better capitalized banks in our sample were strongly advised by regulators to cut dividends. The decreased importance of L O G A S S E T S is somewhat more

Table 3 Estimates of the regressions in Eqs. (6) A1 = flo + fllDpREI981D + ei

130

fll

R2

Dependent variable: MM excess return for t ~ [0, + 1] -0.049 *** -0.129 *** 0.207 (-3.55) (-4.54) -0.562 * * ' ( - 3.29)

-0.112 " * * ( - 3.47)

0.180

F-stat

N

20.65 * **

81

12.06 * * *

57 a

a All dividend announcements with contemporaneous earnings announcements have been omitted * Significant at the 10% level. Significant at the 5% level. * * * Significant at the 1% level. *

*

W. Bessler, 1". Nohel / Journal of Banking & Finance 20 (1996) 1485-1508

1503

Table 4 Estimates o f the regressions in Eqs. (5) separately for before and after the 1981 capital standards

A t = ,8o +/31( A D I V / P ) + /32CAPADQ + ,83LOGASSET + ei /30

/3t

Pre 1 2 / 8 1 sample 11.483 * * 2.300 (2.663) (0.693) -3.284 7.552 * (0.79) (1.749) 4.412 (1.123) 10.751 * * (2.71 I ) 11.489 * * * 2.040 (2.742) (0.651)

,82

[33

R-"

-0.821 ( - 0.33)

-0.012 * * ( - 2.16)

0.646

9.12 ~ * *

19 '~

0.151

3.(12 *

19 '~

-5.793 * ~ * ( - 3.88)

Post 1 2 / 8 1 sample 2.543 * 2.392 * (1.834) (1.823) 0.213 3.508 * * * (0.235) (2.780) (I.150 (0.117) 1.648 (1.247) 2.820 * * 2.906 * * (2.060) (2.350)

1.491 (1.146)

F-stat

N

0.469

15.03 ~ * *

19 ~'

-0.014 * * * ( - 5.42) -0.014 * * ~ ( - 4.7(/)

(I.634

29.42 * ~ *

19 ~

0.643

14.42 * * *

19 ~

-0.005 (-2.06)

0.215

5.28 . . . . .

62 h

0.114

7.73 . . . .

62 b

0.(147

2.99 ~

62 b

0. 122

8.30 * * *

62 t,

0.197

7.23 * * ~

62 h

~*

-- 1.001 * ( -- 1.73) -- 0.003 * * * ( - - 2.88) --0.003 * * ( -- 2.47)

~' A n n o u n c e m e n t dates are all before December, 1981. b A n n o u n c e m e n t dates are all after December, 1981. Significant at the 10% level. * Significant at the 5% level. * * * Significant at the 1% level.

surprising

because

17 l a r g e s t

banks

two

thirds

banks

of the

were

the new

dividend

in 1990 and

(i.e., the Basle

capital

(see the Federal

Accord

cuts

standards Reserve in our

1991, when

of 1981 did not apply

Bulletin sample

capital

of December, announced

standards

by

had been

directly

1981). the

to the

However,

money

center

substantially

raised

of 1988).

4.3. The influence o f d o w n g r a d e s and reported losses it usually as

well

as

information that have

can be expected the

announcement

to the market their debt rating

that a downgrade of

regarding downgraded

a

loss,

of a bank provide

the bank's

by a debt rating

valuable,

risk exposure

by Standard

and

Poors

though

agency, negative,

and viability. (S&P)

Banks

or Moodys

1504

W. Bessler, T. Nohel / Journal of Banking & Finance 20 (1996) 1485-1508

in the vicinity of a dividend cut and banks that report losses in the same quarter as the dividend cut may react differently to the announcement of a dividend change particularly when the downgrade or loss announcement comes prior to the dividend cut. On one hand, these banks should suffer a more severe negative reaction to an announced dividend decrease because, for such banks, it would be clear that the dividend cut is intended for financial survival rather than to boost equity for purposes of asset growth. On the other hand, in periods of losses or rating downgrades, a dividend cut may already have been anticipated by the market, leading to less surprise at the announcement date, and hence, to a weaker negative stock-market reaction. Thus, the expected impact of the sum of these effects on the stock-market reaction to dividend cuts by commercial banks depends on which of these effects dominate for banks. In the following equation we investigate whether the nearly contemporaneous announcement of accounting losses and corporate bond downgrades by S &P or Moodys help to explain the magnitude of the negative excess returns. We estimate a regression of the following form: A i = a o + ~ j L O S S + ~2 D O W N G R A D E

+ ei

(7)

where Ai is the two-day announcement period excess return; L O S S is a dummy variable that equals one when the announcing bank reported a loss in the quarter of the dividend cut or omission (and prior to the dividend announcement) and zero otherwise; D O W N G R A D E is a dummy variable that equals one when the announcing bank had its debt downgraded in the quarter of the dividend cut (and prior to the dividend announcement) and zero otherwise; and e i is an error term assumed to be distributed N(0, 0"/2). As shown in Table 5, the estimate of the coefficient, /3~, is positive and significant at the 1% level, implying that when contemporaneous accounting losses are announced (within days or weeks of the dividend cut), the dividend cut is anticipated by the financial markets. In such instances, a dividend cut following an announcement of accounting losses is less of a surprise than a dividend cut in the face of continuing, albeit (possibly) declining, accounting profits. The coefficient, /32, is insignificantly different from zero, suggesting that an announcement of a downgrading of debt by S & P or Moodys conveys little if any information to investors regarding the impending dividend cut. Therefore, a dividend cut, although perceived as additional negative news, results in smaller negative abnormal returns when losses have been previously announced but not when the banks' debt has recently been downgraded. If we exclude, in the estimation of Eq. (7), all events with contemporaneous earnings announcements, i.e. earnings announcements within two days of the dividend announcement, the directions of the results hold although the significance of/3~ drops slightly. All in all the cross-sectional results suggest that the negative valuation effect to a bank dividend decrease is proportional to the size of the dividend cut. This result is consistent with an informational or signaling explanation of dividend announce-

W. Bessler, 72 Nohel / Journal of Banking & Finance 20 (19961 1485 1508

1505

Table 5 Estimates of the regressions in E q s . 7 A t = / 3 o + / 3 1 D L o s s q- /31DDOWNGRADE q- ,E, /30

/31

/32

R2

F-stat

N

Dependent variable: M M excess return for t ~ [0, + 1] -6.166

4.522

( - 6.44)

(3.410)

-5.913 (-6.43)

4.542

***

--5.558 (.-5.52)

0.129

***

-- 4 . 0 0 3 -5.632

0.139

~.32 .....

8l

I 1.75 . . . .

8I

(3.427) 1.869

( - 5.24) (-5.33)

1.770 (0.949)

0.011

().885

8I

0.100

L(II ~

57 ~

0.099

(~.07 * *

5 7 :'

0.001

11.(14

57 ~'

(0.941) 4.097

**

(2.448) 4.087

0.671 (0.255)

**

(2.463)

-4.106 (-4.61)

0.510

(0.186)

S i g n i f i c a n t at t h e 1 0 % level. * ~ Significant at the 5% level. * * * Significant at the 1 % level. ~' All dividend announcements with contemporaneous earnings announcements have been omitted

ments. Furthermore, the stock-market reaction is less severe if the dividend announcement is preceded by an announcement of accounting losses. Following the enhancement in capital standards in 1981, the magnitude of the negative reaction has declined considerably. Finally the results provide evidence that the largest banks experience the strongest negative reaction when announcing a dividend cut. Thus, the reaction is an increasing function of bank asset size. This result is opposite to that usually observed for industrial or non-financial firms.

5. Conclusions We have investigated the valuation effects of dividend cuts and omissions by U.S. commercial banks for the period 1974 to 1991. Our results indicate that the banks in our sample experience significant negative abnormal returns around the announcement date. Not only are the banks' reactions significantly negative and more pronounced than those commonly found for non-financial firms, but they also are stronger than the valuation effects resulting from the release of other unfavorable information about banks. In addition, we find a significant relationship between the abnormal returns and specific bank characteristics, most notably bank asset size. In particular, the abnormal returns are stronger for large banks. This is in contrast to the usual inverse relationship between firm size and abnormal returns observed for non-financial firms. We argue that this is due to the fact that

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W. Bessler, T. Nohel / Journal of Banking & Finance 20 (1996) 1485-1508

large banks may lose large corporate customers if the bank is feared to have financial difficulties as evidenced by the fact that dividends need to be cut. Our results support the notion that dividend cuts by banks convey negative information and that the stock-market reaction is stronger for banks, in particular for larger banks, than for other firms, suggesting that banks are different from non-financial firms. If a cut in dividends is perceived as a reliable method to signal true, albeit negative, information to stockholders and bank customers, then this raises the question of whether dividend policy should be employed by banks to signal financial viability. It remains to be seen whether such a policy of full disclosure and forced signaling is in the best interests of the financial system. Evidence from other countries where banks experience stricter regulation but operate under less stringent disclosure rules, such as Germany, does not support this conclusion. Since the banking business is usually cyclical, it is reasonable to expect that in such a strict regulatory environment banks will have to decrease their dividends more frequently, thus sending negative signals more often. Constantly growing dividend payments would then be a relic of the past. A positive consequence of such a policy would be that stockholders, depositors, and borrowers would likely be better informed about the financial institution's financial strength and viability. However, a negative outcome of such a policy also could be that bank customers might panic subsequent to the announcement of a dividend cut, leading, in the worst case, to a run on that particular bank or contagion effects for other banks. The proposed implementation of market value accounting for banks in the United States could result in more information but also in such a cyclical dividend policy. Whether this is good news or bad news for the banking industry, the stock market, and the financial system is left for future research.

Acknowledgements The authors are grateful to Edward Kane, David Runkle, John Boyd, Craig Dunbar, and David Goldenberg and three anonymous referees for their helpful comments. Earlier versions of this paper were presented at the Northern Finance Association Meeting 1993, the Eastern Finance Association Meeting 1994, and the Financial Management Association Meeting 1994. Helpful comments and suggestions from conference participants are gratefully acknowledged. All remaining errors are the responsibility of the authors.

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