Real regulatory capital management and bank payouts: Evidence from available-for-sale securities

This study examines whether payout policies create incentives for banks to engage in cherry-picking activities using available-for-sale (AfS) securities, otherwise known as gains trading. Such activities are more likely to arise in situations in which capital ratios would otherwise constrain banks’ ability to distribute resources to shareholders. Using a large sample comprising 766 unique US banks, we find a significant and positive association between total payout and realized gains on AfS securities for banks with low regulatory capital. This is consistent with the conjecture that capital-constrained banks engage in gains trading to free up resources for dividend payments or share repurchases. When partitioning our sample, we find that capital-constrained banks realize gains and losses on AfS securities only when it is costly to decrease the payout and when the monitoring level is weaker. Further analyses reveal that banks engaging in gains trading to distribute cash to shareholders exhibit significantly higher levels of future default risk and more negative extreme bank-specific daily returns, patterns that are consistent with risk-shifting. Finally, with the advent of Basel III, the practice seems to continue among banks that chose to retain prudential filters.