Share Repurchases as Signals in Banking: Do They Work?

The fundamental premise of corporate finance is that the decisions of the managers (agents) should lead to value maximization for their shareholders (principals). When firms have excess cash flow, managers have to choose among the various alternatives for use of the funds, i.e., investments, operations, and cash payout (dividends and repurchases). The principal mechanisms used by firms to distribute excess cash flow and avoid agency conflict are dividends and share repurchases, with an increasing percentage going to repurchases. This study examines the use of share repurchases by banking firms to signal the market about future operating performance (signaling hypothesis), and to reduce agency conflicts (cash flow hypothesis). Previous empirical studies in the non-financial sector have shown weak support for signaling hypothesis and strong support for cash flow hypothesis. The results of this study show strong support for cash flow hypothesis, similar to the non-financial sector. However, the use of repurchase as signal by banking firms does not coincide with superior future performance, contradicting the results obtained in the non-financial sector. This study also examined the data on the banking firm's operating performance relative to its record of satisfying prior repurchase commitments before announcing new programs (time inconsistency hypothesis) during the study period. The results of the analysis do not support time inconsistency hypothesis, contradicting the results in the non-financial sector.