The rate tells a board how fast it can grow and how much it can pay out without raising capital, provided it is measured on the right base.
A bank's internal capital generation rate is the earnings it keeps, net income less dividends and buybacks, divided by its opening capital: the classic shortcut is ROE × (1 − payout ratio). It is also the fastest the bank can grow risk-weighted assets without its capital ratio falling. On an illustrative bank earning $110m with a 40 per cent payout, the shortcut gives 6.95 per cent on book equity, but measured on common equity tier 1 the bank generates 8.25 per cent a year, and that is the growth rate its CET1 ratio can sustain.
Worked in full in Bank Management by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The ratio answers the question a board asks every budget round: how much can we lend, and how much can we pay out, without raising capital? It takes three lines to compute. The usual error is in the denominator.
| Input | Value |
|---|---|
| Common shareholders' equity | 950 |
| Goodwill and intangibles, deducted from CET1 | 150 |
| CET1 capital | 800 |
| Risk-weighted assets | 8,000 |
| CET1 ratio | 10.0% |
| Net income for the year | 110 |
| Dividend payout ratio | 40% |
Other deductions, unrealised gains and losses and the tax effects are left out so the mechanics stay visible; a real bank adds each of them to the same bridge.
Retained earnings = net income − dividends − buybacks
ICG (shortcut) = ROE × (1 − payout ratio)
ICG on CET1 = retained earnings ÷ opening CET1 = maximum RWA growth at a constant CET1 ratio
In Excel: =(NetIncome-Dividends-Buybacks)/OpeningCET1
Step 1: what is kept. Dividends are 40 per cent of $110m, $44m. Retained earnings are $66m.
Step 2: the shortcut. ROE on opening equity is 110 ÷ 950 = 11.58 per cent. Retaining 60 per cent of it gives 11.58% × 0.60 = 6.95 per cent. That is how fast book equity grows.
Step 3: on the capital that counts. The $150m of intangibles is already deducted from CET1 and does not grow with earnings, so all $66m lands on a smaller base: 66 ÷ 800 = 8.25 per cent. Equivalently, the return on CET1 is 13.75 per cent, and 60 per cent of it is retained.
Step 4: the growth it funds. CET1 rises from $800m to $866m. Divide by risk-weighted assets grown at the same 8.25 per cent, $8,660m, and the ratio is exactly 10.00 per cent again.
| RWA growth | Year-end RWA | Year-end CET1 | CET1 ratio | Change, bp |
|---|---|---|---|---|
| 0.00% | 8,000 | 866 | 10.82% | 82 |
| 5.00% | 8,400 | 866 | 10.31% | 31 |
| 8.25% | 8,660 | 866 | 10.00% | 0 |
| 10.00% | 8,800 | 866 | 9.84% | −16 |
| 12.00% | 8,960 | 866 | 9.67% | −33 |
Turn it round and the same arithmetic sets the payout. To grow risk-weighted assets 10 per cent at a 10.0 per cent ratio the bank needs $80m of new CET1, $14m more than it retains: either the payout falls to 27.3 per cent, $30m of dividends, or growth slows. At 6 per cent growth it needs $48m and could distribute $62m, a 56.4 per cent payout.
Had the board used the 6.95 per cent shortcut as its growth limit, the ratio would have ended at 10.12 per cent, with $10.4m of capital left idle. On a bank with large intangibles the shortcut understates capacity; on one with few, the two figures converge.
| ROE | Payout 20% | Payout 40% | Payout 60% | Payout 80% |
|---|---|---|---|---|
| 8.00% | 7.60% | 5.70% | 3.80% | 1.90% |
| 11.58% | 11.00% | 8.25% | 5.50% | 2.75% |
| 14.00% | 13.30% | 9.98% | 6.65% | 3.33% |
Buybacks count exactly like dividends. Add $30m of repurchases to the $44m dividend and the total payout is 67.3 per cent, retained earnings $36m and capital generation 4.50 per cent: half the growth capacity, for the same earnings.
And when earnings fall but the dividend does not, the rate turns negative. If net income drops to $40m with the $44m dividend held, the payout is 110 per cent, capital generation is −0.50 per cent, and the ratio slips to 9.95 per cent with no growth at all. A bank in that position is funding its dividend out of its capital.
Using ROE on book equity as the capital base. Book equity includes goodwill, intangibles and, depending on the regime, unrealised losses that the capital ratio treats differently, so the growth rate of equity is not the growth rate of CET1. The second mistake is to forget that risk-weighted assets can grow faster than loans: a shift into higher-weighted lending, or a model change, consumes capital with no growth in the balance sheet. Compute the rate on CET1 capital and compare it with RWA growth, not asset growth; the earnings side is the ROE calculation for a bank.
Retained earnings over opening CET1 is the speed limit: here 8.25 per cent, against 6.95 on the shortcut. Grow risk-weighted assets faster and the ratio falls; pay out more and the limit drops. Bank Management reads one bank's capital four different ways, and the free workbook for this case bridges published CET1 to the capital a buyer would actually recognise.
One at least equal to planned growth in risk-weighted assets, so the capital ratio holds without new equity. On an illustrative bank earning an 11.58 per cent ROE and paying out 40 per cent, capital generation on CET1 is 8.25 per cent: growth of 10 per cent takes the CET1 ratio from 10.0 to 9.84 per cent, growth of 5 per cent lifts it to 10.31.
Yes, exactly like dividends. On an illustrative bank retaining $66m of $110m of earnings, adding $30m of buybacks to a $44m dividend raises total payout to 67.3 per cent and cuts capital generation on $800m of CET1 from 8.25 to 4.50 per cent, roughly halving the growth it can fund.
The share of earnings left after funding the capital its growth needs. An illustrative bank at a 10.0 per cent CET1 ratio with $8,000m of risk-weighted assets needs $48m of new CET1 to grow 6 per cent, so of $110m earned it can distribute $62m, a 56.4 per cent payout; at 10 per cent growth, only 27.3 per cent.
This article is one calculation from Bank Management. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: regulation, compliance and banking → · All 1340 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.