Retained earnings power capital growth at top eurozone banks

Retained earnings increased €29.7 billion as part of CET1 at 16 large eurozone banks in two years to end-2018

Large eurozone banks held back earnings to boost capital over the two years to end-2018 more than they issued new capital instruments, Risk Quantum analysis shows. 

Sixteen large eurozone banks had aggregate Common Equity Tier 1 (CET1) capital, prior to regulatory adjustments, amounting to €826.1 billion as of Q4 2018, up 4% on end-2016.

Of the €31.5 billion net increase over this period, €29.7 billion was achieved through a build-up of retained earnings. Net capital instruments, such as ordinary shares and share premium accounts, increased by €17.5 billion.

Independently reviewed interim profits, minus expected charges and planned dividends, grew by €12.7 billion over the two year period.

In contrast, minority interests allowed as part of CET1 declined by €5.9 billion and accumulated other comprehensive income (AOCI) and reserves by €22.6 billion.

As of end-2018, capital instruments made up 46.3% of total capital, retained earnings 34.9%, AOCI 12%, adjusted interim profits 4% and minority interests 2.9%.

What is it?

The best form of loss-absorbing capital is designated CET1 under Basel Committee-rules, and is largely made up of shareholders’ equity and retained earnings net of regulatory adjustments.

Banks need to maintain a minimum ratio of CET1 capital to risk-weighted assets of 4.5%, plus additional buffers.

Why it matters

Eurozone banks are under pressure from regulators and investors to increase their CET1 capital.  

There are only a few ways they can do this. One is by selling shares in the market. This isn’t a popular choice as it can raise less capital than expected if the market values a bank’s equity below its own estimate.

Another option is to hold back profits. This can also cause banks problems, as it means they have less available to distribute to shareholders.

The above analysis shows that most large eurozone banks have opted to retain more profits despite these downsides. These lenders have been less profitable than their global peers in recent years, though depressing their ability to raise huge amounts this way. It’s also made them less attractive to investors compared with their US rivals as they’ve had less to give away as dividends.

Efforts to bolster capital through earnings growth have also been undermined by fluctuations in AOCI. This largely reflects the unrealised gains and losses on available-for-sale (AFS) assets.  

One way banks can reduce AOCI impacts is by reclassifying AFS assets as held-to-maturity (HTM). Assets classified under the latter category are not marked-to-market, and therefore their valuation changes do not flow into AOCI. 

This technique has caught the attention of Andrea Enria, chair of the European Central Bank, however, as he fears that banks are improperly designating certain assets as HTM to artificially inflate their capital.

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