Vincent Papa, director of financial reporting at the CFA Institute, argues that investors should not underestimate the importance of comprehensive income when assessing bank performance and risk levels.
With banks’ earnings season in full swing and the looming threat of rising interest rates, a pertinent question remains: How effectively are investors monitoring the performance and risk profile of banks?
At the same time, a source of continued debate among financial reporting stakeholders and accounting standard setters is the relevance of information reported through the “other comprehensive income” (OCI) statement. During valuation, most investors typically monitor and are familiar with income statement line items (e.g., net interest income, fee income, loan impairments for the bank business model). In contrast, the OCI statement — where valuation changes of interest rate risk-sensitive debt instruments are reported — is not monitored as closely by investors.
CFA Institute recently released a report to help inform the debate. Analyzing Bank Performance: Role of Comprehensive Income, an extension of our earlier studies on bank performance reporting during the financial crisis, is based on analysis of bank data from 44 banks (US, EU, and Canada) over an eight-year period (2006 to 2013), including many systemically important financial institutions. Drawing on the bank data, we make the case for drawing increased investor attention towards key business activities that are reported through the OCI statement. The relevance of OCI information for valuation purposes is also evident in current academic literature, including a 2011 Columbia University working paper on valuation of US insurance companies. The relevance has also been highlighted in a previous blog post, as well as in media coverage. Two articles by Bloomberg writer Matt Levine lucidly outline the need to vigilantly monitor what is reported through OCI:
- Banks Prefer Losses They Don’t Have to Talk About
- Bank Of America Lost $5.7 Billion Gambling With Your Deposits (illustrates how banks taking bets on interest rate movements through their asset portfolio selection can result in losses that are not reflected on the traditional “bottom line” or net income)
What Is Comprehensive Income?
There are two portions to the comprehensive income statement, namely the income statement and OCI statement. Taken together, these two statements reflect the wealth created during a reporting period including: the value added from operating and investing activities as well as gains or losses from re-measurements of assets and liabilities. The OCI statement is comprised of the following line items:
- Debt and equity securities re-measurements
- Derivatives used to hedge anticipated transactions (capital acquisition commitments, future interest rate payment/receipt fluctuations)
- Pension obligation re-measurements
- Foreign currency translation gains or losses
As shown here, net OCI during any reporting period has an impact on the change in and aggregate book value of equity reflected on the balance sheet: Net OCI + (Net Income – Dividends) + Net Capital Contribution = Change in Book Value of EquityMonitoring the dynamics of the balance sheet is a vital part of comprehending the performance and risk profile of reporting entities — which is especially true for financial institutions.
Why Comprehensive Income Reporting Is Important for Banks
A focus on OCI reporting for banks is appropriate because these institutions have large categories of assets and liabilities whose gains or losses are recorded in OCI. For example, “available for sale” securities (AFS) are part of the liquidity buffers used to structurally hedge fixed-rate liabilities. These securities are held by most banks, and a recent academic study showed that AFS assets are, on average, 11% of total assets. In addition, banks often use derivatives designated as cash-flow hedges for the purposes of hedging variable interest rate and foreign currency anticipated transactions. As seen in the table below, AFS re-measurements can be material. For example, in 2008 Belgian bank Dexia’s book value of equity was decimated in large part due to the significant AFS unrealized losses (11.1 billion euros) that occurred that year. Even so, despite massive losses and the need for a state bailout in 2008, Dexia’s regulatory capital (which filters out AFS unrealized gains or losses) actually portrayed the picture of a healthy bank from 2007 to 2010. This underscores why investors should not ignore the unrealized losses that are reported in the OCI statement, but not through net income, when assessing bank solvency and risk.
Another important analytical consideration is how the likely reversal of low interest rates will affect the profitability and net asset values of banks. As noted, valuation changes of interest rate risk-sensitive financial instruments (e.g., debt instruments) are reported through the OCI statement, and monitoring these valuation changes can help investors anticipate how bank net asset value and price-to-book ratios are vulnerable to interest rate changes. As illustrated through the sensitivity analysis from Barclays’ 2014 annual report, the OCI statement may reveal a more significant impact of interest rate changes than on the net interest income reported on income statement. If there is a 100 basis points (1%) increase in interest rates, AFS and cash flow hedge reserve would contribute a 5.7% reduction in equity while net interest income would increase equity by only 0.2%. Tellingly, as illustrated in a recent blog post on unwinding low interest rates, many reporting banks’ interest sensitivity analysis only focus on net interest income effects of rate changes; it omits the often more significant OCI effects, potentially leaving readers of financial statements blindsided by the overall balance sheet effects of interest rate changes.
Basel III: Regulatory Effects on Capital Adequacy
One other reason investors should pay greater attention to debt and equity securities classified as AFS is because they could impact the regulatory capital of banks to a greater extent than in the past. Prudential regulators, under Basel II, allowed banks to strip out AFS re-measurements when determining regulatory capital. However, Basel III eliminates the prudential filter and therefore AFS re-measurements will influence regulatory capital in certain countries (e.g., UK, Greece) where Basel III is fully adopted without opt-outs. The newly issued International Financial Report Standards (IFRS) financial instruments accounting requirements (IFRS 9) will no longer classify securities as AFS, but this is unlikely to neuter the impact of securities valuation changes on regulatory capital. Under IFRS 9, equity and debt securities re-measurements will likely be classified as fair value through OCI and still have an impact on regulatory capital for banks in countries that strictly follow Basel III requirements. This article provides further analysis and bank-specific examples of regulatory capital sensitivity due to potential interest rate changes.
In conclusion, it is worth emphasizing that while the worst economic ravages from the global financial crisis — including increased credit risk and the resulting erosion in asset quality — may be in the past, there remains the need for a sustained focus by preparers, regulators, and standard setters on enhancing the transparency of banks. Assessing the full comprehensive income reporting (i.e., both income and OCI statements) is a necessary component of understanding bank performance. Along similar lines, we will discuss the relevance of OCI information for insurance companies and nonfinancial institutions in future blog coverage. Stay tuned.