Dividend Policy As the Financial system's capital was being depleted, many banks continued to pay dividends well

into the depth of the 2007-2009 Financial crisis. Large bank holding companies such as Bank of America, Citigroup and JP Morgan maintained a smooth dividend behavior, while securities companies such as Lehman Brothers and Merrill Lynch even increased their dividends as losses were accumulating. This behavior represents a type of risk-shifting or asset substitution that favors equity holders over debt holders. We present a simple model where, in the presence of risky debt, risk shifting incentives can motivate the payment of dividends as observed during the crisis. In our model, the bank has assets in place that generate some cash ow in the current period and some uncertain cash flow in the next period. At any given point in time, the bank has a franchise value (say, the present value of all its future cash ows) that is largely determined by the relationship with its customers and counterparties. The bank can pay dividends out of the current cash ow, and carry the remaining cash to the next period. The bank has to fulfill non-negotiable debt obligations in the next period out of the next period's cash flow and cash savings from the current period. If debt obligations are not satisfied, the bank is in default. In this case, equity holders receive no value from the next period cash flow, and furthermore, the bank's franchise value is lost, for example, through a disorderly liquidation or transfer to another bank or government. Given this setup, the first best solution that maximizes the total equity and debt value of the bank is to pay zero dividends. This is because risk shifting will decrease the total value of the bank by increasing the probability that its franchise value will be lost. Any gain from risk shifting by the bank's equity holders is a loss to its creditors in a zero sum game. However, we show that in practice when the dividend policy of a bank is set to maximize its equity holders' value, the optimal dividend policy can stray away from the first best solution. Here, the dividend policy reflects a tradeoff between (i) paying out to equity holders the available cash today rather than transferring it to creditors in default states in the future; and (ii) saving the equity's option on the franchise value since dividend payout raises the likelihood of default and thus foregoing this value.