{"id":54346,"date":"2019-04-11T08:38:25","date_gmt":"2019-04-11T07:38:25","guid":{"rendered":"https:\/\/valuesque.com\/?p=54346"},"modified":"2019-04-12T14:41:11","modified_gmt":"2019-04-12T13:41:11","slug":"santanders-inflated-earnings-the-when-oci-is-core-business-financial-analysis-problem","status":"publish","type":"post","link":"https:\/\/valuesque.com\/en\/blog\/2019\/04\/11\/santanders-inflated-earnings-the-when-oci-is-core-business-financial-analysis-problem\/","title":{"rendered":"Santander\u2019s Inflated Earnings: The \u201cWhen-OCI-is-Core-Business\u201d Financial Analysis Problem"},"content":{"rendered":"\n

The idea of\nthe Standard Setters was straightforward. In order to allow investors a focus\non recurring, business-related and controllable earnings components the whole\ncomprehensive income (i.e. the change of equity that is not due to\ncompany-owner transactions) of a company is split into two components for\nreporting purposes: a) the profit & loss statement (P&L) and b) the so\ncalled other comprehensive income (OCI). The OCI comprises all changes in\nequity that are not seen as relevant for understanding the recurring\nperformance of the company or might even mislead investors (and that are not\ndue to company-owner transactions) such as actuarial gains and losses on\ndefined benefit pension plans, unrealised gains and losses on certain\nsecurities, effects from translating foreign currency financial statements into\nthe home (functional) currency and certain revaluation effects. Some of these\neffects might be recycled to the profit and loss statement at a later point in\ntime, some not.<\/p>\n\n\n\n

In fact, there\nis a lot of debate around the nature of OCI with a fair number of investors\narguing that there is a lack of systematic structure about which components to\ninclude into OCI. And they are right. Depending on the business model of the\nreporting company it sometimes seems more appropriate from an economic point of\nview to include a certain accounting item into OCI, and sometimes less so. At\nthe extreme, we can see even situations where the economic logic seems to be\nturned upside down, as is the case for the P&L\/OCI of the Spanish bank\nSantander SA. <\/p>\n\n\n\n

Santander is\nnot a local European bank, it is also doing big business via its foreign\nentities in Latin America: Brazil, Mexico, Chile and Argentina. And all these\ncountries have one thing in common: They are (on average, over time) more\ninflationary countries than Spain (or the Eurozone). Interestingly, for doing\ninvestment business in inflationary countries financial theory has two concepts\nthat can tell us what we can expect to happen in capital markets of the\ninflationary countries (i.e. the Latin American countries) on the one hand and of\nthe home country (i.e. the Eurozone) on the other hand. These two concepts are the\ninterest rate parity (IRP) and the purchase power parity (PPP).<\/p>\n\n\n\n

Under these\ntwo theories we should see \u2013 under certain circumstances and in perfect markets\n\u2013 a) higher interest rates in Latin America than in the Eurozone and b) a\ndepreciation of the Latin American currencies as compared to the Euro. In an\nultimate market equilibrium this means that it doesn\u2019t matter here whether a\nEuro-investor invests in the Eurozone at lower interest rates or in Latin\nAmerica but with higher interest rates being partly eaten up by exchange rate\nlosses. Admittedly, in reality there are also some other factors to include\ninto the analysis, and international capital markets are not at all perfect. In\nthe context of Santander, it is e.g. worth noting that home interest rates are\nartificially driven down by the quantitative easing activities of the European\nCentral Bank ECB. However, this does not weaken the general message here: the\nIRP and the PPP are in many real world cases a good indicator for the direction\nof market movements.<\/p>\n\n\n\n

And in the\ncase of Santander it really worked exactly as it should: Relatively attractive\ninterest rate income in Latin America has been partly compensated by constant\ncurrency losses over the years. As predicted by IRP and PPP, it has been a\nclosed-circuit transaction from an economic point of view\u2026 but unfortunately\nnot from an accounting point of view.<\/p>\n\n\n\n

According to the above explained idea of OCI, in its financial reporting the high interest rates have flown into the Santander profit & loss statement but the currency losses only show up in OCI. Looking at the numbers since 2012 (information on the years before is a bit blurred, that\u2019s why it is left out here), we can see that Santander constantly built up negative exchange rate positions in OCI which cumulatively amounted to 21.7 bn Euros at the end of 2018 (adjusted for the net Argentine Peso balance which has been transferred to other reserves according to IAS 29 [hyper-inflationary economies] in 2018). This accumulated amount compares to a current market cap of Santander of roughly 71 bn Euros \u2013 quite a big portion that got lost during the last seven years due to currency effects, and all this without touching the profit & loss statement at all.<\/p>\n\n\n\n

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We can see\nin the graph that in the recent past the only year that did not contribute to\nthis negative balance was 2014 which is due to the strong GBP and USD\nappreciation against the Euro in this year. And we can also see that the\ncurrency effects made up a big part of total comprehensive income in at least\nfour of the seven years under analysis (here measured as percent of profit\nbefore tax).<\/p>\n\n\n\n

Two aspects\nabout this phenomenon are worth shedding some more light on:<\/p>\n\n\n\n