Written by Francesco Lo Faso
The EU “Dividend Culture”
As a general rule of thumb, companies reward their shareholders in two main ways: by paying dividends or by buying back shares.
In the last decades, dividend pay-outs have represented the primary vehicle by which European equity investors have been rewarded. It has been proven to be a more successful approach to equity investing than share buyback strategies, much more popular in the United States.
The main difference between the two strategies is that from the investor’s standpoint, a dividend payment is a definite return in the current timeframe that will be taxed, while a share buyback is an uncertain future return, on which tax is deferred until the shares are sold.
With regards to the company’s perspective, unlike dividend payouts, a share-buy back decreases the number of the firm’s outstanding shares, and this usually increases the company’s profitability and performance measures like earnings-per-share (EPS) or return on equity (ROI), while driving the share price higher over time.
If looking at the performance of the pan-European Stoxx Europe 600 index over the last 20 years, it is worth noting that without dividends, the European stocks’ return for shareholders should have been negative. On a total return basis – with dividends included – the Stoxx 600 Europe Index has almost doubled since 2000 (see Exhibit 1). Hence, there is a tendency of European equity investors to add dividend stocks to their portfolios in order to obtain higher and more consistent returns on their investments.
 With a fixed number of 600 components, the STOXX Europe 600 Index represents large, mid and small capitalization companies across 17 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Norway, Poland, Portugal, Spain, Sweden, Switzerland and the United Kingdom.
However, the Covid-19 pandemic has severely affected the strong “dividend culture” of many European firms, which were forced to postpone, limit or even cancel the amount of dividends destined to shareholders. Across industries, the hardest-hit industries were dividends-rich sectors such as energy firms or banks.
European and UK Banks under pressure
Shortly after the virus’ outbreak in Europe in March 2020, the European Central Bank ordered its 113 banks under supervision to cancel dividends, worth €30 bn. Similar pressures on lenders’ pay-outs came some weeks later from the Bank of England, which suspended £7.5 bn of dividend payments to shareholders. The debate regarding banks’ dividend ban has divided financial regulators and lenders, and there is still widespread uncertainty surrounding the issue.
On the one hand, banking supervisors strongly believe that banks should continue to conserve capital ahead of a potential surge in defaults which is likely to occur as soon as the governments’ stimulus packages will halt.
On the other hand, bankers argue that a prolonged ban on dividends will drive investors away from the banking industry, which could result in a limited ability for banks to raise capital in the future. For this reason, senior banking executives have been lobbying hard for stronger banks to resume dividend pay-outs to shareholders.
The president of Société Générale Lorenzo Bini Smaghi, for example, said that the dividend ban policy was making the banks “uninvestable”, while Santander Bank’s executive chair Ana Botín criticized the ECB guidelines by claiming that all this pressure from European regulators would give a substantial advantage to U.S. competitors.
Moreover, according to Bloomberg’s estimates, the total amount of dividends for the banking industry is likely to take more than 4 years to recover and finally exceed the amount paid in the financial year of 2019, in which the overall dividends paid accounted for € 51.4 bn (see Exhibit 2).
Extreme prudence for 2021
After having imposed a temporary suspension of all cash dividends and share buy-backs in the banking industry for the entire year of 2020, the European Central Bank recommended on the 15th of December of that same year that banks have to be extremely prudent for resumption of dividend pay-outs and shares repurchases until the fixed date of 30 September 2021.
This certain approach requested by the ECB implies that banks in the eurozone only distribute dividends up to 15% of the accumulated profit for 2019-20 and no higher than 20 basis points of CET1 ratio. The European Central Bank expects that only solid and profitable banks, with “robust capital trajectories” able to address the future impact and implications of the pandemic, should restart dividend payments. These limitations clearly have a major and profound impact on the typically high dividend-yielding industry. According to UBS analysts, returns are estimated to be falling from an average of 3.5 % to 1.5%. Undoubtedly, the most solid banks with stronger balance sheets such as Intesa San Paolo (Italy) or ING (Netherlands) will be the hardest hit.
Common Equity Tier 1 (CET1) is a capital measure introduced in 2014 as a precautionary means to protect the economy from a financial crisis. It is expected that all banks should meet the minimum required CET1 ratio of 4.5% by 2019. Definition by Investopedia: https://www.investopedia.com/terms/c/common-equity-tier-1-cet1.asp
Less stringent limits were instead given to British banks, as the Bank of England recently announced that it will allow the most solid and profitable banks in the nation to distribute dividends up to 25% of the cumulative profits for the years of 2019-20 and 0.2% of their risk weighted assets.
This could imply higher returns on investments for UK-equity shareholders with potential dividend yields ranging from 1.6% (Lloyds) to 3.2% (Barclays).
Banking Sector in the US
The most popular way through which equity investors in the U.S. are rewarded is the companies’ buyback of shares. With regards to the banking industry, share repurchases are particularly important since they typically account for more than 70% of the sector’s capital payouts to shareholders.
Despite the Covid-19 pandemic deeply impacting the U.S. economy throughout 2020 and a following temporary suspension of dividend pay-outs and share buy-backs, the Federal Reserve allowed the nation’s big banks to resume share buybacks in the first quarter of 2021 – subject to certain rules – while dividends continued to be capped. The main reasons behind the relaxation of these measures are to be found in the FED’s increased satisfaction with the amount of capital that the largest U.S. banks have been able to compile over the course of 2020.
After the above mentioned measures were announced, the board of JPMorgan Chase, the largest U.S. bank by assets, approved a new share repurchase program of $30 billion, prompting the share to rise up to 5.3% in after-hours trading, while other major U.S. banks such as Goldman Sachs and Wells Fargo rose up to 4.4% and 3.5% respectively on the same day.
The question that is still in place is whether shareholders will continue to rely on the fragile European banking sector, with constraints set by the ECB’s strict guidelines – or time has come for an investors’ flight towards U.S. banks that are more independent and less under the central bank’s pressure. Analysts hope to gain a better understanding after September 30th, when the ECB is expected to finally cut the dividend and shares buyback ban. Provided that European banks’ are willing to distribute dividends and buying back shares will be profitable, the capital positions will return back to be solid enough to absorb any further potential losses.