The Board of Governors of the
Federal Reserve System considers adequate capital to be critical to
the health of individual banking organizations and to the safety and
stability of the banking system. A major determinant of a bank’s or
bank holding company’s capital adequacy is the strength of its earnings
and the extent to which its earnings are retained and added to capital
or paid out to shareholders in the form of cash dividends.
Normally, during profitable periods,
dividends represent an appropriate return of a portion of a banking organization’s
net earnings to its shareholders. However, the payment of cash dividends
that are not fully covered by earnings, in effect, represents the
return of a portion of an organization’s capital at a time when circumstances
may indicate instead the need to strengthen capital and concentrate
financial resources on resolving the organization’s problems.
As a matter of prudent banking,
therefore, the Board believes that a bank or bank holding company
generally should not maintain its existing rate of cash dividends
on common stock unless (1) the organization’s net income available
to common shareholders over the past year has been sufficient to fully
fund the dividends and (2) the prospective rate of earnings
retention appears consistent with the organization’s capital needs,
asset quality, and overall financial condition. Any banking organization
whose cash dividends are inconsistent with either of these criteria
should give serious consideration to cutting or eliminating its dividends.
Such an action will help to conserve the organization’s capital base
and assist it in weathering a period of adversity. Once earnings have
begun to improve, capital can be strengthened by keeping dividends
at a level that allows for an increase in the rate of earnings retention
until an adequate capital position has been restored.
The Board also believes it is inappropriate
for a banking organization that is experiencing serious financial
problems or that has inadequate capital to borrow in order to pay
dividends since this can result in increased leverage at the very
time the organization needs to reduce its debt or increase its capital.
Similarly, the payment of dividends based solely or largely upon gains
resulting from unusual or nonrecurring events, such as the sale of
the organization’s building or the disposition of other assets, may
not be prudent or warranted, especially if the funds derived from
such transactions could be better employed to strengthen the organization’s
financial resources.
A fundamental principle underlying the Federal Reserve’s
supervision and regulation of bank holding companies is that bank
holding companies should serve as a source of managerial and financial
strength to their subsidiary banks. The Board believes, therefore,
that a bank holding company should not maintain a level of cash dividends
to its shareholders that places undue pressure on the capital of bank
subsidiaries, or that can be funded only through additional borrowings
or other arrangements that may undermine the bank holding company’s
ability to serve as a source of strength. Thus, for example, if a
major subsidiary bank is unable to pay dividends to its parent company—as
a consequence of statutory limitations, intervention by the primary
supervisor, or noncompliance with regulatory capital requirements—the
bank holding company should give serious consideration to reducing
or eliminating its dividends in order to conserve its capital base
and provide capital assistance to the subsidiary bank.
The Board’s guidelines on capital
adequacy define primary capital to include perpetual preferred stock,
and the Board is aware that such instruments have become an increasingly
significant element in the capital base of some banking organizations.
As part of a balanced capital structure, this instrument can serve
as a useful vehicle for supplementing common stockholders’ equity,
the most critical component of an organization’s capital base, and
for augmenting primary capital. However, in formulating capital plans
and meeting regulatory capital requirements, banking organizations
should avoid excessive reliance on preferred stock since this could
limit an organization’s financial flexibility in the event it encounters
serious and protracted earnings weaknesses.
This statement of principles is not meant to establish
new or rigid regulatory standards; rather, it reiterates what for
most banks, and businesses in general, constitutes prudent financial
practice. Boards of directors should continually review dividend policies
in light of their organizations’ financial condition and compliance
with regulatory capital requirements, and should ensure that such
policies are consistent with the principles outlined above. Federal
Reserve examiners will be guided by these principles in evaluating
dividend policies and in formulating corrective action programs
for banking organizations that are experiencing earnings weaknesses
or asset-quality problems, or that are otherwise subject to unusual
financial pressures. STATEMENT of Nov. 14, 1985.
