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Turning Off the Dividend Spigot

NEW YORK – European banks’ high litigation and restructuring costs have resulted in major losses on their books and abysmal stock-market performance. As the industry and European regulators now reflect on this dismal state of affairs and search for solutions, they should consider banks’ revenue distribution – including employee bonuses and shareholder dividends – as part of the problem.

Revenue distribution is one primary reason for European banks’ capital shortfalls. To understand why, we should look back to October 2014, when the European Banking Authority began balance-sheet stress tests for the eurozone’s largest 123 banks and found a capital shortfall of €25 billion ($28 billion) in all of them.

At the time, the EBA required the banks to devise plans to address their respective shortfalls within 6-9 months. Some banks took action and raised equity through rights issues, sometimes with substantial help from governments. But most banks mollified regulators by simply shedding riskier assets to improve their capital ratios.

Needless to say, these efforts were ineffective, and European banks’ share prices have declined by 50%, on average, since the initial 2014 assessment. Banks that failed the stress test and didn’t take the result seriously are partly to blame, but so, too, are regulators who did not sufficiently hold the banks’ feet to the fire to improve their balance sheets, and who may have applied stress tests that were too weak to detect financial frailty.