Fed to banks: don't use bailout funds for dividends

WASHINGTON (Reuters) - The Federal Reserve Board on Tuesday put more pressure on banks to cut dividends as conditions deteriorate, and said it would discourage the use of federal rescue money to fund such payouts.

In a guidance letter to the 12 regional Fed banks and the bank holding companies they supervise, the Fed signaled increased scrutiny of dividends in assessing capital adequacy -- especially for those firms that receive funds from the U.S. Treasury’s Capital Purchase Program.

“While many organizations place great importance on maintaining their dividends, a board of directors should reduce or eliminate dividends when the quantity and quality of the bank holding company’s earnings have declined or the (firm) is experiencing other financial problems or when the macroeconomic outlook for the (firm’s) primary profit centers has deteriorated,” the Fed said.

A New York-based source said earlier that the Fed has been urging banks “in increasingly strong language” to use the bailout money to issue new loans and bolster their reserves, not to pay dividends.

“This letter is a firm reminder that the Fed is going to be tightening the noose on banks,” said Mark Williams, a former Fed bank examiner who is now a finance professor at Boston University. “They are reminding banks that they are stewards of cash and have to use it in appropriate ways.”

He said the letter gives more power to bank examiners to deny an institution’s request to pay a dividend if they believe this would reduce safety and soundness.

In the letter, the Fed said recipients of federal rescue funds must explain to Fed supervisors how their “proposed dividends, capital redemptions and capital repurchases are consistent with requirements applicable to its receipt of capital under the program.”

It said it was discouraging federal funds recipients from using the money to pay dividends on trust preferred securities or repay debt obligations.

The U.S. Treasury said on Tuesday it has invested about $236 billion in bank preferred stock since mid-October, including the Capital Purchase Program and one-off bank rescues.

Banks should cut, eliminate or defer their common stock dividends if earnings for the past four quarters are not sufficient to fully fund the payouts, if prospective earnings are not consistent with prospective financial conditions, or if the firm is in danger of not meeting minimum regulatory capital adequacy ratios.

“Failure to do so could result in a supervisory finding that the organization is operating in an unsafe and unsound manner,” the Fed warned in the letter.

The Fed guidance on dividends comes a day before the U.S. Treasury Department is expected to start a program of “stress tests” for larger banks that aims to determine whether their capital levels are sufficient to withstand a deeper-than-expected recession.

Authorities will provide additional, temporary capital cushions to those firms found needing one, U.S. regulators said on Monday. The program also aims to convert government preferred stock investments to convertible preferred shares and ultimately, common equity if needed to bolster capital.

Additional reporting by Kristina Cooke in New York, Editing by Chizu Nomiyama