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Banco Santander, S.A. 20-F 2006 Documents found in this filing:
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 20-F
Commission file number 1-14554 BANCO SANTANDER-CHILE (d/b/a Banco Santander Santiago and Santander Santiago) (Exact name of Registrant as specified in its charter) SANTANDER-CHILE BANK (d/b/a Santander Santiago Bank and Santander Santiago) (Translation of Registrant’s name into English) Chile (Jurisdiction of incorporation or organization) Bandera 140 Santiago, Chile Telephone: 011-562 320-2000 (Address of Principal Executive Offices) Securities registered or to be registered pursuant to Section 12(b) of the Act:
Securities
registered or to be registered pursuant to Section 12(g) of the Act: Securities
for which there is a reporting obligation pursuant to Section 15(d)
of the Act: Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.
Note - Checking the box above will not relieve any registrant required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 from their obligations under those Sections. Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark which financial statement item the registrant has elected to follow.
If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
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We have made statements in this Annual Report on Form 20-F that constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements appear throughout this annual report and include statements regarding our intent, belief or current expectations regarding:
The sections of this Annual Report which contain forward-looking statements include, without limitation, “Item 3: Key Information—Risk Factors,” “Item 4: Information on the Company—Strategy,” “Item 5: Operating and Financial Review and Prospects—,”“Item 8: Financial Information—Legal Proceedings,” and “Item 11: Quantitative and Qualitative Disclosures About Market Risk—.” Our forward-looking statements also may be identified by words such as “believes,” “expects,” “anticipates,” “projects,” “intends,” “should,” “could,” “may,” “seeks,” “aim,” “combined,” “estimates,” “probability,” “risk,” “VaR,” “target,” “goal,” “objective,” “future” or similar expressions. You should understand that the following important factors, in addition to those discussed elsewhere in this annual report and in the documents which are incorporated by reference, could affect our future results and could cause those results or other outcomes to differ materially from those expressed in our forward-looking statements:
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You should not place undue reliance on such statements, which speak only as of the date that they were made. Our independent public auditors have neither examined nor compiled the forward-looking statements and, accordingly, do not provide any assurance with respect to such statements. The forward-looking statements contained in this document speak only as of the date of this Annual Report, and we do not undertake to update any forward-looking statement to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. 6 CERTAIN TERMS AND CONVENTIONS As used in this Annual Report, “Santander-Chile”, “the Bank”, “we,” “our” and “us” mean Banco Santander-Chile and its consolidated subsidiaries, the bank resulting from the merger of Santiago and Old Santander-Chile. When we refer to “Santiago” in this Annual Report, we refer to Banco Santiago and its consolidated subsidiaries prior to its merger with Old Santander-Chile. When we refer to “Old Santander-Chile” in this Annual Report, we refer to the former Banco Santander-Chile and its consolidated subsidiaries, which ceased to exist upon its merger into Santiago, effected on August 1, 2002. As used in this Annual Report, the term “billion” means one thousand million (1,000,000,000). In this Annual Report, references to “$”, “US$”, “U.S.$”, “U.S. dollars” and “dollars” are to United States dollars, references to “Chilean pesos,” “pesos” or “Ch$” are to Chilean pesos and references to “UF” are to Unidades de Fomento. The UF is an inflation-indexed Chilean monetary unit with a value in Chilean pesos that changes daily to reflect changes in the official Consumer Price Index (“CPI”) of the Instituto Nacional de Estadísticas (the Chilean National Institute of Statistics). See “Item 5: Operating and Financial Review and Prospects” and Note 1(c) to the Audited Consolidated Financial Statements. In this Annual Report, references to the Audit Committee are to the Bank’s Comité de Directores y Auditoría. This committee is the successor of the Directors Committee created under Law 19,705 in 2000 and the Audit Committee created by the Board of Directors of Banco Santiago in 1995. On September 22, 2004, the Superintendency of Banks authorized that the functions of the Audit Committee be performed by the Directors Committee. On October 19, 2004, the Board of Directors of Banco Santander Chile, by resolution No. 357, approved the merger of both committees and the transfer of all functions of both committees to the Comité de Directores y Auditoría, which was created on the same date. In this Annual Report, references to “BIS” are to the Bank for International Settlement, and references to “BIS ratio” are to the capital adequacy ratio as calculated in accordance with the Basel Capital Accord.
7 PRESENTATION OF FINANCIAL INFORMATION Currency and Accounting Principles Santander-Chile is a Chilean bank and maintains its financial books and records in Chilean pesos and prepares its Audited Consolidated Financial Statements in conformity with generally accepted accounting principles in Chile and the rules of the Superintendencia de Bancos e Instituciones Financieras (the Superintendency of Banks and Financial Institutions, which is referred to herein as the “Superintendency of Banks”), which together differ in certain significant respects from generally accepted accounting principles in the United States (“U.S. GAAP”). References to “Chilean GAAP” in this Annual Report are to accounting principles generally accepted in Chile, as supplemented by the applicable rules of the Superintendency of Banks. See Note 27 to the Audited Consolidated Financial Statements of Santander-Chile as of December 31, 2004 and 2005 and for the years ended December 31, 2003, 2004 and 2005 contained elsewhere in this Annual Report (together with the notes thereto, the “Audited Consolidated Financial Statements”) for a description of the principal differences between Chilean GAAP and U.S. GAAP, as they relate to Santander-Chile, and a reconciliation to U.S. GAAP of net income and shareholders’ equity. Pursuant to Chilean GAAP, amounts expressed in the Audited Consolidated Financial Statements and all other amounts included elsewhere throughout this Annual Report for all periods expressed in Chilean pesos are expressed in constant Chilean pesos as of December 31, 2005. See Note 1(c) to the Audited Consolidated Financial Statements. Loans Unless otherwise specified, all references herein (except in the Audited Consolidated Financial Statements) to loans are to loans and financial leases before deduction for loan loss allowance, and, except as otherwise specified, all market share data presented herein are based on information published periodically by the Superintendency of Banks. Non-performing loans include loans for which either principal or interest is overdue, and which do not accrue interest. Restructured loans for which no payments are overdue are not ordinarily classified as non-performing loans. Past due loans include, with respect to any loan, only the portion of principal and interest that is 90 or more days overdue, and do not include the installments of such loan that are not overdue or that are less than 90 days overdue, unless legal proceedings have been commenced for the entire outstanding balance according to the terms of the loan, in which case the entire loan is considered past due within 90 days after initiation of such proceedings. This practice differs from that normally followed in the United States, where the amount classified as past due would include the entire amount of principal and interest on any and all loans which have any portion overdue. See “Item 5D: Asset and Liability Management—Selected Statistical Information—Loan Portfolio—Classification of Loan Portfolio—Classification of Loan Portfolio Based on the Borrower’s Payment Performance.” According to the regulations established by the Superintendency of Banks, Santander-Chile is required to charge off commercial loans no later than 24 months after being classified as past due, if unsecured, and if secured, no later than 36 months after being classified as past due. When an installment of a past due corporate loan (whether secured or unsecured) is charged off, Santander-Chile must charge off all installments which are overdue. However, this does not preclude Santander-Chile from charging off the entire amount of the loan, if it deems such action to be necessary. Once any amount of a loan is charged off, each subsequent installment must be charged off as it becomes overdue. In the case of past due consumer loans, after the first installment becomes three months past due, Santander-Chile must charge off the entire remaining part of the loan. Santander-Chile may charge off any loan (whether corporate or consumer) before the first installment becomes overdue, but only in accordance with special procedures established by the Superintendency of Banks and must charge off an overdue loan (whether corporate or consumer) before that time according to the terms set forth above in certain circumstances. Outstanding loans and the related percentages of Santander-Chile’s loan portfolio made up of corporate and consumer loans in the section entitled “Item 4B: Business Overview” are 8 categorized based on the nature of the borrower. Outstanding loans and related percentages of the loan portfolio of Santander-Chile made up of corporate and consumer loans in the section entitled “Item 5D: Asset and Liability Management—Selected Statistical Information” are categorized in accordance with the reporting requirements of the Superintendency of Banks, which are based on the type and term of loans. Effect of Rounding Certain figures included in this Annual Report and in the Audited Consolidated Financial Statements have been rounded for ease of presentation. Percentage figures included in this Annual Report have not in all cases been calculated on the basis of such rounded figures but on the basis of such amounts prior to rounding. For this reason, certain percentage amounts in this Annual Report may vary from those obtained by performing the same calculations using the figures in the Audited Consolidated Financial Statements. Certain other amounts that appear in this Annual Report may not sum due to rounding. Economic and Market Data In this Annual Report, unless otherwise indicated, all macro-economic data related to the Chilean economy is based on information published by the Banco Central de Chile (the Chilean Central Bank) (the “Central Bank”), and all market share and other data related to the Chilean financial system is based on information published by the Superintendency of Banks and our analysis of such information. Information regarding the consolidated risk index of the Chilean financial system as a whole is not available. Exchange Rates This Annual Report contains translations of certain Chilean peso amounts into U.S. dollars at specified rates solely for the convenience of the reader. These translations should not be construed as representations that the Chilean peso amounts actually represent such U.S. dollar amounts, were converted from U.S. dollars at the rate indicated in preparing the audited consolidated financial statements, could be converted into U.S. dollars at the rate indicated or were converted at all. Unless otherwise indicated, such U.S. dollar amounts, in the case of information concerning Santiago and Old Santander-Chile, have been translated from Chilean pesos based on the observed exchange rate reported by the Central Bank on December 31, 2005, which was Ch$514.21 per US$1.00. The observed exchange rate reported by the Central Bank on December 31, 2005 is based upon the actual exchange rate of December 30, 2005 and is the exchange rate specified by the Superintendency of Banks for use by Chilean banks in the preparation of their financial statements for the periods ended December 31, 2005. The observed exchange rate on March 31, 2006 was Ch$527.70 per US$1.00, reflecting an accumulated depreciation of 2.62% from December 31, 2005. The Federal Reserve Bank of New York does not report a noon buying rate for the Chilean peso. For more information on the observed exchange rate see “Item 3: Exchange Rates.” Merger – Accounting Treatment On August 1, 2002, Old Santander-Chile merged into Santiago. Immediately thereafter, Santiago changed its name to “Banco Santander Chile.” The merger was accounted for under Chilean GAAP in a manner commonly referred to as a “pooling of interests” on a prospective basis from January 1, 2002. Under Chilean GAAP, any financial statements we issue as of or for periods ending August 1, 2002 or thereafter reflect the combined operations of Santiago and Old Santander-Chile from January 1, 2002. Our historical financial statements under Chilean GAAP as of and for periods ended prior to August 1, 2002 have not been and will not be restated to reflect the merger. As such, for Chilean GAAP purposes, our historical financial statements as of and for the years ended December 31, 2001 are those of Santiago which is deemed to be the predecessor entity of Santander-Chile. 9 Under US GAAP, the merger was accounted for as a merger of entities under common control, as Banco Santander Central Hispano S.A (“Banco Santander Central Hispano”) controlled both Santiago and Old Santander-Chile beginning May 3, 1999. US GAAP requires that we record the transaction in a manner similar to a pooling of interests based on the carrying values for Santiago and Old Santander-Chile included in the accounting records of the common parent, Banco Santander Central Hispano. However, to the extent that in connection with the merger Santiago issued Santiago shares or paid cash (in the case of fractional shares) for Old Santander-Chile shares held by parties other than Banco Santander Central Hispano and its affiliates, the transaction has been accounted for using the purchase method based on fair values. As a consequence of the merger, Santiago and Old Santander-Chile were required to restate their US GAAP historical financial statements previously issued for all periods during which common control existed. See “Item 8A: Consolidated Statements and Other Financial Information.” ITEM 2. OFFER STATISTICS AND EXPECTED TIMETABLE Not Applicable. 10 ITEM 3. KEY INFORMATION A. Selected Financial Data The following table presents historical financial information about us as of the dates and for each of the periods indicated. The following table should be read in conjunction with, and is qualified in its entirety by reference to, our Audited Consolidated Financial Statements appearing elsewhere in this Annual Report. Our Audited Consolidated Financial Statements are prepared in accordance with Chilean GAAP, which differs in certain significant respects from U.S. GAAP. Note 27 to our Audited Consolidated Financial Statements provides a description of the material differences between Chilean GAAP and U.S. GAAP and a reconciliation to U.S. GAAP of net income for the years ended December 31, 2003, 2004 and 2005 and shareholders’ equity at December 31, 2004 and 2005. Under Chilean GAAP, the merger between Santiago and Old Santander-Chile was accounted for as a “pooling of interest” on a prospective basis. As such, the historical financial statements for periods prior to the merger were not restated under Chilean GAAP. Under U.S. GAAP, the merger between the two banks, which have been under the common control of Banco Santander Central Hispano since May 3, 1999, is accounted for in a manner similar to a pooling of interest under U.S. GAAP. As a consequence of the merger, we were required to restate our previously issued U.S. GAAP historical financial information to retroactively present the financial results for the merged bank as if Santiago and Old Santander-Chile had been combined throughout the periods during which common control existed. See Note 27(a) to our Audited Consolidated Financial Statements. 11
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13 Note: n/a = not applicable.
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Exchange Rates Chile has two currency markets, the Mercado Cambiario Formal, or the Formal Exchange Market and the Mercado Cambiario Informal, or the Informal Exchange Market. Under Law 18,840, the organic law of the Central Bank, or the Central Bank Act (Ley Orgánica Constitucional del Banco Central de Chile), the Central Bank determines which purchases and sales of foreign currencies must be carried out in the Formal Exchange Market. Pursuant to Central Bank regulations which are currently in effect, all payments, remittances or transfers of foreign exchange abroad which are required to be effected through the Formal Exchange Market may be effected with foreign currency procured outside the Formal Exchange Market. The Formal Exchange Market is comprised of the banks and other entities so authorized by the Central Bank. The conversion from pesos to U.S. dollars of all payments and distributions with respect to the ADSs described in this Annual Report must be transacted at the spot market rate in the Formal Exchange Market. Current regulations require that the Central Bank be informed of certain transactions and that they be effected through the Formal Exchange Market. Purchases and sales of foreign currencies may be legally effected outside the Formal Exchange Market in the Informal Exchange Market. The Informal Exchange Market reflects transactions carried out at informal exchange rates by entities not expressly authorized to operate in the Formal Exchange Market. There are no limits imposed on the extent to which the rate of exchange in the Informal Exchange Market can fluctuate above or below the observed exchange rate. On December 31, 2005, the average exchange rate in the Informal Exchange Market was Ch$512.0 or 0.43% lower than the published observed exchange rate for such date of Ch$514.21 per U.S.$1.00. The following table sets forth the annual low, high, average and period-end observed exchange rate for U.S. dollars for each of the following periods, as reported by the Central Bank. We make no representation that the Chilean peso or the US dollar amounts referred to herein actually represent, could have been or could be converted into US dollars or Chilean pesos, as the case may be, at the rates indicated, at any particular rate or at all. 15
Source: Central Bank.
Dividends Under the current General Banking Law, a Chilean bank may only pay a single dividend per year (i.e., interim dividends are not permitted). Santander-Chile’s annual dividend is proposed by its Board of Directors and is approved by the shareholders at the annual ordinary shareholders’ meeting held the year following that in which the dividend is proposed. For example, the 2005 dividend must be proposed and approved during the first four months of 2006. Following shareholder approval, the proposed dividend is declared and paid. Historically, the dividend for a particular year has been declared and paid no later than one month following the shareholders meeting. Dividends are paid to shareholders of record on the fifth day preceding the date set for payment of the dividend. The applicable record dated for the payment of dividends to holders of ADSs will, to the extent practicable, be the same. Under the general Banking Law, subject to certain exceptions, unless otherwise decided by a two-thirds vote of its issued and subscribed shares, a bank must distribute cash dividends in respect of any fiscal year in an amount equal to at least 30% of its net income for that year. Under the Chilean Companies Law, Chilean companies are generally required to distribute at least 30% of their earnings (calculated in accordance with Chilean GAAP) as dividends, but are permitted to distribute less than 30% of their earnings, and may distribute no dividends at all, in any given year if the holders of at least two-thirds of their outstanding shares of common stock so determine. The balances of our distributable net income are generally retained for use in our business (including for the maintenance of any required legal reserves). Although our Board of Directors currently intends to pay regular annual dividends, the amount of dividend payments will depend upon, among other factors, our then current level of earnings, capital and legal reserve requirements, as well as market conditions, and there can be no assurance as to the amount or timing of future dividends. Dividends payable to holders of ADSs are net of foreign currency conversion expenses of the depositary and will be subject to the Chilean withholding tax currently at the rate of 35% (subject to credits in certain cases as described in “Taxation—Chilean Tax Considerations”). See “Item 10E: Taxation.” Owners of the ADSs will not be charged any dividend remittance fees by the depositary with respect to cash or stock dividends. Under the Foreign Investment Contract (as defined herein), the Depositary, on behalf of ADS holders, is granted access to the Formal Exchange Market to convert cash dividends from Chilean pesos to U.S. dollars and to pay such U.S. dollars to ADS holders outside Chile, net of taxes, and no separate registration by ADS holders is required. In the past, Chilean law required that holders of shares of Chilean companies who were not residents of Chile to register as foreign investors under one of the foreign investment regimes contemplated by Chilean law in order to have dividends, sale proceeds or other amounts with respect to their shares remitted outside Chile through the Formal Exchange Market. On April 19, 2001, the Central Bank deregulated the Exchange Market eliminating the need to obtain approval from the Central Bank in order to remit dividends, but at the same time this eliminated the possibility of accessing the Formal Exchange Market. These changes do not affect the current Foreign Investment Contract, which was signed prior to April 19, 2001, which grants access to the Formal Exchange Market with prior approval of the Central Bank. See “Item 10D: Exchange Controls.” The following table presents dividends paid by us in nominal terms: 16
B. Capitalization and Indebtedness Not applicable C. Reasons for the Offer and Use of Proceeds Not applicable D. Risk Factors You should carefully consider the following risk factors, as well as all the other information presented in this Annual Report before investing in securities issued by us. The risks and uncertainties described below are not the only ones that we face. Additional risks and uncertainties that we do not know about or that we currently think are immaterial may also impair our business operations. Any of the following risks, if they actually occur, could materially and adversely affect our business, results of operations, prospects and financial condition. We are subject to market risks that are presented both in this subsection and in “Item 5: Operating and Financial Review and Prospect.” and “Item 11: Quantitative and Qualitative Disclosures about Market Risk” Risks Associated with Our Business Increased competition and industry consolidation may adversely affect results of our operations. The Chilean market for financial services is highly competitive. We compete with other Chilean private sector domestic and foreign banks, with Banco del Estado, a public-sector bank, with department stores and the larger supermarket chains that make consumer loans and sell other financial products to a large portion of the Chilean population. The lower-middle to middle income segments of the Chilean population and the small and medium-sized corporate segments have become the target markets of several banks, and competition in these segments is likely to increase. As a result, net interest margins in these segments are likely to decline. Although we believe that demand for financial products and services from individuals and for small and medium-sized companies will continue to grow during the remainder of the decade, we cannot assure you that net interest margins will be maintained at their current levels. We also face competition from non-bank and non-finance competitors (principally department stores) with respect to some of our credit products, such as credit cards, consumer loans and insurance brokerage. In addition, we face competition from non-bank finance competitors, such as leasing, factoring and automobile finance companies, with respect to credit products, and from mutual funds, pension funds and insurance companies, with respect to savings products. Currently, banks continue to be the main suppliers of leasing, factoring and mutual funds, and the insurance sales business has seen rapid growth. The increase in competition within the Chilean banking industry in recent years has led to, among other things, consolidation in the industry. For example, in January 2002, Banco de Chile and Banco de A. Edwards, the third and fifth largest banks in Chile respectively, merged to become the largest Chilean bank at that time. We expect the trends of increased competition and consolidation to continue and result in the formation of new large financial groups. Consolidation, which can result in the creation of larger and stronger competitors, may adversely affect our financial condition and results of operations by decreasing the net interest margins we are able to generate. In addition, Law No. 19,769 allows insurance companies to participate and compete with us in the residential mortgage and credit card businesses. 17
Banco Santander Central Hispano controls 84.14% of our outstanding ordinary shares, which gives it the power to elect a majority of our board of directors and to determine the outcome of most matters submitted to a vote of shareholders, including matters that could affect our duration and existence. We currently engage in, and expect from time to time in the future to engage in, financial and commercial transactions with subsidiaries and affiliates of Banco Santander Central Hispano. Among other transactions, we may, from time to time, have credit lines outstanding with Banco Santander Central Hispano and its affiliated financial institutions around the world. As of December 31, 2005, we had no outstanding loan amounts with Santander Central Hispano. In addition, from time to time, in the normal course of business and on prevailing market terms, we enter into certain transactions with Banco Santander Central Hispano and other related parties for the provision of advisory and advertising services and for the rental of real estate. For additional information concerning our transactions with affiliates and other related parties, see Note 15 to our Audited Consolidated Financial Statements. While we believe that such transactions in the past have generally had a beneficial effect on us, no assurances can be given that any such transaction, or combination of transactions, will not have a material adverse effect on us in the future. A substantial number of our customers consists of individuals (approximately 41.5% of the value of the total loan portfolio as of December 31, 2005) and, to a lesser extent, small and medium-sized companies (those with annual sales of less than US$2.3 million) which comprised approximately 14.4% of the value of the total loan portfolio as of December 31, 2005. As part of our business strategy, we seek to increase lending and other services to small companies and individuals. Small companies and individuals are, however, more likely to be adversely affected by downturns in the Chilean economy than large corporations and high-income individuals. Consequently, in the future we may experience higher levels of past due loans, which could result in higher provisions for loan losses. There can be no assurance that the levels of past due loans and subsequent write-offs will not be materially higher in the future. Our results of operations are affected by interest rate volatility. Our results of operations depend to a great extent on our net interest revenue. In 2005, net interest revenue represented 81.3% of our operating revenue. Changes in market interest rates could affect the interest rates earned on our interest-earning assets differently from the interest rates paid on our interest-bearing liabilities leading to a reduction in our net interest revenue. Interest rates are highly sensitive to many factors beyond our control, including the reserve policies of the Central Bank, deregulation of the financial sector in Chile, domestic and international economic and political conditions and other factors. Any volatility in interest rates could adversely affect our business, our future financial performance and the price of our securities. The following table shows the yields on the Chilean government’s 90-day note as reported by the Central Bank of Chile at year-end for the last five years.
Source: Central Bank of Chile The growth of our loan portfolio may expose us to increased loan losses. From December 31, 2000 to December 31, 2005, our aggregate loan portfolio (on an unconsolidated combined basis) grew by 35.2% in nominal terms to Ch$10,139,333 million (US$19,718 million), while our consumer loan portfolio grew by 92.5% in nominal terms to Ch$1,189,842 million (US$2,314 million), excluding lines of credit and calculated in accordance with the loan classification system of the Superintendency of Banks. Because the method of classification of loans used by the Superintendency of Banks for its public information differs in minor respects from that used by us for internal accounting purposes, the foregoing figures may differ from the figures included in our financial statements. The further expansion of our 18 loan portfolio (particularly in the consumer, small and mid-sized companies and real estate segments) can be expected to expose us to a higher level of loan losses and require us to establish higher levels of provisions for loan losses. Our loan portfolio may not continue to grow at the same rate. There can be no assurance that in the future our loan portfolio will continue to grow at the same or similar rates as the historical growth rate previously experienced by Santiago or Old Santander-Chile. Average loan growth has remained significant in the last five years. According to the Superintendency of Banks, from December 31, 2000 to December 31, 2005, the aggregate amount of loans outstanding in the Chilean banking system (on an unconsolidated basis) grew 59.7% in nominal terms to Ch$44,833,507 million (US$87,530 million) as of December 31, 2005. A reversal of the rate of growth of the Chilean economy could adversely affect the rate of growth of our loan portfolio and our risk index and, accordingly, increase our required allowances for loan losses. Santander-Chile, like all large financial institutions, is exposed to many types of operational risks, including the risk of fraud by employees and outsiders, failure to obtain proper internal authorizations, failure to properly document transactions, equipment failures and errors by employees. Although Santander-Chile maintains a system of operational controls, there can be no assurance that operational problems or errors will not occur and that their occurrence will not have a material adverse impact on our business, financial condition and results of operations. Risks Relating to Chile Our growth and profitability depend on the level of economic activity in Chile. A substantial amount of our loans are to borrowers doing business in Chile. Accordingly, the recoverability of these loans in particular, our ability to increase the amount of loans outstanding and our results of operations and financial condition in general, are dependent to a significant extent on the level of economic activity in Chile. Our results of operations and financial condition could be affected by changes in economic or other policies of the Chilean government, which has exercised and continues to exercise a substantial influence over many aspects of the private sector, or other political or economic developments in Chile. The recent positive growth figures of the Chilean economy can be attributed in part to the rising prices of Chile’s main exports, most importantly, copper. The price of copper in 2005 reached record levels, increasing 45.4% in 2005, following a rise of 42.9% in 2004. Exports of cooper totaled US$17.4 billion in 2005 or 44% of total Chilean exports. Other important commodities exported from Chile include paper pulp, fish meal and agricultural products. We cannot assure you that the Chilean economy will continue to grow in the future or that those future developments in or affecting Chile’s exports will not materially and adversely affect our business, financial condition or results of operations.
The prices of securities issued by Chilean companies, including banks, are to varying degrees influenced by economic and market considerations in other countries. We cannot assure you that the Chilean economy will continue to grow in the future or that future developments in or affecting the Chilean economy, including consequences of economic difficulties in other markets, will not materially and adversely affect our business, financial condition or results of operations. Although economic conditions are different in each country, investors’ reactions to developments in one country may affect the securities of issuers in other countries, including Chile. For instance, the devaluation of the Mexican peso in December 1994 set off an economic crisis in Mexico that negatively affected the market value of securities in many countries throughout Latin America. The crisis in the Asian markets, beginning in July 1997, resulted in sharp devaluation of other Asian currencies and negatively affected markets throughout Asia, as well as in many markets in Latin America, including Chile. Similar adverse consequences resulted from the 1998 crisis in Russia and the devaluation of the Brazilian real in 1999. In part due to the Asian and Russian crises, the Chilean stock market declined significantly in 1998 to levels equivalent to 1994. We are directly exposed to risks related to the weakness and volatility of the economic and political situation in Latin America, especially in Argentina and Brazil. If Argentina’s economic environment significantly deteriorates or does not improve, the economy in Chile, as both a neighboring country and a trading partner, could also be affected and could 19 experience slower growth than in recent years. The recent cuts in gas exports from Argentina to Chile could also adversely affect economic growth in Chile. Our business could be affected by an economic downturn in Brazil. This could result in the need for us to increase our loan allowances, thus affecting our financial results, our results of operations and the price of our securities. Diplomatic relations with Bolivia and Peru have worsened. As of December 31, 2005, approximately 1.45% of our loans were held abroad and 0.34% of our loans were comprised of loans to companies in Latin American countries. We cannot assure you that crisis and political uncertainty in other Latin American countries will not have an adverse effect on Chile, the price of our securities or our business. Any future changes in the value of the Chilean peso against the US dollar could affect the dollar value of our securities. The peso has been subject to large devaluations in the past and could be subject to significant fluctuations in the future. Our results of operations may be affected by fluctuations in the exchange rates between the peso and the dollar despite our policy and Chilean regulations relating to the general avoidance of material exchange rate mismatches. In order to avoid material exchange rate mismatches, we enter into forward exchange transactions. As of December 31, 2005, the net position of our foreign currency denominated liabilities and Chilean peso-denominated liabilities that contain repayment terms linked to changes in foreign currency exchange rates exceeded our foreign currency denominated assets and Chilean peso-denominated assets that contain repayment terms linked to changes in foreign currency exchange rates by Ch$6,269 million (US$12.2 million). The following table shows the value of the Chilean peso relative to the US dollar as reported by the Central Bank of Chile at year-end for the lasty five years.
Source: Central Bank of Chile We may decide to change our policy regarding exchange rate mismatches. Regulations that limit such mismatches may also be amended or eliminated. Greater exchange rate mismatches will increase our exposure to the devaluation of the peso, and any such devaluation may impair our capacity to service foreign-currency obligations and may, therefore, materially and adversely affect our financial condition and results of operations. Notwithstanding the existence of general policies and regulations that limit material exchange rate mismatches, the economic policies of the Chilean government and any future fluctuations of the peso against the dollar could affect our financial condition and results of operations. Furthermore, Chilean trading in the shares underlying our ADSs will be conducted in pesos. Cash distributions with respect to our shares of common stock are received in Chilean pesos by the depositary which then will convert such amounts to U.S. dollars at the then-prevailing exchange rate for the purpose of making payment sin respect of our ADSs. If the value of the Chilean peso falls relative to the U.S. dollar, the dollar value of our ADSs and any distributions to be received from the depositary will be reduced. In addition, the depositary will incur customary current conversion costs (to be borne by the holders of our ADSs) in connection with the conversion and subsequent distribution of dividends or other payments. Inflation could adversely affect our financial condition and results of operations. Although Chilean inflation has moderated in recent years, Chile has experienced high levels of inflation in the past. High levels of inflation in Chile could adversely affect the Chilean economy and have an adverse effect on our results of operations and, indirectly, the value of our securities. The following table shows the annual rate of inflation (as measured by changes in the Chilean consumer price index and as reported by the Chilean National Institute of Statistics during the last five years.)
Source: Chilean National Institute of Statistics There can be no assurance that our operating results will not be adversely affected by changing levels of inflation, or that Chilean inflation will not change significantly from the current level. 20 We are subject to regulation by the Superintendency of Banks. In addition, we are subject to regulation by the Central Bank with regard to certain matters, including reserve requirements and interest rates and foreign exchange mismatches and market risks . During the Chilean financial crisis of 1982 and 1983, the Central Bank and the Superintendency of Banks strictly controlled the funding, lending and general business matters of the banking industry in Chile. Pursuant to the Ley General de Bancos, Decreto con Fuerza de Ley No. 3 de 1997, or the General Banking Law, all Chilean banks may, subject to the approval of the Superintendency of Banks, engage in certain businesses other than commercial banking depending on the risk associated with such business and the financial strength of the bank. Such additional businesses include securities brokerage, mutual fund management, securitization, insurance brokerage, leasing, factoring, financial advisory, custody and transportation of securities, loan collection and financial services. The General Banking Law also applies to the Chilean banking system a modified version of the capital adequacy guidelines issued by the Basle Committee on Banking Regulation and Supervisory Practices and limits the discretion of the Superintendency of Banks to deny new banking licenses. There can be no assurance that regulators will not in the future impose more restrictive limitations on the activities of banks, including us, than those currently in effect. Any such change could have a material adverse effect on our financial condition or results of operations. Historically, Chilean banks have not paid interest on amounts deposited in checking accounts. However, effective June 1, 2002, the Central Bank allows banks to pay interest on checking accounts. Currently, there are no applicable restrictions on the interest that may be paid on checking accounts. We have begun to pay interest on some checking accounts under certain conditions. If competition or other factors lead us to pay higher interest rates on checking accounts, to relax the conditions under which we pay interest or to increase the number of checking accounts on which we pay interest, any such change could have a material adverse effect on our financial condition or results of operations. We must maintain higher capital to risk weighted assets than other banks in Chile. The merger of Old Santander-Chile and Santiago required a special regulatory preapproval of the Superintendency of Banks, which was granted on May 16, 2002. The resolution granting this preapproval imposed a mandatory minimum capital to risk-weighted assets ratio of 12% for the merged bank compared to 8% minimum for other banks in Chile. Effective January 1, 2005, the Superintendency of Banks lowered our mandatory effective minimum capital to risk-weighted assets ratio to 11%. Although we have not failed in the past to comply with our capital maintenance obligations, there can be no assurance that we will be able to do so in the future. We prepare our financial statements in accordance with Chilean GAAP, which requires management to make estimates and assumptions with respect to certain matters that are inherently uncertain. The consolidated financial statements include various estimates and assumptions, including but not limited to the adequacy of the allowance for loan losses, estimates of the fair value of certain financial instruments, the selection of useful lives of certain assets and the valuation and recoverability of goodwill and deferred taxes. We evaluate these estimates and judgments on an ongoing basis. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances. Actual results in future periods could differ from those produced by such estimates and assumptions, and if these differences were significant enough, our reported results of operations would be affected materially. Accounting, financial reporting and securities disclosure requirements in Chile differ from those in the United States. Accordingly, the information about us available to you will not be the same as the information available to shareholders of a US financial institution. There are also important differences between Chilean and US accounting and financial reporting standards. As a result, Chilean financial statements and reported earnings generally differ from those reported based on US accounting and reporting standards. As a regulated financial institution, we are required to submit to the Superintendency of Banks unaudited unconsolidated balance sheets and income statements, excluding any note disclosure, prepared in accordance with Chilean GAAP and the rules of the Superintendency of Banks on a monthly basis. Such disclosure differs in a number of significant respects from information generally available in the United States with respect to US financial institutions. The securities laws of Chile, which govern open or publicly listed companies such as us, have as a principal objective promoting disclosure of all material corporate information to the public. Chilean disclosure requirements, however, differ from those in the United States in some important respects. In addition, although Chilean law imposes restrictions on insider trading and price manipulation, applicable Chilean laws are different from those in the United States and in certain respects the Chilean securities markets are not as highly regulated and supervised as the US securities markets. 21
We are a “controlled company” and a “foreign private issuer” within the meaning of the New York Stock Exchange corporate governance standards. Under the New York Stock Exchange rules, a controlled company is exempt from certain New York Stock Exchange corporate governance requirements. In addition, a foreign private issuer may elect to comply with the practice of its home country and not to comply with certain New York Stock Exchange corporate governance requirements, including the requirements that (1) a majority of the board of directors consist of independent directors, (2) a nominating and corporate governance committee be established that is composed entirely of independent directors and has a written charter addressing the committee's purpose and responsibilities, (3) a compensation committee be established that is composed entirely of independent directors and has a written charter addressing the committee's purpose and responsibilities and (4) an annual performance evaluation of the nominating and corporate governance and compensation committees be undertaken. We currently use these exemptions and, following this offering, intend to continue using these exemptions. Accordingly, you will not have the same protections afforded to shareholders of companies that are subject to all New York Stock Exchange corporate governance requirements.
Equity investments in Chile by persons who are not Chilean residents have generally been subject to various exchange control regulations which restrict the repatriation of the investments and earnings therefrom. In April 2001, the Central Bank eliminated the regulations that affected foreign investors except that investors are still required to provide the Central Bank with information related to equity investments and conduct such operations within Chile’s Formal Exchange Market. The ADSs are subject to a contract, dated May 17, 1994, among the depositary, us and the Central Bank that remains in full force and effect. The ADSs continue to be governed by the provisions of such contract subject to the regulations in existence prior to April 2001. The contract grants the depositary and the holders of the ADSs access to the Formal Exchange Market, which permits the depositary to remit dividends it receives from us to the holders of the ADSs. The contract also permits ADS holders to repatriate the proceeds from the sale of shares of our common stock withdrawn from the ADR facility, or that have been received free of payment as a consequence of spin-offs, mergers, capital increases, wind-ups, share dividends or preemptive rights transfers, enabling them to acquire the foreign currency necessary to repatriate earnings from such investments. Pursuant to Chilean law, the contract cannot be amended unilaterally by the Central Bank, and there are judicial precedents (although not binding with respect to future judicial decisions) indicating that contracts of this type may not be abrogated by future legislative changes or resolutions of the Advisory Council of the Central Bank. Holders of shares of our common stock, except for shares of our common stock withdrawn from the ADS facility or received in the manner described above, are not entitled to the benefits of the contract, may not have access to the Formal Exchange Market, and may have restrictions on their ability to repatriate investments in shares of our common stock and earnings therefrom. Holders of ADSs are entitled to receive dividends on the underlying shares to the same extent as the holders of shares. Dividends received by holders of ADSs will be paid net of foreign currency exchange fees and expenses of the depositary and will be subject to Chilean withholding tax, currently imposed at a rate of 35.0% (subject to credits in certain cases). If for any reason, including changes in Chilean law, the depositary were unable to convert Chilean pesos to U.S. dollars, investors would receive dividends and other distributions, if any, in Chilean pesos. We cannot assure you that additional Chilean restrictions applicable to holders of our ADSs, the disposition of the shares underlying them or the repatriation of the proceeds from such disposition or the payment of dividends will not be imposed in the future, nor can we advise you as to the duration or impact of such restrictions if imposed. 22
We are a Chilean corporation. None of our directors are residents of the United States and most of our executive officers reside outside the United States. In addition, a substantial portion of our assets and the assets of our directors and executive officers are located outside the United States. As a result, it may be difficult for ADS holders to effect service of process outside Chile upon us or our directors and executive officers or to bring an action against us or such persons in the United States or Chile to enforce liabilities based on U.S. federal securities laws. It may also be difficult for ADS holders to enforce in the United States or in Chilean courts judgments obtained in United States courts against us or our directors and executive officers based on civil liability provisions of the U.S. federal securities laws. If a U.S. court grants a final judgment in an action based on the civil liability provisions of the federal securities laws of the United States, enforceability of this judgment in Chile will be subject to the obtaining of the relevant "exequator" (i.e., recognition and enforcement of the foreign judgment) according to Chilean civil procedure law currently in force, and consequently, subject to the satisfaction of certain factors. The most important of these factors are the existence of reciprocity, the absence of a conflicting judgment by a Chilean court relating to the same parties and arising from the same facts and circumstances and the Chilean courts’ determination that the U.S. courts had jurisdiction, that process was appropriately served on the defendant and that enforcement would not violate Chilean public policy. Failure to satisfy any of such requirements may result in non-enforcement of your rights. Risks Relating to our ADSs There may be a lack of liquidity and market for our shares and ADSs. The ADSs are listed and traded on the NYSE. The common stock is listed and traded on the Santiago Stock Exchange, the Chile Electronic Stock Exchange and the Valparaiso Stock Exchange, which we refer to collectively as the Chilean Stock Exchanges, although the trading market for the common stock is small by international standards. As of December 31, 2005, we had 188,446,126,794 shares of common stock outstanding. The Chilean securities markets are substantially smaller, less liquid and more volatile than major securities markets in the United States. According to Article 14 of the Ley de Mercado de Valores, Ley No. 18,045, or the Chilean Securities Market Law, the Superintendencia de Valores y Seguros, or the Superintendency of Securities and Insurance, may suspend the offer, quotation or trading of shares of any company listed on one or more Chilean Stock Exchanges for up to 30 days if, in its opinion, such suspension is necessary to protect investors or is justified for reasons of public interest. Such suspension may be extended for up to 120 days. If, at the expiration of the extension, the circumstances giving rise to the original suspension have not changed, the Superintendency of Securities and Insurance will then cancel the relevant listing in the registry of securities. In addition, the Santiago Stock Exchange may inquire as to any movement in the price of any securities in excess of 10 and suspend trading in such securities for a day if it deems necessary. Although the common stock is traded on the Chilean Stock Exchanges, there can be no assurance that a liquid trading market for the common stock will continue. Approximately 15.86% of our outstanding common stock is held by the public (i.e., shareholders other than Banco Santander Central Hispano and its affiliates), including our shares that are represented by ADSs trading on the NYSE. A limited trading market in general and our concentrated ownership in particular may impair the ability of an ADS holder to sell in the Chilean market shares of common stock obtained upon withdrawal of such shares from the ADR facility in the amount and at the price and time such holder desires, and could increase the volatility of the price of the ADSs. You may be unable to exercise preemptive rights. The Ley Sobre Sociedades Anónimas, Ley No. 18,046 and the Reglamento de Sociedades Anónimas, which we refer to collectively as the Chilean Companies Law, and applicable regulations require that whenever we issue new common stock for cash, we grant preemptive rights to all of our shareholders (including holders of ADSs), giving them the right to purchase a sufficient number of shares to maintain their existing ownership percentage. Such an offering would not be possible unless a registration statement under the U.S. Securities Act of 1933, as amended, were effective with respect to such rights and common stock or an exemption from the registration requirements thereunder were available. Since we are not obligated to elect to make a registration statement available with respect to such rights and the common stock, you may not be able to exercise your preemptive rights. If a registration statement is not filed or an applicable exemption is not available, the depositary will sell such holders’ preemptive rights and distribute the proceeds thereof if a premium can be recognized over the cost of any such sale. 23 Our corporate affairs are governed by our estatutos, or bylaws, and the laws of Chile. Under such laws, our shareholders may have fewer or less well-defined rights than they might have as shareholders of a corporation incorporated in a U.S. jurisdiction. For example, under legislation applicable to Chilean banks, our shareholders would not be entitled to appraisal rights in the event of a merger or other business combination undertaken by us.
Under the Chilean Companies Law, if any of the following resolutions is adopted by our shareholders at any extraordinary shareholders meeting, dissenting shareholders have the right to withdraw from Santander-Chile and to require us to repurchase their shares, subject to the fulfillment of certain terms and conditions. A dissenting shareholder is a shareholder who either attends the shareholders meeting and votes against a resolution which results in a withdrawal right or, if absent from the shareholders meeting, a shareholder who notifies the company in writing within 30 days of the shareholders meeting of his opposition to the resolution and that he is exercising his right to withdraw from the company. The resolutions that result in a shareholder’s right to withdraw are the following:
In addition, shareholders of a publicly held corporation such as Santander-Chile, have the right to withdraw if a person acquires 2/3 or more of the outstanding voting stock of the company and does not make a tender offer for the remaining shares within 30 days of that acquisition at a price not lower than the price that would be paid shareholders exercising their rights to withdraw. However, the right of withdrawal described in the previous sentence does not apply in the event the company reduces its capital as a result of not having fully subscribed and paid an increase of capital within the statutory term. ADS holders own a beneficial interest in shares held by the depositary and, accordingly, they are not listed as shareholders on the share registry of Santander-Chile. The depositary will not exercise withdrawal rights on behalf of ADS holders. Accordingly, in order to ensure a valid exercise of withdrawal rights, an ADS holder must cancel his ADSs and become a registered shareholder of the Company no later than the date which is five Chilean business days before the shareholders' meeting at which the vote which would give rise to withdrawal rights is taken, or the applicable record date for withdrawal rights that arise other than as a result of a shareholder vote. Withdrawal rights must then be exercised in the manner prescribed in the notice to shareholders that is required to be sent to shareholders of Chilean public companies advising such holders of their right of withdrawal. If an event occurs that gives rise to withdrawal rights, ADS holders will have a limited time to cancel their ADSs and to become registered shareholders of the Company prior to the record date for the shareholders meeting or other event giving rise to such withdrawal rights. If an ADS holder does not become a registered shareholder of the Company prior to such record date he will not be able to exercise the withdrawal rights available to registered shareholders. 24 ITEM 4. INFORMATION ON THE COMPANY A. History and Development of the Company Overview We were formed on August 1, 2002, by the merger of Santiago and Old Santander-Chile, both of which were subsidiaries of our controlling shareholder, Banco Santander Central Hispano. We are the largest bank in Chile in terms of total assets, total deposits, loans and shareholders’ equity. As of December 31, 2005, we had total assets of Ch$13,096,821 million (US$25,470 million), loans net of allowances outstanding of Ch$9,996,407 million (US$19,440 million), deposits of Ch$8,075,521 million (US$15,705 million) and shareholders’ equity of Ch$1,081,832 million (US$2,104 million). As of December 31, 2005, we employed 7,482 people and had the largest private branch network in Chile with 352 branches. Our headquarters are located in Santiago and we operate in every major region of Chile. We provide a broad range of commercial and retail banking services to our customers, including Chilean peso and foreign currency denominated loans to finance a variety of commercial transactions, trade financing, foreign currency forward contracts, credit lines and a variety of retail banking services, including mortgage financing. We seek to offer our customers a wide range of products while providing high levels of service. In addition to our traditional banking operations, we offer a variety of financial services including financial leasing, financial advisory services, mutual fund management, securities brokerage, insurance brokerage and investment management. The legal predecessor of Santander-Chile was Banco Santiago (Santiago). Santiago was incorporated by public deed dated September 7, 1977 granted at the Notary Office of Alfredo Astaburuaga Gálvez. Santiago received its permission to incorporate and function as a bank by Resolution No. 118 of the Superintendency of Banks on October 27, 1977. The Bank’s bylaws were approved by Resolution No. 103 of the Superintendency of Banks on September 22, 1977. In January 1997, Santiago merged with Banco O’Higgins with Santiago being the surviving entity. In 1999, Santiago became a controlled subsidiary of Banco Santander Central Hispano. As of June 30, 2002, Santiago was the second largest private sector bank in Chile in terms of total assets, deposits, loans and shareholders’ equity. Old Santander-Chile was established as a subsidiary of Banco Santander Central Hispano in 1978. In 1982, Old Santander-Chile acquired a significant portion of the assets and liabilities of Banco Español-Chile, a domestic bank that had become insolvent. In July 1996, Old Santander-Chile was merged into Banco Osorno y la Unión becoming “Banco Santander-Chile”, the third largest private bank in terms of outstanding loans at that date. Our principal executive offices are located at Bandera 140, Santiago, Chile (our telephone number is 011-562-320-2000 and our website is www.santandersantiago.cl). Relationship with Banco Santander Central Hispano We believe that our relationship with our controlling shareholder, Banco Santander Central Hispano, offers us a significant competitive advantage over our peer Chilean banks. Banco Santander Central Hispano is one of the largest financial groups in Latin America, in terms of total assets measured on a region-wide basis. It is the largest financial group in Spain and is a major player elsewhere in Europe, including the United Kingdom through its Abbey subsidiary and Portugal, where it is the third-largest banking group. Through Santander Consumer it also operates a leading consumer finance franchise in Germany, Italy, Spain and nine other European countries. Our relationship with Banco Santander Central Hispano provides us with access to the group’s client base, while its multinational focus allows us to offer international solutions to our clients’ financial needs. We also have the benefit of selectively borrowing from Banco Santander Central Hispano’s product offerings in other countries as well as benefiting from their know-how in systems management. We believe that our relationship with Banco Santander Central Hispano will also enhance our ability to manage credit and market risks by adopting policies and know-how developed by Banco Santander Central Hispano. Our internal auditing function has been strengthened and is more independent from management as a result of the addition of an internal auditing department that concurrently reports directly to our Audit Committee and the 25 Audit committee of Banco Santander Central Hispano. We believe that this structure leads to greater monitoring and control of our exposure to operational risks. Banco Santander Central Hispano’s support includes the assignment of managerial personnel to key supervisory areas of Santander-Chile, like Risks, Auditing, Accounting and Financial Control. Santander-Chile does not pay any management fees to Banco Santander Central Hispano in connection with these support services. B. Organizational Structure Banco Santander Central Hispano controls Santander-Chile through its holdings in Teatinos Siglo XXI and Santander-Chile Holding, which are controlled subsidiaries, and through the indirect ownership of ADSs representing 7.23% of Santander-Chile’s outstanding capital stock. As of December 31, 2005, Banco Santander Central Hispano directly and indirectly owned or controlled 99.0% of Santander-Chile Holding. Banco Santander Central Hispano directly and indirectly owned or controlled 100% of Teatinos Siglo XXI S.A. Banco Santander Central Hispano also owned 7.23% of the Bank through Grupo Empresarial Santander via ADRs. This gives Santander Central Hispano control over 84.14% of the shares of the Bank and actual participation when excluding minority shareholders is 83.94%.
The chart below sets forth the names and areas of responsibility of our senior commercial managers.
26 The chart below sets forth the names and areas of responsibilities of our operating managers. Operating Structure
C. Business Overview We have 352 total branches, 92 of which operated under the Santander Banefe brand name. The remaining 260 branches are operated under the Santander Santiago brand name. We provide a full range of financial services to corporate and individual customers. We divide our clients into the following segments:
27
The table below sets forth our lines of business and certain statistical information relating to each of them for the year ended December 31, 2005. We modified our segmentation model in 2005, and restated our 2004 segment information accordingly. Please see Note 27(y) to our Audited Consolidated Financial Statements.
28 Operations through Subsidiaries The General Banking Law once restricted the ability of banks to provide non-banking financial services. Beginning in 1986, these restrictions were somewhat eased, allowing banks to provide services deemed to be complementary to the commercial banking business, provided that the services are offered through subsidiaries. The new General Banking Law, as amended on November 4, 1997, extended the scope of permissible activities to permit us to provide directly the leasing and financial advisory services we could formerly offer only through our subsidiaries, to offer investment advisory services outside of Chile and to undertake activities we could not formerly offer directly or through subsidiaries, such as factoring, securitization, foreign investment funds, custody and transport of securities and insurance brokerage services. For the year ended December 31, 2005, our subsidiaries collectively accounted for approximately 14.5% of our consolidated net income. The assets and operating income of these subsidiaries as of and for the year ended December 31, 2005 represented 6.5% and 10.4% of our total assets and operating income, respectively.
The Chilean financial services market consists of a variety of largely distinct sectors. The most important sector, commercial banking, includes a number of privately-owned banks and one public sector bank, Banco del Estado (which operates within the same legal and regulatory framework as the private sector banks). The private sector banks include local banks and a number of foreign-owned banks which are operating in Chile. The Chilean banking system is comprised of 25 private sector banks and one public sector bank. Five private sector banks along with the state-owned bank together accounted for 80.7% of all outstanding loans by Chilean financial institutions as of December 31, 2005. The Chilean banking system has experienced increased competition in recent years largely due to consolidation in the industry and new legislation. For example, the merger of Banco de Chile with Banco de A. Edwards, effective January 2, 2002, resulted in the creation at that moment of the largest bank in Chile. As of December 31, 2005 Banco de Chile had a market share in total loans of 18.1% . Shortly after that merger was consummated, Santander Central Hispano announced the merger of the two banks it owned in Chile, Banco Santander-Chile and Banco Santiago, creating the largest bank in Chile. We also face competition from non-bank and non-finance competitors (principally department stores) with respect to some of our credit products, such as credit cards, consumer loans and insurance brokerage. In addition, we face competition from non-bank finance competitors, such as leasing, factoring and automobile finance companies, with respect to credit products, and mutual funds, pension funds and insurance companies, with respect to savings products. Currently, banks continue to be the main suppliers of leasing, factoring and mutual funds, and the insurance sales business has grown rapidly. 29 As shown in the following table, we are the market leader in practically every banking service in Chile:
Source: Superintendency of Banks (1) Excluding special-service payment centers. The following tables set out certain statistics comparing our market position to that of our peer group, defined as the five largest banks in Chile in terms of shareholders’ equity as of December 31, 2005. As of December 31, 2005, our loan portfolio was the largest among Chilean banks. Our loan portfolio on a stand–alone basis represented 22.6% of the market for loans in the Chilean financial system as of such date. The following table sets forth the market shares in terms of loans for us and our peer group as of December 31, 2005:
Source: Superintendency of Banks 30 On a stand alone basis our 21.5% of the market for deposits ranked us in first place among banks in Chile at December 31, 2005. Deposit market share is equal to total time deposits plus average monthly checking and sight accounts, net of clearance. The following table sets forth the market shares in terms of deposits for us and our peer group as of December 31, 2004 and 2005:
With Ch$1,081,832 million (US$2,104 million) in shareholders’ equity, as of December 31, 2005, we were the largest commercial bank in Chile in terms of shareholders’ equity. The following table sets forth the level of shareholders’ equity for us and our peer group as of December 31, 2004 and 2005:
Source: Superintendency of Banks. (1) Percentage of total shareholders’ equity of financial system. 31 As of December 31, 2005, on a stand alone basis we were the second most efficient bank in our peer group. The following table sets forth the efficiency ratio (defined as operating expenses as a percentage of operating revenue which is aggregate of net interest revenue, fees and income from services (net) and other operating income (net)) for us and our peer group as of December 31, 2004 and 2005:
Source: Superintendency of Banks As of December 31, 2005, we were the second most profitable bank in our peer group and the second most capitalized as measured by the BIS ratio as of December 31, 2005. The following table sets forth the average return on equity for the year ended December 31, 2004 and 2005 and BIS ratio for us and our peer group as of December 31, 2004 and 2005:
Source: Superintendency of Banks, except Santander-Chile based on average equity calculated by the Bank (See Item 5 Average Balances). As of December 31, 2005, on a stand alone basis we had the second lowest loan loss allowance to total loans ratio in our peer group. The following table sets forth the ratio of loan loss allowance to total loans ratio as defined by the Superintendency of Banks for us and our peer group as of December 31, 2004 and 2005.
Source: Superintendency of Banks 32 D. Regulation and Supervision General In Chile, only banks may maintain checking accounts for their customers, conduct foreign trade operations, and together with financial companies, accept time deposits. The principal authorities that regulate financial institutions in Chile are the Superintendency of Banks and the Central Bank. Chilean banks are primarily subject to the General Banking Law and secondarily, to the extent not inconsistent with this statute, the provisions of the Chilean Companies Law governing public corporations, except for certain provisions which are expressly excluded. The modern Chilean banking system dates from 1925 and has been characterized by periods of substantial regulation and state intervention, as well as periods of deregulation. The most recent period of deregulation commenced in 1975 and culminated in adoption of a series of amendments to General Banking Law. That law, amended most recently in 2001, granted additional powers to banks, including general underwriting powers for new issues of certain debt and equity securities and the power to create subsidiaries to engage in activities related to banking, such as brokerage, investment advisory, mutual fund services, administration of investment funds, factoring, securitization products and financial leasing services. The Central Bank The Central Bank is an autonomous legal entity created by the Chilean Constitution. It is subject to the Chilean Constitution and its own ley orgánica constitucional, or organic constitutional law. To the extent not inconsistent with the Chilean Constitution or the Central Bank’s organic constitutional law, the Central Bank is also subject to private sector laws (but in no event is it subject to the laws applicable to the public sector). It is directed and administered by a board of directors composed of five members designated by the President of Chile, subject to the approval of the Senate. The legal purpose of the Central Bank is to maintain the stability of the Chilean peso and the orderly functioning of Chile’s internal and external payment system. The Central Bank’s powers include setting reserve requirements, regulating the amount of money and credit in circulation, establishing regulations and guidelines regarding finance companies, foreign exchange (including the Formal Exchange Market) and banks’ deposit-taking activities. The Superintendency of Banks Banks are supervised and controlled by the Superintendency of Banks, an independent Chilean governmental agency. The Superintendency of Banks authorizes the creation of new banks and has broad powers to interpret and enforce legal and regulatory requirements applicable to banks and financial companies. Furthermore, in case of noncompliance with such legal and regulatory requirements, the Superintendency of Banks has the ability to impose sanctions. In extreme cases, it can appoint, with the prior approval of the board of directors of the Central Bank, a provisional administrator to manage a bank. It must also approve any amendment to a bank’s bylaws or any increase in its capital. The Superintendency of Banks examines all banks from time to time, generally at least once a year. Banks are also required to submit their financial statements monthly to the Superintendency of Banks, and a bank’s financial statements are published at least four times a year in a newspaper with countrywide coverage. In addition, banks are required to provide extensive information regarding their operations at various periodic intervals to the Superintendency of Banks. A bank’s annual financial statements and the opinion of its independent auditors must also be submitted to the Superintendency of Banks. Any person wishing to acquire, directly or indirectly, 10.0% or more of the share capital of a bank must obtain the prior approval of the Superintendency of Banks. Absent such approval, the acquiror of shares so acquired will not have the right to vote them. The Superintendency of Banks may only refuse to grant its approval, based on specific grounds set forth in the General Banking Law. According to Article 35 bis of the General Banking Law, the prior authorization of the Superintendency of Banks is required for:
33 Such prior authorization is required solely when the acquiring bank or the resulting group of banks would own a significant market share in loans, defined by the Superintendency of Banks to be more than 15.0% of all loans in the Chilean banking system. The intended purchase may be denied by the Superintendency of Banks; alternatively, the purchase may be conditioned on one or more of the following:
Pursuant to the regulations of the Superintendency of Banks, the following ownership disclosures are required:
Limitations on Types of Activities Chilean banks can only conduct those activities allowed by the General Banking Law: making loans, accepting deposits and, subject to limitations, making investments and performing financial services. Investments are restricted to real estate for the bank’s own use, gold, foreign exchange and debt securities. Through subsidiaries, banks may also engage in other specific financial service activities such as securities brokerage services, equity investments, securities, mutual fund management, investment fund management, financial advisory and leasing activities. Subject to specific limitations and the prior approval of the Superintendency of Banks and the Central Bank, Chilean banks may own majority or minority interests in foreign banks. On March 2, 2002, the Central Bank of Chile authorized banks to pay interest on checking accounts. On March 20, 2002, the Superintendency of Banks published guidelines establishing that beginning on June 1, 2002, banks could offer a new checking account product that pays interest. The Superintendency of Banks also stated that these accounts may be subject to minimum balance limits and different interest rates depending on average balances held in the account and that banks may also charge fees for the use of this new product. For banks with a solvency score of less than A (See Item 4D: Regulation and Supervision—Management and Capitalization Evaluation) the Central Bank has also imposed additional caps to the interest rate that can be paid. Deposit Insurance In Chile, the State guarantees up to 100% of demand deposits and time deposits with a maturity of 10 days or less. The State also guarantees 90.0% of the principal amount of time deposits and savings accounts held by natural persons with a maximum value of UF108 per person (Ch$1,941,280 or U.S.$3,775 as of December 31, 2005) per calendar year in the entire financial system. Reserve Requirements Deposits are subject to a reserve requirement of 9.0% for peso and foreign currency denominated demand deposits and 3.6% for UF, peso and foreign currency denominated time deposits (with terms of less than one year). For purposes of calculating the reserve obligation, banks are authorized to deduct daily from their foreign currency denominated liabilities, the balance in foreign currency of certain loans and financial investments held outside of Chile, the most relevant of which include:
The Central Bank has statutory authority to require banks to maintain reserves of up to an average of 40.0% for demand deposits and up to 20.0% for time deposits (irrespective, in each case, of the currency in which they are denominated) to implement monetary policy. In addition, to the extent that the aggregate amount of the following types of liabilities exceeds 2.5 times the amount of a bank’s paid-in capital and reserves, a bank must maintain a 100% “technical reserve” against them: demand deposits, deposits in checking accounts, or obligations payable on sight incurred in the ordinary course of business, other deposits unconditionally payable immediately or within a term of less than 30 days and time deposits payable within 10 days prior to maturity. Minimum Capital Under the General Banking Law, a bank is required to have a minimum of UF800,000 (approximately Ch$14,380 million and US$28 million as of December 31, 2005) of paid-in capital and reserves, an effective equity of at least 8% of its risk weighted assets, net of required allowances, and paid in capital and reserves of at least 3% of its total assets, net of required allowances. However, a bank may begin its operations with 50.0% of such amount, provided that it has a total capital ratio (defined as effective equity as a percentage of risk weighted assets) of not less than 12.0%. Effective equity is defined as the aggregate of:
In 2002, the General Banking Law was modified, allowing banks to begin operations with a minimum capital of UF 400,000 (approximately US$14 million as of December 31, 2005) of paid-in capital and reserves with the obligation to increase it to UF 800,000 (approximately US$28 million as of December 31, 2005) in an undetermined period of time. If a bank maintains a minimum capital of UF 400,000 (approximately US$14 million as of December 31, 2005), it is required to maintain a minimum BIS ratio of 12%. When such a bank’s paid-in capital reaches UF600,000 (approximately Ch$10,785 million and US$21 million as of December 31, 2005), the total capital ratio required is reduced to 10.0% . Capital Adequacy Requirements According to the General Banking Law, each bank should have an effective equity of at least 8.0% of its risk weighted assets, net of required allowances. The calculation of risk weighted assets is based on a five-category risk classification system for bank assets that is based on the Basle Committee recommendations. Banks should also have Capital básico, or Base Net Capital, of at least 3.0% of their total assets, net of allowances. Base Net Capital is defined as a bank’s paid-in capital and reserves and is similar to Tier 1 capital except that it does not include net income for the period. Lending Limits Under the General Banking Law, Chilean banks are subject to certain lending limits, including the following material limits:
34
In addition, the General Banking Law limits the aggregate amount of loans that a bank may grant to its employees to 1.5% of its effective equity, and provides that no individual employee may receive loans in excess of 10.0% of this 1.5% limit. Notwithstanding these limitations, a bank may grant to each of its employees a single residential mortgage loan for personal use once during such employee’s term of employment. Allowance for Loan Losses Chilean banks are required to provide to the Superintendency of Banks detailed information regarding their loan portfolio on a monthly basis. The Superintendency of Banks examines and evaluates each financial institution’s credit management process, including its compliance with the loan classification guidelines. Banks are classified into four categories: 1, 2, 3 and 4. Each bank’s category depends on the models and methods used by the bank to classify its loan portfolio, as determined by the Superintendency of Banks. Category 1 banks are those banks whose methods and models are satisfactory to the Superintendency of Banks. Category 1 banks are entitled to continue using the same methods and models they currently have in place. A bank classified as a category 2 bank will have to maintain the minimum levels of reserves established by the Superintendency of Banks while its board of directors will be made aware of the problems detected by the Superintendency of Banks and required to take steps to correct them. Banks classified as categories 3 and 4 will have to maintain the minimum levels of reserves established by the Superintendency of Banks until they are authorized by the Superintendency of Banks to do otherwise. We are classified in category 1. Under the classifications effective January 1, 2004, loans are divided into: (i) consumer loans (including loans granted to individuals for the purpose of financing the acquisition of consumer goods or payment of services); (ii) residential mortgage loans (including loans granted to individuals for the acquisition, construction or repair of residential real estate, in which the value of the property covers at least 100% of the amount of the loan); and (iii) commercial loans (includes all loans other than consumer loans and residential mortgage loans). In accordance with the regulations, which became effective as of January 1, 2004, the models and methods used to classify our loan portfolio must follow the following guiding principles, which have been established by the Superintendency of Banks. Models based on the individual analysis of borrowers (Commercial loans)
For loans classified as A1, A2, A3 and B, the board of directors of a bank is authorized to determine the levels of required loan loss reserves. We have assigned a 0% reserve requirement for loans classified as A1 and A2, a 0.5% reserve requirement for loans classified as A3 and a 1% reserve requirement for commercial loans classified as B. For loans classified in Categories C1, C2, C3, C4, D1 and D2, the bank must have the following levels of loan loss reserves: 35
Models based on group analysis
Commencing in 2006 the Bank will no longer analyze commercial loans on a group basis. All commercial loans will be rated on an individual basis in an automated system that has been approved by the Superintendency of Banks and our Board of Directors. Models based on the individual analysis of borrowers (Commercial loans) The risk category of these loans is directly related to the amount of days an installment is past due.
Capital Markets Under the General Banking Law, banks in Chile may purchase, sell, place, underwrite and act as paying agents with respect to certain debt securities. Likewise, banks in Chile may place and underwrite certain equity securities. Bank subsidiaries may also engage in debt placement and dealing, equity issuance advice and securities brokerage, as well as in financial leasing, mutual fund and investment fund administration, investment advisory services and merger and acquisition services. These subsidiaries are regulated by the Superintendency of Banks and, in some cases, also by the Superintendency of Securities and Insurance, the regulator of the Chilean securities market, open-stock corporations and insurance companies. Legal Provisions Regarding Banking Institutions with Economic Difficulties The General Banking Law provides that if specified adverse circumstances exist at any bank, its board of directors must correct the situation within 30 days from the date of receipt of the relevant financial statements. If the board of directors is unable to do so, it must call a special shareholders’ meeting to increase the capital of the bank by the amount necessary to return the bank to financial stability. If the shareholders reject the capital increase, or if it is not effected within the term and in the manner agreed to at the meeting, or if the Superintendency of Banks does not approve the board of directors proposal, the bank will be barred from increasing its loan portfolio beyond that stated in the financial statements presented to the board of directors and from making any further investments in any instrument other than in instruments issued by the Central Bank. 36 In such a case, or in the event that a bank is unable to make timely payment in respect of its obligations or if a bank is under provisional administration of the Superintendency of Banks, the General Banking Law provides that the bank may receive a two-year term loan from another bank. The terms and conditions of such a loan must be approved by the directors of both banks, as well as by the Superintendency of Banks, but need not be submitted to the borrowing bank’s shareholders for their approval. In any event, a creditor bank cannot grant interbank loans to an insolvent bank in an amount exceeding 25.0% of the creditor bank’s effective equity. The board of directors of a bank that is unable to make timely payment of its obligations must present a reorganization plan to its creditors in order to capitalize the credits, extend their respective terms, condone debts or take other measures for the payment of the debts. If the board of directors of a bank submits a reorganization plan to its creditors and such arrangement is approved, all subordinated debt issued by the bank, whether or not matured, will be converted by operation of law into common stock in the amount required for the ratio of effective equity to risk-weighted assets not to be lower than 12.0%. If a bank fails to pay an obligation, it must notify the Superintendency of Banks, which shall determine if the bank is solvent. Dissolution and Liquidation of Banks The Superintendency of Banks may establish that a bank should be liquidated for the benefit of its depositors or other creditors when such bank does not have the necessary solvency to continue its operations. In such case, the Superintendency of Banks must revoke a bank’s authorization to exist and order its mandatory liquidation, subject to agreement by the Central Bank. The Superintendency of Banks must also revoke a bank’s authorization if the reorganization plan of such bank has been rejected twice. The resolution by the Superintendency of Banks must state the reason for ordering the liquidation and must name a liquidator, unless the Chilean Superintendent of Banks assumes this responsibility. When a liquidation is declared, all checking accounts, other demand deposits received in the ordinary course of business, other deposits unconditionally payable immediately or that have a maturity of no more than 30 days, and any other deposits and receipts payable within 10 days, are required to be paid by using existing funds of the bank, its deposits with the Central Bank or its investments in instruments that represent its reserves. If these funds are insufficient to pay these obligations, the liquidator may seize the rest of the bank’s assets, as needed. If necessary and in specified circumstances, the Central Bank will lend the bank the funds necessary to pay these obligations. Any such loans are preferential to any claims of other creditors of the liquidated bank. Obligations Denominated in Foreign Currencies Foreign currency denominated obligations of Chilean banks are subject to various limits and obligations. The regulations of the Central Bank do not permit the difference, whether positive or negative, between a bank’s assets and liabilities denominated in any foreign currency (including assets and liabilities denominated in U.S. dollars but payable in pesos, as well as those denominated in pesos and indexed to the U.S. dollar exchange rate) to exceed 20% of the bank’s paid-in capital and reserves; provided that if the balance of such assets exceeds the balance of such liabilities, the difference may exceed 20% of such capital and reserves in an amount not to exceed the bank's allowances and reserves denominated in such foreign currency (excluding profits to be remitted abroad). Santander-Chile must also comply with various regulatory and internal limits regarding exposure to movements in foreign exchange rates (See “Item 11: Quantitative and Qualitative Disclosure about Market Risks”). Investments in Foreign Securities Under current Chilean banking regulations, banks in Chile may grant loans to foreign individuals and entities and invest in certain securities of foreign issuers. Chilean banks may only invest in equity securities of foreign banks and certain other foreign companies which may be affiliates of the bank or which would be complimentary to the bank’s business if such companies were incorporated in Chile. Banks in Chile may also invest in debt securities traded in formal secondary markets. Such debt securities must be (1) securities issued or guaranteed by foreign sovereign states or their central banks or other foreign or international financial entities, and (2) bonds issued by foreign companies. A Bank may invest up to 5% of its effective equity in securities of foreign issuers. Such securities must have a minimum rating as follows: Table 1
37 In the event that the sum of the investments in foreign securities which have a: (i) rating below to the indicated in the Table 1 above, and equal or exceeds the ratings mentioned in the Table 2 below; and (ii) loans granted to other entities resident abroad; exceed 20% (and 30% for banks with a BIS ratio equal or exceeding 10%), of the effective equity of such bank, the excess is subject to a mandatory reserve of 100%. Table 2
In addition, banks may invest in foreign securities for an additional amount equal to a 70% of their effective equities which ratings are equal or exceeds those mentioned in the following Table 3. This limit constitutes an additional margin and it is not subject to the 100% mandatory reserve. Additionally, a Chilean Bank may invest in foreign securities which rating is equal or exceeds those mentioned in the following Table 3 in: (i) term deposits with foreign banks; and (ii) securities issued or guaranteed by sovereign states or their central banks or those securities issued or guaranteed by foreign entities adhered to the Chilean State; such investment will be subject to the limits by issuer up to 30% and 50%, respectively, of the effective equity of the Chilean bank that make the investment. Table 3
Chilean banks may invest in securities without ratings issued or guaranteed by sovereign states or their central banks and structured notes issued by investment banks with a rating equal or above that in the immediately preceding Table 3, which return is linked with a corporate or sovereign note with a rating equal or above that in Table 2. Subject to specific conditions, a bank may grant loans in U.S. dollars to subsidiaries or branches of Chilean companies located abroad, to companies listed on foreign stock exchanges authorized by the Central Bank and, in general, to individuals and entities domiciled abroad, as long as the Central Bank is kept informed of such activities. New Regulations Regarding Market Risk In 2005, the Superintendency of Banks introduced new market risk limits and measures for Chilean banks. On an unconsolidated basis the Banks must separate its balance sheet in two separate categories: trading portfolio (Libro de Negociación) and unconsolidated non-trading, or permanent, portfolio (Libro de Banca). The trading portfolio as defined by the Superintendency of Banks includes all instruments valued at market prices, free of any restrictions for their immediate sale and that are frequently bought and sold by the bank or are maintained with the intention of selling them in the short-term in order to profit from short-term price variations. The non-trading portfolio is defined as all instruments in the balance sheet not considered in the trading portfolio. 38 E. Property, Plants and Equipment We are domiciled in Chile and own our principal executive offices located at Bandera 140, Santiago, Chile. We also own fifteen other buildings in the vicinity of our headquarters and we rent four other buildings. At December 2005, we owned the locations at which 47% of our branches were located. The remaining branches operate at rented locations.
Below is a summary of the main computer hardware and other systems-equipment that we own. We believe that our existing physical facilities are adequate for our needs.
39 The main software systems used by us are:
ITEM 4A. UNRESOLVED STAFF COMMENTS As of the date of the filing of this Annual Report on 20-F we do not have any unresolved comments from the Securities and Exchange Commission staff regarding our periodical reports under the Exchange Act.
40 Item 5. Operating and Financial Review and Prospects A. Critical Accounting Policies We prepare our financial statements in accordance with Chilean GAAP, which requires management to make estimates and assumptions with respect to certain matters that are inherently uncertain. We also reconcile our financial statements to US GAAP (See Note 27 to our Audited Consolidated Financial Statements) and are required to make estimates and assumptions in this reconciliation process. Certain critical accounting policies, in particular those relating to goodwill and intangible assets are only applicable for US GAAP purposes. Our consolidated financial statements include various estimates and assumptions, including but not limited to the adequacy of the allowance for loan losses, estimates of the fair value of certain financial instruments, the selection of useful lives of certain assets and the valuation and recoverability of goodwill and deferred taxes. We evaluate these estimates and assumptions on an ongoing basis. Management bases its estimates and assumptions on historical experience and on various other factors that are believed to be reasonable under the circumstances. Actual results in future periods could differ from those estimates and assumptions, and if these differences were significant enough, our reported results of operations would be affected materially. We believe that the following are the more critical judgment areas or involve a higher degree of complexity in the application of the accounting policies that currently affect our financial condition and results of operations:
The Notes to the Consolidated Financial Statements contain a summary of our significant accounting policies, including a description of the significant differences between these and the accounting principles generally accepted in the United States, additional disclosures required under such rules, a reconciliation between shareholders’ equity and net income to the corresponding amounts that would be reported in accordance with U.S. GAAP and a discussion of recently issued accounting pronouncements. Interest revenue and expense recognition Interest revenue and expense are recognized on an accrual basis using the effective interest method. Loans, investments and liabilities are stated at their cost, adjusted for accrued interest and the indexation adjustment applicable to such balances that are index-linked. The Bank suspends the accrual of interest and principal indexation adjustments on loans beginning on the first day that such loans are overdue. Accrued interest remains on the Bank’s books and is considered a part of the loan balance when determining the allowances for loan losses. Payments received on overdue loans are recognized as income, after reducing the balance of accrued interest, if applicable. Foreign currency and derivative activities The Bank enters into forward foreign exchange contracts and spot exchange contracts for its own account and the accounts of its customers. The Bank’s forward contracts are valued monthly using the observed rates reported by the Central Bank of Chile at the balance sheet date. The initial premium or discount on these contracts, calculated as the difference between the spot rate and the forward rate, is deferred and included in determining net income over the life of the contract. The Bank’s interest rate and cross-currency swap agreements are treated as off-balance-sheet financial instruments and the net interest effect, which corresponds to the difference between interest income and interest expense arising from such agreements, is recorded in net income in the period that such differences originate. In addition, the Bank makes loans and accepts deposits in amounts denominated in foreign currencies, principally the U.S. dollar. Such assets and liabilities are translated at the applicable rate of exchange at the balance sheet date. 41 The amount of net gains and losses on foreign exchange includes the recognition of the effects that variations in the exchange rates have on assets and liabilities denominated in foreign currencies and the gains or losses on foreign exchange spot and forward transactions undertaken by the Bank. Financial investments Financial investments that have a secondary market are carried at market value. The Bank’s financial investments are classified as trading or permanent in accordance with the regulations of the Superintendency of Banks with unrealized gains and losses on trading investments included in Other operating income (expenses), and unrealized gains and losses on permanent investments included in a separate component of Shareholders’ equity. See “Item 4D: Regulation and Supervision — New Regulations Regarding Market Risk”. The Bank enters into security repurchase agreements as a form of borrowing. In this regard, the Bank’s investments that are sold subject to a repurchase obligation and that serve as collateral for the borrowing are reclassified as “investment collateral under agreements to repurchase” and are carried at market value. The liabilities for the repurchase of the investment are classified as “investments under agreements to repurchase” and are carried at cost plus accrued interest. All other financial investments are carried at acquisition cost plus accrued interest and UF indexation adjustments, as applicable. This includes mainly those with maturities of less than one year (22.8% of total financial investments at December 31, 2005) most of which were liquid government securities or deposits in other Chilean banks. See discussion of Financial Investments in Item 5-Sources of Liquidity-Financial Investments. The Bank also enters into resale agreements as a form of investment. Under these agreements the Bank purchases securities, which are included as assets under the caption “investments under agreements to resell”. In accordance with Circular N°3345 issued by the Superintendency of Banks and Financial Institutions, effective January 1, 2006, the accounting criteria for valuing financial instruments acquired for negotiation or investment purposes, derivative instruments, hedges and disposals from the financial assets on the balance sheets, will be amended. The instructions of Circular N°3345 will become effective starting on June 30, 2006, with valuation differences arising from prior years’ investments being adjusted directly against the Bank’s equity. Premises and equipment Premises and equipment are stated at acquisition cost net of accumulated depreciation and have been restated for price-level changes. Depreciation is calculated on a straight-line method over the estimated useful lives of the underlying assets. The costs of maintenance and repairs are charged to expense. The costs of significant refurbishment and improvements are capitalized and are then amortized over the period of the benefit on a straight-line basis. Allowance for loan losses Chilean banks are required to maintain loan loss allowances in amounts determined in accordance with the regulations issued by the Superintendency of Banks. Under these regulations, we must classify our portfolio into various categories of payment capability. The minimum amount of required loan loss allowances is determined based on fixed percentages of estimated loan losses assigned to each category. As of January 1, 2004, the new loan loss allowance regulations set by the Superintendency of Banks came into effect. Loans are divided into: (i) consumer loans (including loans granted to individuals for the purpose of financing the acquisition of consumer goods or payment of services); (ii) residential mortgage loans (including loans granted to individuals for the acquisition, construction or repair of residential real estate, in which the value of the property covers at least 100% of the amount of the loan); and (iii) commercial loans (includes all loans other than consumer loans and residential mortgage loans). Commencing in 2006 the Bank will no longer analyze commercial loans on a group basis. All commercial loans will be rated on an individual basis in an automated system that has been approved by the Superintendency of Banks and our Board of Directors. In the modified system to be gradually adopted throughout 2006 all commercial loans will be assigned a rating on an individual basis utilizing a more automated and sophisticated statistical model. In 2005 we performed back testing of this more advanced system with minimal differences in the calculation of required provisions compared to the actual amount of provisions under the current system, but no assurance can be given as to the difference in provisioning level the two models would have in 2006. 42 A detailed description of this accounting policy is discussed below under “—Selected Statistical Information—Loan loss allowances” and in Note 1 of our Consolidated Financial Statements. For a description of the regulations relating to loan loss allowances to which we were previously subject to and the new regulations, see “Item 4: Information on the Company—Regulation and Supervision—Allowance for Loan Losses.” Goodwill and Intangible Assets with Indefinite Useful Lives Under U.S. GAAP, we have significant intangible assets consisting of goodwill and trademarks with indefinite useful lives. We record all assets and liabilities acquired in purchase acquisitions, including goodwill and other acquired intangibles, at fair value. These include amounts pushed down from Banco Santander Central Hispano. Goodwill and indefinite-lived assets are no longer amortized over their estimated useful lives using straight-line and accelerated methods, and are subject to at least an annual impairment review. The initial goodwill and intangibles recorded and subsequent impairment analysis requires management to make subjective judgments concerning estimates of how the acquired asset will perform in the future using a discounted cash flow analysis. Additionally, estimated cash flows may extend beyond ten years and, by their nature, are difficult to determine. Events and factors that may significantly affect the estimates include, among others, competitive forces, customer behavior and attrition, changes in revenue growth trends, cost structures and technology and changes in interest rates and specific industry or market sector conditions. For a further discussion of accounting practices for goodwill and intangible assets with indefinite useful lives under U.S. GAAP, see Note 27 to our Audited Consolidated Financial Statements. Differences between Chilean and United States Generally Accepted Accounting Principles Accounting principles generally accepted in Chile vary in certain important respects from the accounting principles generally accepted in the United States. Such differences involve certain methods for measuring the amounts shown in the consolidated financial statements, as well as additional disclosures required by accounting principles generally accepted in the United States and the accounting treatment of the merger. Note 27 to the Consolidated Financial Statements presents a description of the significant differences between Chilean GAAP and U.S. GAAP. B. Operating Results Chilean Economy All of our operations and substantially all of our customers are located in Chile. Accordingly, our financial condition and results of operations are substantially dependent upon economic conditions prevailing in Chile. The Chilean economy grew by 6.3% in 2005 following growth of 6.1% in 2004 and 3.7% in 2003. The strength of the emerging Asian economies and the stable economic environment in the rest of the developed world continued to benefit Chile’s economy in 2005 despite the rise in international oil prices. In 2005 the price of Chile’s main export, copper, surged 45.5%, boosting economic growth. Total exports in 2005 increased 23.5% to US$39.5 billion. This positive external scenario also led to strong consumer and investor confidence that in turn resulted in a strong rebound of internal demand (investment plus consumption). With this growth the Chilean economy ended the year with solid economic fundamentals. The fiscal surplus as a percentage of GDP was 4.5%, the current account surplus reached 0.1% of GDP and the average unemployment rate decreased to 8.1% in 2005 compared to 8.8% in 2004. Inflation in 2005 reached 3.7%, the highest level since 1998 mainly driven by rising oil prices and stronger internal demand. As a result of this increase and growth and rising inflation due to the hike in international oil prices, the Central Bank continued to tighten monetary policy. The overnight interbank rate set by the Chilean Central Bank increased 225 basis points in 2005 to 4.5% in December 2005. Long-term rates on the other hand did not rise at the same pace. In the first 9 months of the year strong liquidity in the Chilean financial systems dampened long-term yields. As the economy strengthened and as inflation continued to go up this trend reversed sharply in the last quarter of the year. As of December 31, 2004 the market rate of the 10 year Central Bank bond in real terms reached 3.29% . As of September 30, 2005 the yield on this same instrument reached 2.43% and as of December 31, 2005 the yield on this bond was 3.29%. This rate environment and the growth of exports led to an 8.2% appreciation of the Chilean peso in 2005. Despite these developments at the macroeconomic level, we believe there still is potential for a reduction in economic activity in Chile given the volatility of international markets and the potential for reduction in world economic growth. 43 Impact of Inflation Inflation impacts the Bank’s results of operations. Although Chilean inflation has moderated in recent years, Chile has experienced high levels of inflation in the past. High levels of inflation in Chile could adversely affect the Chilean economy and have an adverse effect on our business, financial condition and results of operations. In 2005, inflation reached 3.7% compared to 2.4% in 2004, mainly as a result of the recovery in internal demand and consumption and the rise in international oil prices. There can be no assurance that Chilean inflation will not change significantly from the current level. Although we currently benefit from moderate levels of inflation in Chile due to the current structure of our assets and liabilities (i.e., a significant portion of our loans are indexed to the inflation rate, but there are no corresponding features in deposit, or other funding sources that would increase the size of our funding base), there can be no assurance that our business, financial condition and result of operations in the future will not be adversely affected by changing levels of inflation. In summary: • UF-denominated Assets and Liabilities. The Bank’s assets and liabilities are denominated in Chilean nominal pesos, “Unidades de Fomento” (UF), which are inflation indexed pesos, and foreign currencies. The “Unidad de Fomento” (UF) is revalued in monthly cycles. On each day in the period beginning the tenth day of the current month through the ninth day of the succeeding month, the nominal peso value of the UF is indexed up (or down in the event of deflation) in order to reflect a proportional amount of the change in the Chilean Consumer Price Index during the prior calendar month. One UF was equal to Ch$16,920.00, Ch$17,317.05 and Ch$17,974.81 at December 31, 2003, 2004 and 2005, respectively. The effect of any changes in the nominal peso value of our UF-denominated assets and liabilities is reflected in our results of operations as an increase (or decrease, in the event of deflation) in interest revenue and expense, respectively. Our net interest revenue will be positively affected by an inflationary environment to the extent that our average UF-denominated assets exceed our average UF-denominated liabilities. Our net interest revenue will be negatively affected by inflation in any period in which our average UF-denominated liabilities exceed our average UF-denominated assets. Our average UF-denominated assets exceeded our average UF-denominated liabilities by Ch$1,219,507 million, Ch$1,258,606 million and Ch$1,416,266 million during the years-ended December 31, 2003, 2004 and 2005, respectively. See “Item 5D: Asset and Liability Management—Selected Statistical Information—Average Balance Sheets and Interest Rate Data.” The Bank generally has more UF-denominated financial assets than UF-denominated financial liabilities. In 2005, the interest gained on interest earning assets denominated in UF increased 17.9%, in part, as a result of the increase in inflation which increased the nominal rate paid on these assets. The same is true of interest paid on interest bearing liabilities denominated in UF. The interest paid on these liabilities increased 19.1%, in part as a result of the rise in inflation in 2005 versus 2004. Changes in balances of assets and liabilities denominated in UFs also affect the level of interest earned and paid over these items.
Interest Rates Interest rates earned and paid on our assets and liabilities reflect, to a certain degree, inflation, expectations regarding inflation, shifts in short-term interest rates set by the Central Bank and movements in long-term real rates. The Central Bank manages short-term interest rates based on its objectives of balancing low inflation and economic growth. Because our 44 liabilities generally reprice faster than our assets, changes in the rate of inflation or short-term rates in the economy are reflected in the rates of interest paid by us on our liabilities before such changes are reflected in the rates of interest earned by us on our assets. Therefore, when short-term interest rates fall, our net interest margin is positively impacted, but when short-term rates increase, our interest margin is negatively affected. At the same time, our net interest margin tends to be adversely affected in the short term by a decrease in inflation since generally our UF-denominated assets exceed our UF-denominated liabilities. See “Item 5B: Operating Results—Impact of Inflation—Peso denominated Assets and Liabilities.” An increase in long-term rates also has a positive effect on our net interest margin, because our interest-earning assets generally have longer tenors than our interest-bearing liabilities. In addition, because our peso-denominated liabilities have relatively short repricing periods, they are generally more responsive to changes in inflation or short-term rates than our UF-denominated liabilities. As a result, during periods when current inflation or expected inflation exceeds the previous month’s inflation, customers often switch funds from UF-denominated deposits to more expensive peso-denominated deposits, thereby adversely affecting our net interest margin. Foreign Exchange Fluctuations The Chilean government’s economic policies and any future changes in the value of the Chilean peso against the U.S. dollar could adversely affect our financial condition and results of operations. The Chilean peso has been subject to significant devaluation in the past, including a decrease of 14.7% in 2001 and 8.6% in 2002, and may be subject to significant fluctuations in the future. In 2004 and 2005 the Chilean peso appreciated 6.6% and 8.1% against the dollar, respectively. See “Item 3A: Selected Financial Data—Exchange Rates.” A significant portion of our assets and liabilities are denominated in foreign currencies, principally the U.S. dollar, and we historically have maintained and may continue to maintain material gaps between the balances of such assets and liabilities. Because such assets and liabilities, as well as interest earned or paid on such assets and liabilities, and gains and losses realized upon the sale of such assets, are translated to Chilean pesos in preparing our financial statements, our reported income is affected by changes in the value of the Chilean peso with respect to foreign currencies (principally the U.S. dollar). The regulations of the Central Bank do not permit the difference, whether positive or negative, between a bank's assets and liabilities denominated in any foreign currency (including assets and liabilities denominated in U.S. dollars but payable in pesos, as well as those denominated in pesos and the variation of the U.S. dollar exchange rate) to exceed 20% of the bank's paid-in capital and reserves. Provided that if the balance of such assets exceeds the balance of such liabilities, the difference may exceed 20% of such capital and reserves in an amount not to exceed the bank's allowances and reserves denominated in such foreign currency (excluding profits to be remitted abroad). In the years ended December 31, 2003, 2004 and 2005, the gap between foreign currency denominated assets and foreign currency denominated liabilities, including forward contracts, was Ch$62,430 million, Ch$(35,767) million and Ch$(6, 269) million, respectively. The Bank also uses a sensitivity analysis to limit the potential loss in fluctuations of US interest rates on interest income and a VaR model to limit foreign currency trading risk ( See “Item 11: Quantitative and Qualitative Disclosure of Market Risk” ). Foreign currency indexed interest earning assets and interest bearing liabilities. The gain or loss in book value of dollar indexed interest earning assets and liabilities is recorded as interest income and expense. Accordingly, an appreciation of the peso may result in a negative nominal or real rate earned or paid over these assets and liabilities. In 2004 and 2005, the appreciation of the peso was lower than the average increase in stated interest rates, resulting in a positive nominal rate in the period. As a result, on December 31, 2005, the average nominal rate earned on dollar assets reached 2.3%, but the average real rate earned was negative 9.2%, reflecting a loss in book value of assets indexed to the US dollar. In 2004 the nominal rate paid earned on dollar assets reached 1.7% and the real rate earned was negative 7.3%. Foreign exchange transactions . The income statement also includes an item called foreign exchange transactions. This includes net gain or loss in the book value of assets and liabilities denominated in foreign currency (and does not include any gain or loss in the book value of assets or liabilities indexed to a foreign currency of which is included in net interest income). This line also includes the financial results of foreign currency forward contracts. Since the foreign currency gap between assets and liabilities denominated in foreign currencies is limited by Central Bank regulation and our internal policies, the results from foreign exchange transactions are mainly the results of our hedging transactions. The net gain from foreign exchange transactions was Ch$2,684 million in 2005, Ch$7,915 million in 2004 and Ch$161,363 million in 2003. Results of Operations for the Years Ended December 31, 2003, 2004 and 2005 The following discussion is based upon and should be read in conjunction with the Audited Consolidated Financial Statements. The Audited Consolidated Financial Statements have been prepared in accordance with Chilean GAAP (including the rules of the Superintendency of Banks relating thereto), which differ in certain significant respects from U.S. GAAP. Note 27 to the Audited Consolidated Financial Statements describes the principal differences between Chilean GAAP and U.S. GAAP and includes a reconciliation to U.S. GAAP of our net income for the years ended December 31, 2003, 2004 and 2005 and of our shareholders’ equity at December 31, 2004 and 2005. The Audited Consolidated Financial Statements 45 have been restated in constant Chilean pesos of December 31, 2005. See Note 1(c) to the Audited Consolidated Financial Statements. Introduction The following table sets forth the principal components of our net income for the years ended December 31, 2003, 2004 and 2005.
2004 and 2005. Net income for the year ended December 31, 2005 increased 16.4% to Ch$239,710 million compared to net income of Ch$205,991 million in 2004. This increase was mainly due to a 12.5% increase in net interest revenue, a 24.1% decline in provisions for loan losses and a 9.8% increase in fee income. Net interest revenue, net of related hedging transactions recorded under “Foreign exchange transactions, net,” increased 11.2% in 2005 compared to 2004. Our net interest margin for 2005, net of such hedging transactions, improved to 4.7% in 2005 compared to 4.5% in 2004. In 2005 the positive economic environment led to higher loan growth and banking activity in general which fueled the increases of Ch$60,590 million in net interest revenue and the Ch$12,353 million in net fee income. At the same time the quality of the Bank's loan portfolio improved leading to a Ch$20,145 million decrease in provision expense mainly due to an improvement in economic conditions. The results were partially offset by the 77.9% decrease in net gains from trading and brokerage activities which mainly reflects variations in the market value of our debt securities portfolios resulting from interest rate movements. In 2004 the Bank benefited from an important decline in long-term rates which was much more subdued in 2005 leading to a Ch$29,539 46 million drop in gains from trading and brokerage activities. Net non-operating losses also increased Ch$17,262 million or 410.4% in 2005 compared to 2004 because results in 2004 included a one-time gain of Ch$22,614 million from the sale of our Santiago Express division to Empresas París. Operating expenses in 2005 increased 0.4% or Ch$1,064 million and the efficiency ratio, operating expenses divided by operating income, improved to 41.5% in 2005 from 44.0% in 2004. 2003 and 2004 . Net income for the year-ended December 31, 2004 decreased 6.3% compared to the same period in 2003. This decrease was principally attributable to the 87.9% decrease in net other operating income, the 16.9% increase in provisions for loan losses and the 12.2% increase in administrative and other expenses in 2004. The increase in the provision for loan losses was mainly due to the reversal of voluntary loan loss reserves in 2003 and a 16.3% increase in charge-offs in 2004 compared to 2003. The rise in charge-offs was mainly due to the growth of the consumer loan portfolio and the implementation at the beginning of this year of a new loan classification system mandated by the Superintendency of Banks. Net income was also adversely affected by an increase in charge-offs of foreclosed property and a rise in provisions for contingencies, both of which ar e recorded under “non-operating income, net.” This was offset by the gain from the sale of our Santiago Express division to Empresas París. Net income was also positively affected by an increase in the net gains from trading and investment activities, which reflected increases in the market value of our debt securities portfolios resulting from the continuing decline in interest rates. Net income in the 2004 period also benefited from an increase in recoveries of loans previously written off, which was mainly due to an increased stock of written-off loans and improved economic conditions in Chile. Net interest revenue, net of related hedging transactions recorded under “Foreign Exchange transactions, net,” increased 2.2% in 2004 compared to 2003. Our net interest margin for 2004, net of such hedging transactions, remained flat at 4.5% in 2004 compared to the 2003 period. Fee income increased 6.1% in the same period. Net interest revenue
2004 and 2005. Net interest revenue for the year-ended December 31, 2005 increased 12.5% in 2005 mainly as a result of the 6.1% increase in average interest-earning assets and an increase in our net interest margin from 4.4% in 2004 to 4.7% in 2005. Adjusted net interest margin including results of forward contracts reached 4.7% in 2005 compared to 4.5% in 2004. Pursuant to Chilean GAAP, Santander-Chile must include as net interest income the gain or loss in book value of dollar-indexed interest-earning assets and liabilities. Therefore, an appreciation of the peso, as occurred in 2003, 2004 and 2005 affects net interest revenue and net interest margins. In the year-ended December 31, 2005, the average nominal rate earned on dollar assets was 2.3% and the average real rate was negative 9.2%, reflecting the loss in book value of assets indexed to the US dollar. Pursuant to Chilean GAAP, the Bank must report the results of forward contracts that hedge foreign currencies as foreign currency transactions in the income statement. Because the foreign currency gap is limited by Central Bank regulation and our internal policies, the results from foreign exchange transactions are mainly the results of our hedging transactions. The accounting asymmetry produced by incorporating the changes in book value of dollar-indexed assets and liabilities as net interest revenue and the financial results of forward contracts as financial exchange transactions results in a presentation that is not reflective of our underlying business, especially during periods when the exchange rate is highly volatile and, therefore, for analysis purposes only, we add foreign exchange transactions to net interest revenue. The principal factors positively affecting our net interest margin were the change in asset mix and the higher inflation rate. Total average loans in 2005 increased 23.6% compared to a 6.1% increase in interest-earning assets. Average loans in 2005 represented 64.4% of interest-earning assets compared to 55.3% in 2004. The average nominal rate paid on loans was 10.4% compared to 8.5% for average interest earning assets as a whole. 47 Period end loans increased 13.6% in 2005 compared to 2004, led by a 24.4% increase in consumer loans, an 11.9% increase in general commercial loans, mainly reflecting an increase in lending to small and mid-sized companies, and a 23.3% increase in residential mortgage loans. The amount of mortgage loans appearing on our balance sheet, which only includes commercial and residential mortgage loans funded with mortgage bonds, decreased 33.5% . Residential and commercial mortgage lending funded through general borrowings are classified as “other loans”. The following table shows the breakdown of residential mortgage loans into those funded with mortgage bonds and those funded through general funding, and the total growth of this loan product, which was a key area of growth in 2005. This also reflects a change in funding strategy in 2005 away from mortgage bonds in order to increase the spread of mortgage lending.
At the same time the higher inflation rate in 2005 compared to 2004 also helped to boost the net interest margin. In 2005 inflation reached 3.7% compared to 2.4% in 2004. Our average UF-denominated assets exceeded our average UF-denominated liabilities by Ch$1,416,266 million in 2005, compared to Ch$1,258,606 million in 2004. This 12.5% rise in the average UF gap combined with a higher inflation had a positive effect on the net interest margin. See “Item 5B: Operating Results Impact of Inflation”. The principal factors negatively affecting the net interest margin were the rise in short-term interest rates and the lower ratio of non-interest-bearing demand deposits and shareholders’ equity to interest-earning assets. As interest-bearing liabilities generally have shorter terms than interest-earning assets, a rise in short-term rates has a negative effect on the Bank’s net interest margin. The average nominal rate paid on interest-bearing liabilities increased from 4.3% in 2004 to 5.2% in 2005. In 2005 the overnight reference rate set by the Chilean Central Bank increased 225 basis points to 4.50% in December 2005. The average 90-day Central Bank rate, a benchmark rate for deposits, increased in nominal terms from 1.75% in 2004 to 3.29% in 2005. As of December 31, 2005, the amount of our interest bearing liabilities with a maturity of 90 days or less was greater than our interest earning assets with the same maturity by Ch$491,182 million. The main reason for this gap is that interest-bearing liabilities are mainly comprised of time deposits and short-term repurchase agreements. Average time deposits and repurchase agreements represented 66.4% of interest bearing liabilities in 2005, and 51.5% of total time deposits had a maturity of 90 days or less as of December 31, 2005. The rise in short-term interest rate also negatively affected the funding mix. Average time deposits increased 22.0% in 2005 compared to a 4.8% increase in non-interest bearing demand deposits. Average time deposits represented 37.7% of average liabilities in 2005 compared to 33.4% in 2004. As short-term interest rates increased, so did the attractiveness of time deposits. In order to reduce the impact on margins of rising rates, the Bank increased the maturity of deposits. In 2005 16.5% of time deposits had a maturity greater than 12 months compared to 8.8% in 2004. The ratio of average free funds (non-interest bearing liabilities and shareholders’ equity) as a percentage of interest bearing liabilities also decreased as a result of this rise in short-term rates from 26.0% in 2004 to 25.0% in 2005. This was partially offset by the rise in spread earned over free funds as a result of the higher inflation rates in the per iods being compared. 2003 and 2004. Our net interest revenue for the year ended December 31, 2004 increased 51.0% from the same period in 2003, mainly reflecting an increase in our net interest margin from 3.0% to 4.4%, which was principally due to an increase in the yield of dollar-denominated and dollar-indexed interest-earning assets. In the year-ended December 31, 2004, the nominal rate earned on dollar assets reached 1.7%, compared to negative 4.1% in the same period of 2003. In 2004, the exchange rate appreciated 6.6% compared to 15.9% in 2003. The gain or loss in book value of dollar-indexed interest-earning assets is recorded as interest income, and an appreciation of the peso may therefore result in a negative nominal or real rate earned over these assets. In 2003, the aforementioned negative nominal rate resulted from appreciation of the peso in that period at a rate that exceeded the average nominal interest rate on dollar-denominated or indexed interest-earning assets. In 2004, the rate of appreciation of the peso was lower than the average nominal rate resulting in a positive nominal rate and higher yield earned on dollar denominated and dollar indexed interest-earning assets. The gain or loss in book value of such assets due to exchange rate movements is recorded as interest income. The effects of foreign exchange movements are largely eliminated if the results of our foreign exchange hedging transactions are considered. These transactions are entered into to hedge foreign currency exposure arising from our dollar-denominated or dollar-indexed assets and liabilities, but the results of these hedging operations are included in foreign exchange transactions. After hedging transactions, our adjusted net interest margin was essentially flat in the 2003 and 2004 period at 4.5% . The principal factor negatively affecting our net interest margin was the lower interest rate environment, which, together with continued competition in the lending markets, put pressure on spreads. The average 90-day Central Bank rate, a benchmark rate for deposits and loans expressed in nominal terms, decreased from 2.77% in 2003 to 1.75% in 2004. As a result the nominal rate earned on the Bank’s interest earning assets nominally denominated in Chilean pesos declined from 12.6% in 2003 to 11.2% in 2004. The most significant factor positively affecting net interest margin in 2004 was the higher inflation rate in 2004 compared to 2003. Inflation as measured by the Chilean Consumer Price Iindex in 2004 reached 2.4% from 1.1% in 2003. This rise in inflation has a positive impact on net interest margins as the Bank has more inflation-indexed assets than liabilities and, therefore, a rise in the rate of inflation has a positive impact on the net interest margin. In 2004 the nominal rate earned over inflation adjusted assets increased to 7.8% from 6.9% in 2003. 48 The lower interest rate environment also lowered funding costs of interest bearing deposits denominated in nominal Chilean pesos in 2004. The nominal rate paid on nominally (non-indexed) peso-denominated interest-bearing time deposits decreased 90 basis points to 2.7% in 2004 compared to 2003. The majority of these time deposits have a maturity of 90 days or less, and the cost of these funds therefore varies directly corresponding to short-term interest rates. As a result, in 2004 the real rate paid on nominally peso-denominated time deposits fell 240 basis points to 0.2% and the real rate paid on inflation-indexed time deposits fell 80 basis points to 1.8%. Time deposits continue to be the main source of funding. Time deposits represented 33.4% of total average liabilities in 2004 compared to 34.2% in 2003, reflecting the higher growth of cheaper non-interest bearing liabilities to fund asset expansion. Our margins also benefited from an improvement of our funding mix in 2004 as a result of an increase in our non-interest-bearing liabilities. At December 31, 2004, our ratio of average non-interest-bearing demand deposits and equity to average interest-earning assets reached 26.0%, compared to 25.7% in the same period of 2003. We believe that the increase was due in part to increased use of cash management services by our corporate clients, which resulted in growth in non-interest-bearing demand deposits. In addition, the current low interest rate environment led retail customers to prefer readily-available funds deposited in checking accounts rather than low-yielding time deposits. The improvement of our asset mix, through an increased percentage of loans, also helped to minimize the negative impacts on our net interest margin of increased competition and lower rates. Average interest-earning assets in 2004 increased 1.4% compared to 2003. Meanwhile, the average balance of loans increased 3.8% in the same period. The average balance of loans to total interest-earning assets increased from 54.0% in 2003 to 55.3% in 2004. The balance of total loans in 2004 increased 10.4%, with higher yielding consumer loans, excluding lines of credit, increasing 13.3% in the same period. Demand for consumer financing loans increased as a result of prevailing lower interest rates and lower unemployment. Total commercial loans, excluding lines of credit, increased 16.8%, led by a 22.4% increase in loans to higher yielding small and mid-sized companies. As of January 1, 2004, the new loan loss allowance regulations set by the Superintendency of Banks came into effect. For purposes of these new classifications, loans are divided into: (i) consumer loans (including loans granted to individuals for the purpose of financing the acquisition of consumer goods or payment of services); (ii) residential mortgage loans (including loans granted to individuals for the acquisition, construction or repair of residential real estate, in which the value of the property covers at least 100% of the amount of the loan); and (iii) commercial loans (includes all loans other than consumer loans and residential mortgage loans). See “Item 5D: Asset and Liability Management—Loan Portfolio—Classification of Loan Portfolio” and “Item 5D: Asset and Liability Management—Loan Loss Allowances.” In accordance with these regulations, the models and methods used to classify our loan portfolio must follow the guiding principles established by the Superintendency of Banks and the Bank. For statistical information with respect to our substandard loans and reserves for probable loan losses, see “Item 5D: Asset and Liability Management—Loan Loss Provisions—Analysis of Substandard Loans and Amounts Past Due” and “Item 5D: Asset and Liability Management—Loan Loss Provisions—Analysis of Loan Loss Provisions”, as well as Note 7 to the Audited Consolidated Financial Statements. The amount of provision charged to income in any period consists of net provisions established for possible loan losses, net provisions made with respect to real estate acquired upon foreclosure and charge-offs against income (equal to the portion of loans charged off that is not allocated to a required reserve at the time of charge off). 2004 and 2005. Provisions for loan losses totaled Ch$63,532 million in the year ended December 31, 2005, a decrease of 24.1% compared to 2004. The growth of the Chilean economy has led to an improvement in asset quality indicators which in turn resulted in a lower provision expense in the year. Past due loans as of year-end 2005 decreased 21.6% from year-end 2004. Past due loans as a percentage of total loans decreased from 1.52% as of year-end 2004 to 1.05% as of year-end 2005. Substandard loans as of year-end 2005 decreased by 19.9% to Ch$265,902 million. The coverage ratio (loan loss allowance as a percentage of past due loans) improved to 138.8% at year-end 2005 from 132.2% as of year-end 2004. Charge-offs in 2005 totaled Ch$136,773 million, increasing 10.5% in the twelve month period ended December 31, 2005 compared to the same period of 2004, mainly as a result of an increase in charge-off of commercial loans that had been previously restructured and that bear no interest See Item5D: Asset and Liability Management – Analysis of Loan Loss Allowances and Item5: Classification of Loan Portfolio Based on the Borrower’s Payment Performance). These loans were already classified as D2 and were 90% 49 provisioned for. Therefore, this increase in charge-offs was offset by the subsequent release of provisions previously set aside for these loans. We expect provisions for loan losses to increase in future periods in line with overall growth of our loan portfolio and our increased lending to small companies and individuals. See “Risk Factors—Risks Associated with our Business—Our exposure to individuals and small businesses could lead to higher levels of past due loans and subsequent write-offs” and “Risk Factors—Risks Associated with our Business— The growth of our loan portfolio may expose us to increased loan losses.” 2003 and 2004. In the year-ended December 31, 2004, provisions for loan losses increased 16.9% and charge-offs in the period grew 16.3% from 2003. This rise in charge-offs was mainly due to the increase in loans, especially consumer lending which involves a higher risk and according to the guidelines of the Superintendency of Banks must be completely charged-off after 180 days past due. The rise in charge-offs was also due in part to the implementation at the beginning of the year of a new loan classification system mandated by the Superintendency of Banks, which among other things, required banks to reclassify overdraft lines of credit for individuals from Other loans to Consumer loans, thus placing these loans under the charge-off policy established for consumer lending. Past due loans as of year-end 2004 decreased 24.8% from year-end 2003, principally due to improved economic conditions in Chile and high levels of charge-offs resulting from the reclassification of lines of credit. As a result of this decrease in past due loans, the coverage ratio (loan loss allowance as a percentage of past due loans) improved to 132.2% at year-end 2004 from 98.9% as of year-end 2003. Past due loans as a percentage of total loans decreased from 2.23% as of year-end 2003 to 1.52% as of year-end 2004. Substandard loans as of year-end 2004 increased by 14.5%, principally due to application of the new Superintendency of Banks classification system, which classifies as “substandard” loans with required allowance levels that would not have resulted in a substandard classification under the old system. Loan loss allowance as a percentage of substandard loans declined from 61.7% as of year-end 2003 to 54.2% as of year-end 2004. The following table sets forth certain components of our income from services (net of fees paid to third parties directly connected to providing those services, principally fees relating to credit card processing and ATM network administration) in the years ended December 31, 2003, 2004 and 2005.
50 2004 and 2005 In 2005 total fee income increased 9.8% to Ch$138,366 million. The positive economic environment led to a rise in the usage and penetration of bank products in 2005. Fees from checking accounts and lines of credit increased 19.8% mainly a result of a rise in the fee charged for lines of credit and greater usage and opening of lines of credits on behalf of checking account holders. These products are sold together and, therefore, are being analyzed as a single product (See Item 5G. Reconciliation of Non-GAAP Measures). Insurance brokerage fees went up 23.8% mainly as a result of an industry wide expansion of insurance brokerage as banks have successfully introduced simple and low cost insurance products to the market. The 6.4% rise in ATM fees was mainly driven by the rise of ATMs installed by the Bank that increased 19.5% in 2005 to 1,422 tellers. This was offset in part by the US$2 million one-time fee earned in 2004 as a result of the strategic alliance signed between the Bank and Empresas París in December 2004. Excluding this item, ATM fees increased 17.1% in line with the increase of ATMs in the period. Other fees increased by 4,008% mainly due to a Ch$2,102 million in fees paid to the Bank in connection with financial advisory services provided to a companies. Fees from our mutual fund asset management subsidiary increased 1.0% . Total assets under management increased 4.7% in 2005 compared to 2004 to Ch$1,507,312 million (US$2,931 million). In 2005 the Bank launched 12 new funds. The inflow to these new funds offset a reduction in amount managed in fixed income funds as money flowed away from these funds toward bank deposits. The growth in fees was offset by a 41.7% decrease in fees from letters of credit, guarantees, pledges and other contingent operations in line with the decline in low yielding contingent loans. Underwriting fees decreased 62.3% mainly due to lower corporate bond issuances in 2005 compared to 2004. Payment agency service fees declined 31.2% in 2005 compared to 2004. These charges are mainly related to collection services the Bank performs on behalf of corporate customers. These services are increasingly being performed through our internet banking services. Fees charged for Office Banking, which is internet banking service for companies, totaled Ch$1,351 million in 2005 compared to no significant income in previous years. 2003 and 2004. Fee income for the year ended December 31, 2004 increased 6.1% from the same period in 2003. The overall rise in fee income was due to an increase in fees from various business lines. Fees from underwriting increased 62.8% in 2004 compared to 2003 as a result of growth of non-lending activities in wholesale banking and the strength of our corporate finance division. The low interest rate environment and the recovery of the economy also led to a greater demand on behalf of corporate clients for issuing bonds in the market. Fees for insurance brokerage and mutual fund services sold by our subsidiaries were substantially higher in 2004 period compared to 2003. The 38.6% rise in mutual fund fees is directly related to a 30.8% increase in assets under management as of December 31, 2004. We believe that the increase in mutual fund fees was primarily attributable to the low interest rate environment in Chile in 2004, which made the rate of return on our mutual funds more attractive for our clients than deposit accounts. We believe that we could experience a decrease in mutual fund fees if interest rates were to increase in the future. Fees from insurance brokerage increased 29.7% in the year-ended December 31, 2004 compared to the same period of 2003, reflecting our introduction of new products and marketing campaigns. The rise in fee income from these products was offset in part by decreases in fee income from checking accounts and lines of credit and from credit card and payment agency services. The 10.4% decrease in fee income from checking accounts and lines of credit and from credit cards was mainly due to a decrease in the average number of accounts resulting from customer service challenges. These challenges arose in connection with integration of the operations of Old Santander-Chile and Santiago and from our current promotional policy, which was adopted in 2004, of waiving certain checking account fees as an incentive to increase the client base and promote increased product usage. As a result of this promotional policy, our customer base has begun to rebound. The total number of checking accounts in retail banking has risen 13.4% between year-end 2003 and year-end 2004. The decrease in fees from payment agency services mainly reflects the sale of our subsidiary Cobranzas y Recaudaciones Limitada (C y R) in October 2003. Fee income in 2004 also included a US$2 million fee paid by Empresas París to the Bank in connection with the strategic alliance signed by these two companies which included both the sale of the Santiago Express Division to Empresas París and the payment of a fee for access on behalf of future Banco París card holders to the Bank’s ATM network. Excluding this fee, fees from ATMs increased 0.6% in 2004 compared to 2003. 51 Other operating income (expenses), net The following table sets forth information regarding our Other operating income (expenses), net in the years ended December 31, 2003, 2004 and 2005.
2004 and 2005. Other operating income, net totaled a loss of Ch$12,514 million in 2005 compared to a gain of Ch$20,556 million in 2004. This was mainly due to the 77.9% decline in net gains from trading and mark-to-market. These lower gains reflect the movement of long-term local interest rates in 2005 compared to 2004. In the first 9 months of the year strong liquidity in the Chilean financial systems dampened long-term yields, resulting in important mark-to-market gains. As the economy strengthened and as inflation continued to rise, this trend reversed sharply in the last quarter of the year, reversing a substantial portion of the gains recorded to that point in the year. As of December 31, 2004 the market rate of the 10 year Central Bank bond in real terms was 3.29%. As of September 30, 2005 the yield on this same instrument had declined to 2.43%, but by December 31, 2005 it recovered to 3.29%. In 2004, the 10-year Chilean Central Bank bond was yielding 3.23%, down 104 basis points from year-end 2003. Foreign exchange transactions, net in 2005 decreased 66.1% from 2004, to Ch$2,684 million. This line item includes the net gain or loss in book value of assets and liabilities denominated in foreign currency, excluding the gain or loss in book value of assets or liabilities indexed to a foreign currency that is included as net interest income. This line also includes the financial results of foreign currency trading and foreign currency forward contracts. The Bank usually enters forward exchange transactions in order to avoid material exchange rate mismatches. Since the foreign currency gap is limited by Central Bank regulation and our internal policies (See Item 11: Quantitative and Qualitative Disclosures about Market Risk), the results from foreign exchange transactions are mainly the results of our hedging transactions. The accounting asymmetry produced by incorporating the changes in book value of dollar indexed assets and liabilities as net interest revenue and the financial results of forward contracts as financial exchange transactions results in a presentation that is not reflective of our underlying business and therefore, for analysis purposes only, we add foreign exchange transactions to net interest revenue. Other operating losses, net decreased 6.7% in 2005 compared to 2004, totaling a loss of Ch$23,602 million. This decrease was mainly due to the 20.9% decrease in commissions paid to our external sales force which totaled Ch$16,869 million in 2005. This decrease was mainly due to the fact that in 2004 sales force expenses included the recognition of Ch$4,087 million in one-time sales force expenses as a result of the sale of the Santiago Express Division to Empresas París. Expenses on assets received in lieu of payment also decreased 84.4% in 2005 compared to 2004. This was offset by a 16.6% decline in income from the sale of repossessed assets and a rise in other expenses related to our credit card business. 2003 and 2004. Other operating income, net for the year-ended December 31, 2004 decreased 87.9% compared to the year-ended December 31, 2003, principally reflecting a 95.1% decrease in the gain from foreign exchange transactions in 2004 compared to 2003. The lower gain from foreign exchange transactions was offset in part by a 30.2% increase in unrealized gains on financial investments and realized gains from trading. These gains reflected the increase in the value of our investment securities portfolios resulting from declining interest rates. At December 31, 2004 the 10-year Chilean Central Bank bond was yielding 3.23% in real terms compared to 4.27% as of December 31, 2003. Net gain from trading and mark-to-market of securities in the year-ended December 31, 2004 also included a one-time gain of Ch$10,602 million arising from the sale of a single, large substandard loan and a one-time pre-tax loss of Ch$6,537 million arising from the pre-payment of US$170 million in various senior bonds, which were issued at higher rates of interest than those currently prevailing in the market. These bonds were replaced with lower cost funding which compensates for this one-time loss. The 19.7% increase in the loss in other categories of other operating income, net in 2004 compared to 2003 was primarily the result of the recognition of Ch$4,087 million in sales force expenses in connection with the sale of the Santiago Express Division to Empresas París. The expenses were incurred in relation to fees earned by the sales force on sales of bank products, which are generally recognized on an accrual basis over the life of the product as other operating expenses. 52 Other income and expenses, net The following table sets forth information regarding our operating expenses in the years ended December 31, 2003, 2004 and 2005.
2004 and 2005. The net loss recorded in Other income and expenses, net increased 410.4% in 2005 compared to 2004. In 2004 the Bank recognized a one-time gain of Ch$22,614 million from the sale of our former Santiago Express Division to Empresas París. Excluding the sale, the net loss recorded in Other income and expenses, net decreased 20.0% in 2005 compared to 2004 mainly as a result of the 141.1% increase in income from the sale of repossessed assets previously charged off. This was partially offset by the 67.1% increase in provisions for other contingencies. These contingencies are mainly related to non-credit risks, including non-specific contingencies, tax contingencies and other non-credit contingencies or impairments. See Note 17 to our Consolidated Financial Statements. 2003 and 2004. Other income and expenses, net for the year-ended December 31, 2004 totaled a loss of Ch$4,206 million compared to a gain of Ch$2,132 million in this item in 2003. This reflects an increase in charge-off of assets acquired upon foreclosure. The increase in charge-offs of assets acquired upon foreclosure mainly reflects a change in Superintendency of Bank guidelines in the last quarter of 2004 regarding the charge-off of repossessed assets. Repossessed assets must be charged off if not sold twelve months after they have been repossessed. This limit can be extended by eighteen months in some cases. In 2000 the Superintendency of Bank temporarily extended this 18 month period to all assets repossessed between 1999 and 2002. In 2003 this extension period was reduced to 12 additional months for all assets repossessed in 2003. In the last quarter of 2004 the extension period was reduced to six months for assets repossessed in 2004. We expect that in 2005 the Superintendency of Banks will eliminate this extension period and the repossessed assets will have to be charged off after 12 months. Non-operating losses, net in 2004 included an increase in provisions for contingencies which mainly reflect a billing dispute with a vendor and a probable loss due to fraud by a vendor. These losses were offset by one-time gain obtained from the sale of the Santiago Express Division to Empresas París. See Note 17 to our Consolidated Financial Statements. The following table sets forth information regarding our operating expenses in the years ended December 31, 2003, 2004 and 2005.
2004 and 2005. Operating expenses in 2005 increased 0.4% compared to 2004. The 1.0% rise in personnel expenses reflects an increase in variable compensation paid to commercial teams for reaching commercial targets. This was partially offset by the 1.7% decrease in average headcount in 2005 compared to 2004 as a result of the sale of Santiago Express. The 0.6% increase in administrative expenses reflects an increase in spending in branches and ATMs, which was partially offset by savings produced by the outsourcing of certain back office functions, such as systems management and mortgage processing, which we believe has improved productivity. We expect personnel and administrative expenses to grow at a higher pace in future periods as a result of our strategy to expand our retail banking business. This trend was already observable in the second half of 2005. 53 Depreciation and amortization expenses decreased 2.2% in 2005 compared to 2004. Depreciation and amortization expenses were positively affected by the completion of the depreciation schedule of our core systems. Going forward we expect depreciation expenses to rise as the Bank continues to invest in branches and other fixed assets. 2003 and 2004. Operating expenses for the year-ended December 31, 2004 increased 4.6% over 2003, and the efficiency ratio reached 44.0% in 2004 compared to 43.6% in 2003. The increase in operating expenses was mainly due to efforts to expand our retail banking business. The increase in administrative expenses in 2004 was due in part to the outsourcing of certain systems management functions to Altec, a wholly-owned subsidiary of Banco Santander Central Hispano, in order to save costs and improve the management of systems. As a result, certain fixed personnel costs were eliminated and new variable costs associated with the Altec contract and recognized in administrative expenses were being incurred. Loss from price level restatement 2004 and 2005. Losses from price level restatement totaled Ch$18,140 and increased 46.1% compared to 2004. The higher loss from price level restatement reflected the higher inflation rate used for calculating price level restatement in the periods being analyzed (3.62% in 2005 compared to 2.35% in 2004). The Bank must adjust its capital, fixed assets and other assets for the variations in price levels. Because our capital is larger than the sum of our fixed and other assets, price level restatement usually results in a loss and fluctuates with the inflation rate. 2003 and 2004. Loss from price level restatement for the year-ended December 31, 2004 increased 51.8% compared to the same period of 2003. The higher loss from price level restatement reflected the higher inflation rate used for calculating price level restatement in the periods being analyzed (2.35% compared to 1.05%) . Income tax 2004 and 2005. Our income tax expense increased 4.7% to Ch$49,828 million for the year-ended December 31, 2005 compared to the same period in 2004. This rise was mainly due to a net charge to deferred taxes of Ch$4,756 million compared to a net benefit of Ch$12,715 million in 2004. This was partially offset by a 23.7% reduction in income tax provisions in 2005 compared to 2004. (See Note 20 of our Consolidated Financial Statements). As a result the total income tax expenses in 2005 increased at a lower rate than the growth of pre-tax income leading to a lower effective tax rate. The Bank’s effective tax rate was 17.2% in the year-ended December 31, 2005, compared to 18.8% in 2004. The statutory corporate tax rate is 17%. 2003 and 2004. Our income tax expense increased 2.6% in 2004 compared to 2003. The Bank’s effective tax rate reached 18.8% in the year-ended December 31, 2004, compared to 17.4% in 2003. This increase was mainly due to the rise in provisions for contingencies described above under “Other income and expenses, net,” which are not deductible from income in calculating tax, and to the increase in the statutory corporate tax rate from 16.5% in 2003 to 17% in 2004. 54 C. Liquidity and Capital Resources Santander-Chile’s liquidity depends upon its (i) capital, (ii) reserves and (iii) financial investments, including investments in government securities. To cover any liquidity shortfalls and to augment its liquidity position, Santander-Chile has established lines of credit with foreign and domestic banks and also has access to Central Bank borrowings. The following table sets forth our contractual obligations and commercial commitments by time remaining to maturity. As of December 31, 2005, the scheduled maturities of our contractual obligations and of other commercial commitments, including accrued interest were as follows:
Operational leases Certain bank premises and equipment are leased under various operating leases. Future minimum rental commitments as of December 31, 2005 under non-cancelable leases are as follows:
55 As of December 31, 2005, the scheduled maturities of other commercial commitments, including accrued interest, were as follows:
(i) Capital and Reserves Santander-Chile currently has shareholders' equity in excess of that required by all current Chilean regulatory requirements. According to the General Banking Law, a bank should have an effective equity of at least 8% of its risk-weighted assets, net of required allowances, and paid-in capital and reserves (“basic capital”) of at least 3% of its total assets, net of required allowances. For these purposes, the effective equity of a bank is the sum of (a) the bank's basic capital and (b) subordinated bonds issued by the bank valued at their placement price up to 50% of its basic capital; provided that the value of the bonds shall decrease 20% for each year that elapses during the period commencing six years prior to their maturity. The calculation of the effective equity does not include the capital contributions made to subsidiaries of the bank nor its foreign branches. The merger of Old Santander - Chile an d Santiago required a special regulatory preapproval of the Superintendency of Banks, which was granted on May 16, 2002. The resolution granting this preapproval imposed a mandatory minimum capital to risk-weighted assets ratio of 12% for the merged bank. This indicator was reduced to 11% by the Superindentency of Banks effective January 1, 2005. For purposes of weighing the risk of a bank's assets, the General Banking Law considers five different categories of assets, based on the nature of the issuer, the availability of funds, the nature of the assets and the existence of collateral securing such assets.ers five different categories of assets, based on the nature of the issuer, the availability of funds, the nature of the assets and the existence of collateral securing such assets. The following table sets forth our minimum capital requirements set by the Superintendency of Banks as of the dates indicated. See Note 13 to our financial statements for a description of the minimum capital requirements.
56 The following table sets forth our investment in Chilean government and corporate securities and certain other financial investments as of December 31, 2003, 2004 and 2005. Financial investments that have a secondary market are carried at market value. All other financial investments are carried at acquisition cost, plus accrued interest and indexation readjustments, as applicable.
57 The following table sets forth an analysis of our investments as of December 31, 2005, by time remaining to maturity and the weighted average nominal rates of such investments:
Unused sources of liquidity The Bank also has credit ratings from three international agencies. Our ratings are equivalent to the Chilean sovereign ratings, but our bond ratings from Moody’s Investor Services pierce the sovereign ceiling. We believe our credit ratings are a positive factor when obtaining financing. In 2005, Fitch rating also improved the Bank’s credit ratings from A- to A following a similar change for the Republic of Chile. Moody’s in 2005 improved the outlook for the Bank’s long-term deposit rating from Stable to Positive.
58
As a bank, we satisfy our working capital needs through general funding, the majority of which derives from deposits and other borrowings from the public. See “Item 5C: Liquidity and Capital Resources Deposits and other Borrowings.” In our opinion, our working capital is sufficient for our present needs. Liquidity management seeks to ensure that, even under adverse conditions, we have access to the funds necessary to cover client needs, maturing liabilities and capital requirements. Liquidity risk arises in the general funding for our financing, trading and investment activities. It includes the risk of unexpected increases in the cost of funding the portfolio of assets at appropriate maturities and rates, the risk of being unable to liquidate a position in a timely manner at a reasonable price and the risk that we will be required to repay liabilities earlier than anticipated. Our general policy is to maintain liquidity adequate to ensure our ability to honor withdrawals of deposits, make repayments of other liabilities at maturity, extend loans and meet our own working capital needs. Our minimum amount of liquidity is determined by the reserve requirements of the Central Bank. Deposits are subject to a reserve requirement of 9% for demand deposits and 3.6% for peso and UF-denominated time deposits. See “Item 4D: Business Overview–Regulation and Supervision.” The Central Bank has statutory authority to increase these percentages to up to 40% for demand deposits and up to 20% for time deposits. In addition, a 100% special reserve (reserva técnica) applies to demand deposits, deposits in checking accounts, other demand deposits received or obligations payable on sight and incurred in the ordinary course of business, other than deposits unconditionally payable immediately or within a term of less than 30 days and other time deposits payable within 10 days. This special reserve requirement applies to the amount by which the total of such deposits exceeds 2.5 times the amount of a bank's paid-in capital and reserves. Interbank loans are deemed to have a maturity of more than 30 days, even if payable within the following 10 days. The Central Bank also requires us to comply with the following liquidity limits:
We have set other liquidity limits and ratios that minimize liquidity risk. See “Item 11: Quantitative and Qualitative Disclosure About Market Risk.” Cash FlowThe tables below set forth our main sources of cash. The subsidiaries are not an important source of cash flow for us and therefore have no impact on our ability to meet our cash obligations. No legal or economic restrictions exist on the ability of subsidiaries to transfer funds to us in the form of loans or cash dividends as long as these subsidiaries abide by the regulations in the Ley de Sociedad Anónimas regarding loans to related parties and minimum dividend payments.
The Ch$85,291 million reduction in cash provided by operating activities in 2005 compared to 2004 was mainly due to a Ch$82,679 million decrease in the net change in interest accruals in the same period. Cash provided by operating activities 59 increased Ch$103,074 million in 2004 compared to 2003, reflecting a higher level of operating activity in 2004 than in 2003 and the net change in interest accruals in 2004 compared to 2003.
Net cash used in investing activities in 2005 totaled Ch$668,349 million mainly as a result of the growth of the Bank’s loan book. Compared to 2004 net cashed used decreased 36.6% as the growth of loans in 2005 was partially offset by the sale of financial investments. Cash provided by investing activities decreased Ch$1,533,541 million in 2004 compared to 2003 primarily as a result of loan growth in 2004 compared to 2003.
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