Abstract
This paper describes the effects of dividend regulation on payout incentives. In the model, risk-shifting, excess cash flow, and signaling incentives affect a firm’s decision to issue dividends. The regulator aims to prevent risk shifting through dividend restrictions on undercapitalized firms. However, this action increases the firms’ incentives to pay dividends for signaling, potentially inducing capital outflows in some firms that would otherwise use funds for the real sector. Thus, welfare benefits of prudential dividend restrictions at risk-shifting firms are partially offset through less capital and investment at moderately capitalized firms. We discuss environments in which the signaling effect is stronger and suggest policies to mitigate inefficient capital outflows through dividends.
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