Bank dividends, interest expenses, and leverage

This paper documents that the dividend payout ratios of larger US banks rise when interest rates increase. To account for this pattern, I develop a model of optimal investment and deposit issuance under a risk-based constraint. Smaller banks primarily generate profits from the Fed funds-deposit spread, which typically widens with higher rates. Larger banks, by contrast, hold a greater share of risky assets and keep government bonds mainly as precautionary buffers. In high-interest-rate environments, these larger banks see only a modest increase in profitability. Consequently, they have weaker incentives to expand their investments and instead opt to reduce their buffer of safe assets to distribute higher dividends. Empirical evidence on payout behavior and leverage across banks that gain different shares of income from government bonds aligns with the prediction of the model. The findings highlight the importance of monitoring banks’ payout and leverage during periods of rising interest rates.