Coordinating bank dividend and capital regulation

This paper examines how state-dependent dividend restrictions (taxes and bans) and capital requirements influence a bank's optimal capital buffers accumulation and risk-taking decisions. In the model, the bank distributes dividends and issues costly equity to maximise shareholder value, while its loans generate stochastic income under time-varying macroeconomic conditions. We solve the bank's stochastic control problem and derive the distribution of its capital buffers in closed form. We find that imposing dividend restrictions in bad macroeconomic states generates an intertemporal trade-off, as it encourages capital buffers accumulation in those states but promotes dividend payouts in the good ones. Furthermore, we show that the policy can undermine financial stability by reducing the bank's value and weakening its incentives to recapitalise in all states. Coordinating dividend taxes with counter-cyclical capital requirements can mitigate value losses and ease the trade-off, but it also exacerbates disincentives for recapitalisation. Finally, we show that when the bank can (optimally) reduce its risky loans in bad states, capital buffers generated through dividend restrictions mitigate the contraction by dampening its precautionary motive against costly recapitalisation.