The Greens are followed up on an earlier suggestion by Julie Anne Genter, the Green’s Shadow Minister of Finance, that KiwiBank should be refocused to keeping interest rates low. To that end, it would not be required to pay dividends to the government to help fund the effort. KiwiBank has only just started paying dividends to its parent, KiwiPost.
Banks failing to fully pass on benefits of OCR cut shows need to strengthen Kiwibank, give it mandate to compete on interest rates. #nzpol
If that were to be the case, that KiwiBank was no longer be required to pay dividends, that would blow quite a hole in the balance sheet of its parent company KiwiPost.
.@cjsbishop could do a lot more good for NZ economy, households and business driving interest rates down than returning a dividend to Govt.
KiwiPost owns the share capital of KiwiBank, which must be valued on a commercial basis to pass auditing as a state owned enterprise which is commercially orientated.
That share capital owned by KiwiPost in KiwiBank would be have to be written off if KiwiBank were to pay no further dividends because it is no longer commercially orientated entity. Such a write-off of its investment in KiwiBank would write off most of Kiwi Post’s equity capital.
The reason why state owned enterprises are required to be valued on commercial principles is to ensure that any subsidies or other favours sought by politicians show up in the profit and loss statement or the balance sheet through asset write-offs. Section 7 of the State-Owned Enterprises Act 1986 non-commercial activities states that:
Where the Crown wishes a State enterprise to provide goods or services to any persons, the Crown and the State enterprise shall enter into an agreement under which the State enterprise will provide the goods or services in return for the payment by the Crown of the whole or part of the price thereof.
This statutory safeguard ensures that the cost of any policies proposed by ministers, and the Greens are very keen on transparency and independent costing of political promises, are plain to all.
This expansion into a market that is not the mortgage market is to be underwritten by a capital injection as the Greens explain:
Inject a further $100 million of capital in KiwiBank to speed its expansion into commercial banking;
Allow KiwiBank to keep more of its profits to help it grow faster; and,
Give KiwiBank a clear public purpose to lead the market in passing on interest rate cuts.
Note well that the $100 million capital injection is to expand in to commercial banking. More aggressive passing on of interest rate cuts may jeopardise credit ratings if this lowers the profitability of KiwiBank. KiwiBank has an A- rating
The bigger hole in the policy is the more aggressive mortgage rate setting by KiwiBank will be done by keeping more of its profits and paying fewer dividends to its parent company Kiwi Post and through that to the taxpayer. There are next to no dividends currently to stop distributing to fund a more aggressive mortgage rate setting policy.
KiwiBank paid its first dividend last year. Prior to that, the bank kept all profits to allow it to expand its lending base. $20 million in foregone dividends does not go far given the actual size of all lending markets in New Zealand.
KiwiBank is minnow in the mortgage market and a pimple in commercial lending. Rapid business expansion is risky in any market, much less in banking.
The government has declined further capital injections so profits were retained to meet capital adequacy ratios. The government in 2010 earmarked NZ$300 million for an uncalled capital facility for NZ Post to help maintain its credit rating and KiwiBank’s growth.
Saving the best for last, KiwiBank last year announced plans to borrow up to $150 million through an issue of BB- perpetual capital notes to be used to bolster the bank’s regulatory capital position.
The Perpetual Capital Notes have a BB- credit rating compared to KiwiBank which has an A- rating. These capital notes were issued in addition to prior subordinate debt in the form of CHF175 million (about NZ$233 million) worth of 5-year bonds.
If Govt owns a bank, makes sense to use it to increase public good in NZ. (Same for television station, really) https://t.co/WiUhBcZMvE
— Julie Anne Genter (@JulieAnneGenter) April 2, 2016
I doubt that KiwiBank can raise capital through subordinated debt under normal commercial conditions if it does not plan to seek profits in the same way as other commercial banks do. The current issue of Perpetual Capital Notes are already rated as junk bonds:
An issue of $150 million of perpetual capital notes from KiwiBank with a speculative, or "junk", credit rating have been priced at the bottom of their indicative margin range.
The closest the prospectus for these Perpetual Capital Notes got to complementing KiwiBank changing from a normal business to being a public good is the following risk statement:
Kiwibank’s banking activities are subject to extensive regulation, mainly relating to capital, liquidity levels, solvency and provisioning.
Its business and earnings are also affected by the fiscal or other policies that are adopted by various regulatory authorities of the New Zealand Government.
The interest rate on this subordinate debt will go up to offset the additional risk of aggressive lending and aggressive expansion, which will cancel out many of the advantages of not having to pay for dividends and the capital injection.
That discipline is one of the purposes of subordinate debt in the regulatory capital of banks. This is to provide another pair of eyes and ears to watch the performance of the bank and through rising costs of lending and risk ratings, signal trouble of imprudent lending and lack of cost control.
The proposal to use KiwiBank to lower mortgage rates does not add up. KiwiBank does not pay much in the way of dividends to fund such a foray. KiwiBank is already far more leveraged than any other New Zealand major bank.
It is obvious that businesses find dividends sensible to pay because otherwise they will face disquiet from investors. Managers believe that higher dividends mean higher share prices.
Economists finds dividends to be a mysterious (Easterbrook 1984). Miller and Modigliani (1958) declared dividends to be irrelevant because investors can homebrew their own dividends by selling shares or borrowing against their share portfolios.
Modigliani (1980, p. xiii) explains the Miller and Modigliani Theorem as follows:
… with well-functioning markets (and neutral taxes) and rational investors, who can ‘undo’ the corporate financial structure by holding positive or negative amounts of debt, the market value of the firm – debt plus equity – depends only on the income stream generated by its assets.
It follows, in particular, that the value of the firm should not be affected by the share of debt in its financial structure or by what will be done with the returns – paid out as dividends or reinvested (profitably).
Warren Buffett has never paid a dividend. He only agreed to a stock split. Shareholders pressed him to do so. They wanted to bequeath their shares to children without having to sell them.
What is even more mysterious is a simultaneous existence of dividends and the raising of new capital, either through the share market or from borrowing (Easterbrook 1984).
Dividends are costly and ubiquitous so something causes them. Even if investors were irrational, dividends would go away if there cost exceeds their benefits.
If dividends were a bad idea, firms that pay few dividends would prosper relative to others; investors who figure out the truth would also prosper relative to others and before long dividends will be features of failing firms (Easterbrook 1984).
Dividends exist because they influence the firms financing policies. Dividends dissipate free cash and thereby induce the firm to float new shares and borrow. If the firm is constantly in the market for new capital, it must constantly prove the value of the investment to the market (Easterbrook 1984).
The interests and incentives of managers and shareholders frequently conflict over the optimal size of the firm and paying free cash flows as dividends. Jensen (1986) defines free cash flow as follows:
Free cash flow is cash flow in excess of that required to fund all of a firm’s projects that have positive net present values when discounted at the relevant cost of capital. Such free cash flow must be paid out to shareholders if the firm is to be efficient and to maximize value for shareholders (Jensen 1986, p. 323).
The problem is how to motivate managers to pay out this cash rather than invested at below the cost of the capital. By issuing debt, managers bind themselves to pay out future cash flows in a way that a future dividend policy cannot.
Creditors can take the firm into bankruptcy court if they do not repay. Investors and bankers play an important role in monitoring the firm and its proposed projects.
The control function of debt is more important in organisations with large cash flows but low growth prospects. Investors in the share market are alert to the control function of debt. Most leverage increasing transactions result in positive increases in share prices while most transactions that reduce leverage results in share price falls (Jensen 1986).
There is nothing new about using high debt leverage ratios to create greater business value through limiting managerial discretion in focusing entrepreneurial attention on the bottom line.
One of the driving forces behind management leverage buyouts in the 1980s was that they borrowed to take over a company to run it better. The high levels of debt in management buyouts made sure that there was no incentives to tolerate waste or inefficiency or underperforming divisions or product lines of the firm. Any slack with the organisation would very quickly be punished perhaps in bankruptcy. Heavy debt ratios focused the attention of managers and boards of directors.
New debt puts managers under additional scrutiny of a range of bankers and the share market, which is the principal reason for keeping firms constantly in the market for capital. Managers of firms that do not have to go into the market repeatedly and regularly for new capital have more discretion to behave in their own interest rather than those of investors (Easterbrook 1984). The function of dividends is to keep firms in the capital market.
Managers of firms with unused borrowing power and large free cash flows are more like to undertake expansions that are less profitable. The burst of takeovers and leverage buyouts in the 1980s were very much driven by opportunities to profit from reducing corporate slack and downsizing flabby corporate headquarters of large publicly listed companies (Jensen 1986).
Dividends reduce the resources under managers’ control and subjecting them to the monitoring by the capital markets that occurs when a firm must obtain new capital. Financing projects internally avoids this monitoring and the possibility that funds will be unavailable or available only at high explicit prices. Project finance replicates the disciplinary effect of paying regular dividends by borrowing a huge amount at the start of the project. High debt prevents management wasting resources on low return projects.
Dividends are paid by companies to tie the hands of management. Dividends make sure that there is less free cash about for them to spend on projects at their own discretion. When a major expansion must be undertaken, the management of a company must either go to the share market or banks for it to go forward. This means multiple set of decision-makers agree that it is a worthwhile project and provide funding.
The art of business is identifying assets in low-valued uses and devising ways to profitably move them into higher values uses (Froeb and McCann 2008). Wealth is created when entrepreneurs move assets to higher-valued uses.
Froeb and McCann (2008) argued that mistakes are made – business opportunities are missed – for one of two reasons:
1. A lack of information; or 2. Bad incentives.
Rational, self-interested actors err because either they do not have enough information to make better decisions, or they lack incentives to make the best use of information they already have.
Froeb and McCann (2008) argued that three questions arise about all business problems:
1. Who is making the bad decision? 2. Does the decision maker have enough information to make a good decision? 3. Does the decision maker have the incentives to make a good decision?
For Froeb and McCann (2008), the answers to these questions immediately suggest ways to fix them:
1. Let someone else make the decision; 2. Give more information to the decision maker; or 3. Change the decision makers’ incentives.
Dividends follow all three points in this matrix. Dividends include others in investment and expansion decisions of the company. These bankers or new share investors must be given more information on the merits of the new or enlarged project.
The project will not go ahead and any benefits to the careers of the executives championing it will not be forthcoming unless they can persuade these outside parties with plenty of other investment options of the merits of the project.
Dividend show that the market process as well alert to the risks of separating ownership from control. Counter strategies are developed to channel the efforts and align the interests of management teams towards those of investors and owners.
The ownership structure and dividend policies of firms arise out of the search for the capital structure that maximises profits. Different divisions of risk between creditors and shareholders and decision-making rights between owners, boards of directors and managers all affect the value and profitability of a firm. Dividends contribute to that search more profitable forms of organisation by restricting free cash flows in the hands of management.
I did not know so many people were on a fixed rate mortgage. Labour is risking its economic credibility on regulating the rates for a minority of mortgages.
Capped mortgages cannot be linked to the current official cash rate of the Reserve Bank of New Zealand because they are based on expected future interest rates over an up to 5 year span, not current interest rates.
An important motivation for going onto a floating rate is you can repay faster. Fixed rate mortgages have penalties for early repayment.
In consequence, price controls linking floating rate mortgages to the official cash rate of the Reserve Bank would benefit better off mortgagees expecting to repay quickly. A typical policy of the modern Labour Party.
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