The policy approach with regard to payment of dividends by banks has been recently reviewed by the RBI and the regulatory focus has been shifted from quantum of dividend to dividend payout ratio. According to RBI's revised guidelines announced on 24th April'04 eligibility criteria for declaration of dividend without prior approval, cover banks with  capital adequacy ratio (CRAR) of 11% for preceding two years and net non-performing assets of less than 3%. The bank should also comply with   provisions of  Banking Regulation Act, 1949 Sec.15 (completely written off all capitalized expenses, losses incurred and expenditure item in the form of intangible assets) and Sec.17 (have created reserve fund not less than one-fifth of such profit). In addition , banks should ensure that the dividend payout ratio does not exceed 33.33% (excluding dividend tax) of net profit after removing any extra ordinary profits/income.

Banks are free to declare interim dividend out of the relevant accounting period's profit without prior approval from RBI if they satisfy the above guidelines. If any bank desires to declare dividend higher than the one third payout ratio on attaining the above eligibility, it will need to obtain prior approval of RBI. The request received from banks will be considered by RBI on a case to case basis. Earlier, all banks had to take RBI's permission if the dividend declared was in excess of 25% of equity.

In a bid to keep their shareholders satisfied, banks sought to declare higher and higher dividends. RBI appears to be keen to reverse this trend and instead encourage banks to plough back their profit to shore up their core business.  Over the last couple of years, banks have been riding on lower interest rates and deriving bumper profits emanating from treasury operations. So banks have been generous in declaring profits. Total dividends handed out by listed banks in FY02-03 were Rs.193556 crore compared with Rs.70022 crore in 1999. A higher outflow of dividends implies that less is being ploughed back from profits. This in turn, limits the ability of a bank to take large exposure and mars the translation into higher growth. High dividends also favour shareholders over depositors. So far, banks have been concentrating on the quantum of dividend paid whereas the payout ratio actually saw a decline.  The banks will have to strike a balance to keep both depositors as well as shareholders pleased.

The new regulation will not only hit banks with high NPAs but also those not carrying extra capital. About 20 banks out of a list of 57 public & private banks do not meet the stipulation of capital adequacy levels and 49 banks do not meet the stipulation of net NPA level (on the basis of FY02 & FY03) for automatic dividend declaration. Hence the new guidelines may keep out shareholders looking for quick earnings from banking stocks. However, from the perspective of creating a strong banking sector, this is a welcome measure as banks will be encouraged to improve their financial health which in turn will improve capital appreciation and will, therefore be perceived as investor friendly. 

As fewer banks will be eligible to pay dividend without prior permission from RBI under the revised guidelines, the Centre stands to lose a chunk of its non-tax revenues through dividends from public sector banks. Around Rs.800crore was paid by public sector banks as dividend to the Government  in the year 2002-03 and looking to the buoyancy in growth of these banks during FY04, the Centre had increased such estimates by Rs.515crore. However, while the quantum of dividends paid by banks could fall in FY04, this could increase in FY05 with the expected improvement in the financial health of banks.

The proposed guidelines by RBI are clearly aimed at improving the financial performance of banks and preparing them for a turn in the interest rate scenario, as earnings in the last couple of years have essentially resulted from treasury-bond gains. Another view is that the RBI is trying to put in place stringent practices for banks to help them gear up for the proposed Basel II norms that are expected to come into play by 2006-07. 

The announcement made by RBI augers well for the banking system as it will prompt banks to augment their capital base, reduce their NPA or both. Some banks may go for another round of capital raising via public/right issue or subordinated bonds route to augment their capital adequacy. Banks are also likely to focus on NPA recovery and improving asst quality. In any case the new norms will encourage banks to grow their core business as the cap of 33.33% payout ratio will be applicable to the profits, net of the extra-ordinary profit/income from other sources. As banks improve their recovery, reduce NPAs, strengthen their capital base and focus on building up their core business, there is no doubt that it will have a positive impact on stability of the financial sector in India.

(The opinions expressed are those of the individual researcher and do not necessarily reflect those of the Bank or its Associates)

Edited by General Manager, Economic Research Department, State Bank of India, Corporate Centre, Mumbai.