Coordinating Bank Dividend and Capital Regulation

ABSTRACT This paper examines how state‐dependent dividend restrictions (taxes and bans) and capital requirements influence a bank's capital buffer 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 its capital buffer distribution in closed form. Binding dividend restrictions in bad macroeconomic states increase capital retention but shift dividend payouts toward good states, reducing shareholder value. This reduction disincentivizes equity issuance following adverse income shocks. Dividend shifting and recapitalisation disincentives increase the bank's capital buffer dispersion in the long run. Coordinating dividend restrictions with counter‐cyclical capital requirements mitigates value losses in bad states and capital‐buffer dispersion, but reduces shareholder value in good states and further weakens recapitalisation incentives. When the bank can optimally reduce lending in bad states, the capital buffers induced by dividend restrictions mitigate the contraction by weakening its precautionary motive.