Definitions of Other Variables

Traditionally, a firm’s dividend payout represents the proportion of current earnings paid out in dividends. However, since we are dealing with accounting data of banks in countries with different accounting practices and standards, to mitigate the potential bias in the measurement of earnings that may result from differences in accounting, we consider alternative definitions of dividend payout. We consider two measures of dividend payout (dividend-to-earnings ratio - DTE and dividend-to-cash-flow ratio - DTCF) from La Porta et al. (2000). These authors argue in favour of the use of dividend-to-cash-flow measure since it has a natural economic meaning being the ratio of cash distributed to cash generated during a given period. The use of dividend-to-earnings and dividend-to-cash- flow ratios suggests that, as expected, bank managers rationally consider both the level of current earnings and cash flows in setting the dividend policy. However, the dividend-to- cash-flow measure also presents a challenge for cross-country studies as it depends on a country’s accounting conventions that may affect the determination of accruals and cash flows, thus making cross-country comparison less precise. In addition, managers may easily manipulate earnings and cash flows and diversion of resources may occur before reporting earnings or cash flows. If this is the case, these two ratios may overestimate the share of true earnings or cash flows paid out as dividends. Because of this, we also present results based on three additional measures of dividend payout.

The use of dividend-to-equity ratio is intuitively appealing and underlines the import- ance of equity capital in banking. Although it does not lend itself to easy interpretation,

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we use revenue as a deflator of dividends as revenue is more difficult to manipulate through accounting practices. We define revenue as the sum of a bank’s interest and dividend income. The use of dividend-to-asset ratio is motivated by Allen and Michaely (2003) and Li and Zhao (2008) and ensures that results are not affected by dividend pay- ing banks with negative earnings. Like the equity based measure, the dividend-to-asset ratio is also appealing in banking as regulatory authorities are interested in the level of bank assets for capital regulatory purpose, which may involve restriction of dividends. We use the average of these measures over the period of the study for our country-level (bank-level) regressions.

4.3.4.2 Control Variables

While our primary interest is in the proposed earnings quality variable, empirical evidence suggests additional institutional, economic wide, and firm-level factors that may exert significant influence on dividend payments and/or earnings quality. We consider the influence of the following factors on bank dividend payout:

Legal System: Evidence suggests that the legal environment of firms’ country of incor- poration determines their corporate policy behaviour. For example, La Porta et al. (2000) provide evidence that firms incorporated in common law countries pay higher dividends compared to firms incorporated in civil law countries. Ferris et al. (2009) find evidence of international presence of dividend catering across a sample of common law countries but not for those in civil law countries. We measure legal system (LAW) using a binary variable that takes the value of 1 for common law countries and 0 for civil law countries. We obtain this measure from La Porta et al. (2000), and in line with their study, we expect a positive relation between dividend payout and LAW.9

Investor Protection: Investor protection mitigates the tendency to expropriate minor- ity shareholders and creditors within the constraints imposed by law. Even though their sample excludes financial institutions, La Porta et al. (2000) argue and show that consist- ent with the “outcome” agency model of dividends, firms in countries with high investor protection, including stronger minority shareholder rights, pay higher dividends com- pared to firms in countries with low investor protection. We measure investor protection (PROTECT) as the sum of three variables from La Porta et al. (1998): rights of minor- ity shareholders (antidirector), creditors’ rights, and legal enforcement. Higher values of these variables indicate stronger protection of shareholders, creditors, and stronger legal

9_{While we appreciate the differences even among civil law countries, because of the limitation in the}

enforcement. We expect a positive relation between dividend payout and PROTECT. Per capita GDP: We control for the potential influence of economic wide factor on bank dividend payout using the log of the average per capita GDP (LnGDP) over the period of the study. We obtain the data on per capita GDP from the World Bank database.10 We predict a positive relation between dividend payout and LnGDP as banks in countries with greater national output are likely to pay higher dividends.

Profitability: Using a cross-country sample of firms, Denis and Osobov (2008) find evidence of a positive relation between firm profitability and propensity to pay dividend. We measure profitability (ROE) as the average of ratio of earnings after tax to book value of total equity over the period of the study. Consistent with literature, we predict a positive relation between dividend payout and ROE.

Investment Opportunities: While not perfect, it is traditional to measure firm’s growth prospect using Tobin’s Q or the market to book ratio. However, because our sample consists of private and public banks, we are unable to use either of these variables. As retention of earnings and issue of new equity are likely to rank high in financing investment opportunities, we measure growth opportunities (GROWTH) as the average annual change in book value of equity over the period of the study. Consistent with prior studies (e.g. Denis and Osobov, 2008), we expect a negative relation between bank dividend payout and GROWTH.

Capital Adequacy: Empirical evidence suggests that bank earnings quality is a function of bank capital adequacy. For example, Ahmed et al. (1999) provide evidence in support that banks use of loan loss provisions, an important element of bank accruals, in earnings management. In addition, the high regulatory environment of banks impact greatly on the level of dividend payout as regulators may exercise their oversight powers by curtailing dividend payments by banks with low capital ratio. We control for the regulation and bank capital adequacy using the ratio of book value of capital to total assets (CAPR). As we expect banks with more capital relative to the value of their assets to be under less pressure from regulatory authorities to reduce dividends, we predict a positive relation between bank dividend payout and CAPR.11

Dividend Tax Advantage: Using the dividend tax advantage (DTA) variable in La Porta et al. (2000), we also control for the possibility that differences in the treatment of dividend tax in different jurisdictions may explain the differences in dividend payout across countries. However, as noted by La Porta et al. (2000) the question regarding the role of

10_{Available from http://data.worldbank.org/indicator/NY.GDP.PCAP.CD/countries/1W?display=default}

11_{As this measure also reliably captures the risk profile of banks we do not include a separate risk variable}

dividend tax on dividend payment is unsettled. While the traditional view suggests that the double taxation regime (for example, in the US) deter dividend payment by firms, more recent studies suggest that taxes do not deter dividend payments as shareholders have no preference for the timing of dividends (see, for example, Harris et al., 2001). In view of this controversy, we are agnostic regarding the direction of the relation between dividend payout and DTA.