A Prudential Paradox: The Signal in (Not) Restricting Bank Dividends

By restricting dividends in the weakest banks, prudential regulators counterintuitively induce more capital payouts in marginal banks. The potential for bank runs exacerbates the incentive to signal strength through dividend payments. Regulatory restrictions on those payments can be used to achieve the first‐best outcome, but only if the prevailing capital requirements are sufficiently high. In a crisis, the optimal dividend policy is more restrictive, since it allows the weak but solvent banks to pool with the strong. Finally, we show that the optimal release of regulatory bank information depends critically on the regulator's information and dividend restriction policies.