Bank Capital and Dividend Externalities

Dividend payouts affect the relative value of claims within a firm. When firms have contingent claims on each other, as in the banking sector, dividend payouts can shift the relative value of stakeholders' claims across firms. Through this channel, one bank's capital policy affects the equity value and risk of default of other banks. In a model where such externalities are strong, bank capital takes on the attribute of a public good, where the private equilibrium features excessive dividends and inefficient recapitalization relative to the efficient policy that maximizes banking sector equity. We compare the implications of the model with observed bank behavior during the crisis of 2007-09