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[March 07, 2014]
S Y BANCORP INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations
(Edgar Glimpses Via Acquire Media NewsEdge) Financial Section Roadmap The financial section of this Form 10-K includes management's discussion and analysis, consolidated financial statements, and the notes to those financial statements. Bancorp has prepared the following summary, or "roadmap," to assist in your review of the financial section. It is designed to give you an overview of S.Y. Bancorp, Inc. and summarize some of the more important activities and events that occurred during 2013.
The financial section includes the following: Management's discussion and analysis, or MD&A (pages 13 through 44) - provides information as to the analysis of the consolidated financial condition and results of operations of Bancorp. It contains management's view about industry trends, risks, uncertainties, accounting policies that Bancorp views as critical in light of its business, results of operations including discussion of the key performance drivers, financial position, cash flows, commitments and contingencies, important events, transactions that have occurred over the last three years, and forward-looking information, as appropriate.
Financial statements (pages 45 through 49) - include Consolidated Balance Sheets as of the end of the last two years, and Consolidated Statements of Income, Comprehensive Income, Cash Flows, and Changes in Stockholders' Equity, for each of the last three years. Bancorp's financial statements are prepared in accordance with US GAAP.
Notes to the financial statements (pages 50 through 92) - provide insight into, and are an integral part of, the financial statements. The notes contain explanations of significant accounting policies, details about certain captions on the financial statements, information about significant events or transactions that have occurred, discussions about legal proceedings, commitments and contingencies, and selected financial information relating to business segments. The notes to the financial statements also are prepared in accordance with US GAAP.
Reports related to the financial statements and internal control over financial reporting (pages 93 through 97) - include the following: † A report from KPMG LLP, an independent registered public accounting firm, which includes their opinion on the presentation of Bancorp's consolidated financial statements based on their audits; † A report from management indicating Bancorp's responsibility for financial reporting and the financial statements; † A report from management indicating Bancorp's responsibility for the system of internal control over financial reporting, including an assessment of the effectiveness of those controls; and † A report from KPMG LLP, which includes their opinion on the effectiveness of Bancorp's internal control over financial reporting.
Our Business S.Y. Bancorp, Inc. ("Bancorp"), incorporated in 1988, and its business is substantially the same as that of its wholly owned subsidiary, Stock Yards Bank & Trust Company ("the Bank"). The Bank has operated continuously since it opened in 1904. The Bank conducted business at one location for 85 years and began branching in 1989. At December 31, 2013, the Bank had 28 full service banking locations in the Louisville MSA, three full service banking locations in the Indianapolis MSA, and three full service banking locations in the Cincinnati MSA. Bancorp's focus on flexible, attentive customer service has been key to its growth and profitability. The wide range of services added by investment management and trust, securities brokerage, and mortgage origination helps support the corporate philosophy of capitalizing on full service customer relationships.
13 -------------------------------------------------------------------------------- Table of Contents On April 30, 2013, Bancorp completed the acquisition of 100% of the outstanding shares of THE BANCorp, Inc. ("Oldham"), parent company of THE BANK - Oldham County, Inc. As a result of the transaction, THE BANK - Oldham County merged into Stock Yards Bank & Trust Company. Since the acquisition date, results of operations acquired in the Oldham transaction have been included in Bancorp's financial results.
Forward-Looking Statements This report contains forward-looking statements under the Private Securities Litigation Reform Act that involve risks and uncertainties. These forward-looking statements may be identified by the use of words such as "expect", "anticipate", "plan", "foresee", "believe" or other words with similar meaning. Although Bancorp believes the assumptions underlying the forward-looking statements contained herein are reasonable, any of these assumptions could be inaccurate. Factors that could cause actual results to differ from results discussed in forward-looking statements include, but are not limited to: economic conditions both generally and more specifically in the markets in which Bancorp and its subsidiaries operate; competition for Bancorp's customers from other providers of financial services; government legislation and regulation which change from time to time and over which Bancorp has no control; changes in interest rates; material unforeseen changes in liquidity, deterioration in the real estate market, results of operations or financial condition of Bancorp's customers; or other risks detailed in Bancorp's filings with the Securities and Exchange Commission and Item 1A of this Form 10-K all of which are difficult to predict and many of which are beyond the control of Bancorp.
Critical Accounting Policies Bancorp has prepared the consolidated financial information in this report in accordance with US GAAP. In preparing the consolidated financial statements in accordance with US GAAP, Bancorp makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurances that actual results will not differ from those estimates.
Management has identified the accounting policy related to the allowance and provision for loan losses as critical to the understanding of Bancorp's results of operations and discussed this conclusion with the Audit Committee of the Board of Directors. Since the application of this policy requires significant management assumptions and estimates, it could result in materially different amounts to be reported if conditions or underlying circumstances were to change. Assumptions include many factors such as changes in borrowers' financial condition which can change quickly or historical loss ratios related to certain loan portfolios which may or may not be indicative of future losses.
To the extent that management's assumptions prove incorrect, the results from operations could be materially affected. The impact and any associated risks related to this policy on Bancorp's business operations are discussed in the "Allowance for Loan Losses" section below.
The allowance for loan losses is management's estimate of probable losses in the loan portfolio. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.
Prior to the third quarter of 2013, management measured the appropriateness of the allowance for loan losses in its entirety using (a) quantitative (historical loss rates) and qualitative factors (management adjustment factors); (b) specific allocations on impaired loans, and (c) an unallocated amount. The unallocated amount was evaluated on the loan portfolio in its entirety and was based on additional factors, such as national and local economic trends and conditions, changes in volume and severity of past due loans, volume of non-accrual loans, volume and severity of adversely classified or graded loans and other factors and trends that affect specific loans and categories of loans, such as a heightened risk in the commercial and industrial loan portfolios.
Bancorp utilized the sum of all allowance amounts derived as described above, including a reasonable unallocated allowance, as an indicator of the appropriate level of allowance for loan and lease losses.
During the third quarter of 2013, Bancorp refined its allowance calculation whereby it "allocated" the portion of the allowance that was previously deemed to be unallocated allowance based on management's determination of the appropriate qualitative adjustment. This refined allowance calculation includes specific 14 -------------------------------------------------------------------------------- Table of Contents allowance allocations to loan portfolio segments at December 31, 2013 for qualitative factors including, among other factors, (i) national and local economic and business conditions, (ii) the quality and experience of lending staff and management, (iii) changes in lending policies and procedures, (iv) changes in volume and severity of past due loans, classified loans and non-performing loans, (v) potential impact of any concentrations of credit, (vi) changes in the nature and terms of loans such as growth rates and utilization rates, (vii) changes in the value of underlying collateral for collateral-dependent loans, considering Bancorp's disposition bias, and (viii) the effect of other external factors such as the legal and regulatory environment. Bancorp may also consider other qualitative factors in future periods for additional allowance allocations, including, among other factors, changes in Bancorp's loan review process. Changes in the criteria used in this evaluation or the availability of new information could cause the allowance to be increased or decreased in future periods. In addition, bank regulatory agencies, as part of their examination process, may require adjustments to the allowance for loan and lease losses based on their judgments and estimates.
Additionally, management has identified the accounting policy related to accounting for income taxes as critical to the understanding of Bancorp's results of operations and discussed this conclusion with the Audit Committee of the Board of Directors. The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity's financial statements or tax returns.
Judgment is required in assessing the future tax consequences of events that have been recognized in Bancorp's financial statements or tax returns.
Fluctuations in the actual outcome of these future tax consequences, including the effects of IRS examinations and examinations by other state agencies, could materially impact Bancorp's financial position and its results from operations.
Additional information regarding income taxes is discussed in the "Income Taxes" section below.
Overview of 2013 The following discussion should be read in conjunction with Bancorp's consolidated financial statements and accompanying notes and other schedules presented elsewhere in this report.
In 2013, Bancorp completed a year of asset and deposit growth with net income totaling $27,170,000, an increase of 5% over 2012, and the fourth consecutive year of increased net income. Increased profitability was primarily due to an increase in net interest income, a decline in the provision for loan losses, an increase in non-interest income, partially offset by higher non-interest expenses and higher income tax expense. Diluted earnings per share for 2013 increased 2% over 2012 to $1.89, exceeding the highest amount recorded in any prior year. Bancorp's results for 2013 included the effect of several non-core items. These items are discussed in the "Non-Interest Income and Non-Interest Expenses" section below. Excluding these items, net income for 2013, was $28.3 million or $1.97 per diluted share. See the "Non-GAAP Financial Measures" section for details on reconciliation to US GAAP measures.
On April 30, 2013, Bancorp completed the acquisition of 100% of the outstanding shares of THE BANCorp, Inc. ("Oldham"), parent company of THE BANK - Oldham County, Inc. As a result of the transaction, THE BANK - Oldham County merged into Stock Yards Bank & Trust Company. Since the acquisition date, results of operations acquired in the Oldham transaction have been included in Bancorp's financial results. The Oldham transaction has been accounted for using the acquisition method of accounting and, accordingly, assets acquired, liabilities assumed and consideration transferred were recorded at estimated fair value on the acquisition date. The fair value adjustments resulted in net assets acquired in excess of the consideration paid. Accordingly, a non-taxable gain of $449,000 was recognized. In connection with the Oldham acquisition, Bancorp incurred expenses totaling $1,548,000 related to executing the transaction and integrating and conforming acquired operations with and into Bancorp.
As is the case with most banks, the primary source of Bancorp's revenue is net interest income and fees from various financial services provided to customers.
Net interest income is the difference between interest income earned on loans, investment securities and other interest earning assets less interest expense on deposit accounts and other interest bearing liabilities. Loan volume and the interest rates earned on those loans are critical to overall profitability.
Similarly deposit volume is crucial to funding loans and rates paid on deposits directly impact profitability. Business volumes are influenced by overall economic factors including 15 -------------------------------------------------------------------------------- Table of Contents market interest rates, business spending, consumer confidence and competitive conditions within the marketplace.
Bancorp's loan portfolio increased $137 million, or 9%, during 2013 to $1.7 billion. Excluding $40 million of loans acquired in the Oldham transaction, core loan growth was 6% for 2013. Record loan production of approximately $489 million was largely offset by loan payoffs, including the effects of normal payoffs and paydowns and increased competition from banks and non-bank financial firms. Increased loan volume contributed to higher interest income in 2013, but the increase resulting from volume was more than offset by declining interest rates on loans and investments over the past year. Primarily as a result, interest income for 2013 decreased $437,000 over 2012. Despite significant deposit growth, interest expense declined due to lower funding costs on deposits and borrowings. While rates paid on liabilities decreased, rates on earning assets decreased slightly more, resulting in a decreased net interest spread and net interest margin compared to 2012. Net interest margin in 2013 reflected prepayment fees associated with loan refinancing activity. Adjusting for these sources of additional income, Bancorp's more normalized or core net interest margin has trended downward throughout 2013, declining to 3.66% for 2013 from 3.88% for 2012. (See "Non-GAAP Financial Measures" section for reconcilement of non-GAAP measures to US GAAP measures.) Total non-interest income in 2013 increased $545,000 compared to 2012, and remained consistent at 34% of total revenues, reflecting increases in investment management and trust services, service charges on deposit accounts, bankcard transaction revenue, and the gain on the Oldham acquisition, partially offset by a decrease in mortgage banking revenue and brokerage commissions.
Higher non-interest expenses for 2013 resulted from one-time acquisition costs related to the Oldham transaction, write-off of debt issuance costs related to redemption of trust preferred securities, increases in salaries and benefits and data processing expenses, partially offset by decreases in losses on foreclosed assets, furniture and equipment, and FDIC insurance expense. Bancorp's efficiency ratio for 2013 of 60.8% increased from 57.4% in 2012.
Also favorably impacting 2013 results, Bancorp's provision for loan losses decreased to $6,550,000 compared to $11,500,000 for 2012, in response to Bancorp's assessment of risk in the loan portfolio. The provision for loan losses is calculated after considering credit quality factors, and ultimately relies on an overall internal analysis of the risk in the loan portfolio.
Bancorp's allowance for loan losses was 1.66% of total loans at December 31, 2013, compared with 2.01% of total loans at December 31, 2012.
Bancorp's effective tax rate increased to 29.2% in 2013 from 27.2% in 2012.
The increase in income tax expense from 2012 to 2013 is the result of reduced tax exempt interest in 2013 as well as the recognition of certain federal historic rehabilitation tax credits related to an investment in redevelopment of a Louisville landmark in 2012.
Tangible common equity (TCE), a non-GAAP measure, is a measure of a company's capital which is useful in evaluating the quality and adequacy of capital. It is calculated by subtracting the value of intangible assets and any preferred equity from the book value of Bancorp.
16 -------------------------------------------------------------------------------- Table of Contents A summary of Bancorp's TCE ratios at December 31, 2013 and 2012 is shown in the following table.
(in thousands, except per share data and ratios) December 31, 2013 December 31, 2012 Total equity $ 229,444 $ 205,075 Less core deposit intangible (2,151 ) - Less goodwill (682 ) (682 ) Tangible common equity $ 226,611 $ 204,393 Total assets $ 2,389,262 $ 2,148,262 Less core deposit intangible (2,151 ) - Less goodwill (682 ) (682 ) Total tangible assets $ 2,386,429 $ 2,147,580 Tangible common equity ratio 9.50 % 9.52 % Number of outstanding shares 14,609 13,915 Tangible common equity per share $ 15.51 $ 14.69 See "Non-GAAP Financial Measures" section for reconcilement of TCE to US GAAP measures.
Challenges for 2014 will include, maintaining a stable net interest margin, achieving continued loan growth, managing credit quality and increasing regulatory requirements.
† Bancorp expects net interest margin to improve in 2014 as the interest expense from the redeemed trust preferred securities is eliminated.
Other than this, the margin is expected to remain consistent, as rates are expected to be largely unchanged through the fourth quarter of 2014. Loan prepayments are expected to diminish while prevailing rates for new loans will likely result in a relatively unchanged net interest margin for 2014.
Considering prevailing rates, management expects little margin compression to continue in 2014. However, increased deposit and loan rate competition could negatively impact this expectation, as could a decrease in longer term interest rates.
† The Federal Reserve Board lowered its key short term rate in 2008 to unprecedentedly low levels, and rates have remained low through 2013.
Indications are that the Federal Reserve will likely keep short term rates low through 2014 and into 2015. Approximately 35% of Bancorp's loans are indexed to the prime interest rate and reprice immediately with Federal Reserve rate changes. However, approximately 55% of variable rate loans have reached their contractual floor of 4% or higher, meaning they will not reprice immediately when the prime rate increases. Deposit rates generally do not reprice as quickly as loans. Once rates begin to rise, Bancorp's net interest margin likely will be negatively affected until the increase in the prime rate exceeds 75 basis points from today's levels.
† Bancorp's goals for 2014 include net loan growth at a pace similar to that experienced in 2013, excluding the loans acquired in the Oldham transaction. This will be impacted by competition, prevailing economic conditions, and the impact of prepayments in the loan portfolio. Bancorp believes there is an opportunity for growth, and Bancorp's ability to deliver attractive growth over the long-term is linked to Bancorp's success in each market.
† Management is concerned that the slow economic recovery could still revert back to recessionary conditions which will cause a higher level of non-performing loans and potentially lower loan demand, both of which would negatively impact net income. Until sustained improvement in the economy is noted, particularly as it relates to housing and employment, certain borrowers will continue to experience stressed financial conditions.
17 -------------------------------------------------------------------------------- Table of Contents † Bancorp expects a decrease in non-interest income for 2014 in gains on sales of mortgage loans held for sale, as the volume of refinance activity will not continue at the pace experienced in early 2013. Bancorp has experienced a larger volume of loans to purchase homes, a sign of improving housing markets, which should partially offset effects of decreased refinance activity.
† Bancorp expects year-over-year increases in non-interest expense including personnel, data processing and occupancy expenses. Bancorp also anticipates higher non-interest expenses to meet the ongoing and increasing burden of additional regulatory requirements.
The following sections provide more details on subjects presented in this overview.
Results of Operations Net income was $27,170,000 or $1.89 per share on a diluted basis for 2013 compared to $25,801,000 or $1.85 per share for 2012 and $23,604,000 or $1.71 per share for 2011. Net income for 2013 was positively impacted by: † a $3.3 million or 5% increase in net interest income.
† a $5.0 million or 43% decrease in provision for loan losses.
† a $0.5 million or 1% increase in non-interest income.
Net income for 2013 was negatively impacted by: † a $5.9 million or 9% increase in non-interest expenses.
† a $1.6 million or 17% increase in income tax expense.
The following paragraphs provide a more detailed analysis of the significant factors affecting operating results.
Net Interest Income Net interest income, the most significant component of Bancorp's earnings, represents total interest income less total interest expense. Net interest spread is the difference between the taxable equivalent rate earned on average interest earning assets and the rate expensed on average interest bearing liabilities. Net interest margin represents net interest income on a taxable equivalent basis as a percentage of average earning assets. Net interest margin is affected by both the interest rate spread and the level of non-interest bearing sources of funds. The level of net interest income is determined by the mix and volume of interest earning assets, interest bearing deposits and interest bearing liabilities and by changes in interest rates. The discussion that follows is based on tax-equivalent interest data.
18 -------------------------------------------------------------------------------- Table of Contents Comparative information regarding net interest income follows: 2013/2012 2012/2011 (Dollars in thousands) 2013 2012 2011 Change Change Net interest income, tax-equivalent basis $ 78,306 $ 75,653 $ 72,262 3.5 % 4.7 % Net interest spread 3.59 % 3.74 % 3.79 % (15 )bp (5 )bp Net interest margin 3.74 % 3.94 % 3.99 % (20 )bp (5 )bp Average earning assets $ 2,096,088 $ 1,922,134 $ 1,809,043 9.1 % 6.3 % Five year Treasury bond rate at year end 1.75 % 0.73 % 0.83 % 102 bp (10 )bp Average five year Treasury bond rate 1.17 % 0.75 % 1.50 % 42 bp (75 )bp Prime rate at year end 3.25 % 3.25 % 3.25 % 0 bp 0 bp Average prime rate 3.25 % 3.25 % 3.25 % 0 bp 0 bp -------------------------------------------------------------------------------- bp = basis point = 1/100th of a percent All references above to net interest margin and net interest spread exclude the sold portion of participation loans from calculations. Such loans remain on Bancorp's balance sheet as required by US GAAP principles because Bancorp retains some form of effective control; however, Bancorp receives no interest income on the sold portion of these loans. These participation loans sold are excluded in the calculation of margins, which Bancorp believes provides a more accurate determination of the performance of its loan portfolio.
Prime rate and the five year Treasury bond rate are included above to provide a general indication of the interest rate environment in which Bancorp operated.
Approximately $598 million, or 35%, of Bancorp's loans are variable rate; most of these loans are indexed to the prime rate and may reprice as that rate changes. However, approximately $328 million of variable rate loans, have reached their contractual floor of 4% or higher. Approximately $112 million of variable rate loans have contractual floors below 4%. The remaining $158 million of variable rate loans have no contractual floor. Bancorp intends to establish floors whenever possible upon acquisition of new customers. Bancorp's variable rate loans are primarily comprised of commercial lines of credit and real estate loans. At inception, most of Bancorp's fixed rate loans are priced in relation to the five year Treasury bond.
Average loan balances increased $110 million or 7.2% in 2013; however, the declining interest rate environment drove average loan yields lower by 43 basis points. Bancorp grew average interest bearing deposits $121 million or 9.2%.
Average interest costs on interest bearing deposits decreased 19 basis points, again reflecting the declining interest rate market and a more favorable mix of deposits. Average Federal Home Loan Bank ("FHLB") advances decreased by $27.6 million or 45.9%, with average rates decreasing by 136 basis points. In the fourth quarter of 2012, Bancorp prepaid $30 million of fixed rate advances, incurring $1.06 million in prepayment penalties, which were recorded as interest expense. Rate changes, combined with volume changes on loans, deposits and FHLB advances, resulted in higher net interest income, but a lower net interest margin for 2013 compared to 2012.
Management anticipates a stable prime rate for 2014. Time deposit maturities of approximately $111 million, or 32% of total time deposits, in the first two quarters are not likely to spark improvement in interest expense as prevailing market rates are similar to existing rates on those deposits. The redemption of the $30 million trust preferred securities, which paid 10%, will provide an improvement in interest expense. This will be somewhat offset by declining overall rates in the loan portfolio as persistent low prevailing rates are expected to continue to erode the overall yield on loans. The margin could be further affected negatively if competition causes increases in deposit rates or a greater than expected decline in loan pricing in Bancorp's markets.
19 -------------------------------------------------------------------------------- Table of Contents Net interest margin in 2013 reflected a higher amount of prepayment fees associated with loan refinancing activity. Adjusting for these sources of additional income, Bancorp's more normalized or core net interest margin has trended downward throughout 2013, declining to 3.66% for 2013 from 3.88% for 2012. (See "Non-GAAP Financial Measures" section for reconcilement of non-GAAP measures to US GAAP measures.) Management believes these core margins better reveal the pressure of a low interest rate environment and a highly competitive loan market, and it expects margin compression to diminish in 2013.
Asset/Liability Management and Interest Rate Risk Managing interest rate risk is fundamental for the financial services industry.
The primary objective of interest rate risk management is to neutralize effects of interest rate changes on net income. By considering both on and off-balance sheet financial instruments, management evaluates interest rate sensitivity while attempting to optimize net interest income within the constraints of prudent capital adequacy, liquidity needs, market opportunities and customer requirements.
Interest Rate Simulation Sensitivity Analysis Bancorp uses an earnings simulation model to estimate and evaluate the impact of an immediate change in interest rates on earnings in a one year forecast. The simulation model is designed to reflect the dynamics of interest earning assets, interest bearing liabilities and off-balance sheet financial instruments. By estimating the effects of interest rate increases and decreases, the model can reveal approximate interest rate risk exposure. The simulation model is used by management to gauge approximate results given a specific change in interest rates at a given point in time. The model is therefore a tool to indicate earnings trends in given interest rate scenarios and does not indicate actual expected results.
The December 31, 2013 simulation analysis, which shows very little interest rate sensitivity, indicates that an increase in interest rates of 100 to 200 basis points would have a negative effect on net interest income, and a decrease of 100 basis points in interest rates would also have a slightly negative effect on net interest income. These estimates are summarized below.
Net interest income % change Increase 200 bp (5.48 ) Increase 100 bp (3.84 ) Decrease 100 bp (2.08 ) Decrease 200 bp N/A Loans indexed to the prime rate, with floors of 4% or higher, comprise approximately 19% of total loans. Since the prime rate is currently 3.25%, rates would have to increase more than 75 bp before the rates on such loans will rise. This effect, captured in the simulation analysis above, negatively impacts the effect of rising rates.
The scenario of rates decreasing 200 bp is not reasonably possible given current low rates for short-term instruments and most deposits.
Undesignated derivative instruments described in Note 21 to Bancorp's consolidated financial statements are recognized on the consolidated balance sheet at fair value, with changes in fair value, due to changes in prevailing interest rates, recorded in other non-interest income. Because of matching terms of offsetting contracts, in addition to collateral provisions which mitigate the impact of non-performance risk, changes in fair value subsequent to initial recognition have a minimal effect on earnings, and are therefore not included in the simulation analysis results above.
Derivatives designated as cash flow hedges described in Note 21 to Bancorp's consolidated financial statements are recognized on the consolidated balance sheet at fair value, with changes in fair value, due to changes in prevailing interest rates, recorded net of tax in other comprehensive income.
20 -------------------------------------------------------------------------------- Table of Contents The following table presents the increases in net interest income due to changes in rate and volume computed on a tax-equivalent basis and indicates how net interest income in 2013 and 2012 was impacted by volume increases and the lower average interest rate environment. The tax-equivalent adjustments are based on a 35% federal tax rate. The change in interest due to both rate and volume has been allocated to the change due to rate and the change due to volume in proportion to the relationship of the absolute dollar amounts of the change in each.
Taxable Equivalent Rate/Volume Analysis 2013/2012 2012/2011 Increase (decrease) Increase (decrease) due to due to (In thousands) Net change Rate Volume Net change Rate Volume Interest income Loans $ (1,376 ) $ (6,932 ) $ 5,556 $ 586 $ (1,494 ) $ 2,080 Federal funds sold (25 ) 3 (28 ) 65 - 65 Mortgage loans held for sale (125 ) (2 ) (123 ) 113 (32 ) 145 Securities Taxable 442 (1,199 ) 1,641 483 (841 ) 1,324 Tax-exempt (48 ) (205 ) 157 (212 ) (204 ) (8 ) Total interest income (1,132 ) (8,335 ) 7,203 1,035 (2,571 ) 3,606 Interest expense Deposits Interest bearing demand deposits (126 ) (231 ) 105 (86 ) (155 ) 69 Savings deposits (22 ) (34 ) 12 (48 ) (60 ) 12 Money market deposits (569 ) (712 ) 143 (804 ) (987 ) 183 Time deposits (1,438 ) (1,214 ) (224 ) (2,001 ) (1,457 ) (544 ) Securities sold under agreements to repurchase (34 ) (37 ) 3 (73 ) (66 ) (7 ) Federal funds purchased and other short-term borrowings 1 1 - (7 ) (3 ) (4 ) Federal Home Loan Bank advances (1,574 ) (663 ) (911 ) 1,001 1,009 (8 ) Long-term debt (23 ) 77 (100 ) (338 ) 536 (874 ) Total interest expense (3,785 ) (2,813 ) (972 ) (2,356 ) (1,183 ) (1,173 ) Net interest income $ 2,653 $ (5,522 ) $ 8,175 $ 3,391 $ (1,388 ) $ 4,779 Bancorp's tax equivalent net interest income increased $2.7 million for the year ended December 31, 2013 compared to the same period of 2012 while 2012 increased $3.4 million compared to 2011. Net interest income for 2013 compared to 2012 was positively impacted by an increase in loan and securities volume and a decrease in deposit rates, a more favorable mix of deposits, and decreases in volume and rates of FHLB advances. Net interest income was negatively impacted by a decline in the average rate earned on assets. Volume increases of loans and securities boosted net interest income by $7.2 million and declining rates on deposits, particularly time deposits, contributed $2.2 million to the increase of net interest income. Partially 21 -------------------------------------------------------------------------------- Table of Contents offsetting the increases, declining rates on loans and securities negatively impacted net interest income by $8.3 million. FHLB advance interest decreased $1.6 million attributable to both volume and rate decreases.
For the year 2012 compared to 2011, net interest income was positively impacted by an increase in loan and securities volume and a decrease in deposit rates, a more favorable mix of deposits, and the volume of interest-bearing liabilities.
In the fourth quarter of 2012, Bancorp prepaid $30 million of fixed rate FHLB advances, incurring $1.06 million in prepayment penalties, which were recorded as interest expense. Net interest income was negatively impacted by a decline in the average rate earned on assets. Loan volume increases boosted net interest income by $2.1 million and declining rates on deposits, particularly time deposits, contributed $2.7 million to the increase of net interest income.
Partially offsetting the increases, declining rates on loans and securities negatively impacted net interest income by $2.6 million.
Provision for Loan Losses In determining the provision for loan losses, management considers many factors.
Among these are the quality and underlying collateral of the loan portfolio, previous loss experience, the size and composition of the loan portfolio and an assessment of the impact of current economic conditions on borrowers' ability to pay. The provision for loan losses and resulting ratios is summarized below: (Dollars in thousands) 2013 2012 2011 Provision for loan losses $ 6,550 $ 11,500 $ 12,600 Allowance to loans at year end 1.66 % 2.01 % 1.93 % Allowance to average loans for year 1.72 % 2.04 % 1.94 % The provision for loan losses is determined by Bancorp's assessment of inherent risk in the loan portfolio. The allowance for loan losses is calculated after considering credit quality factors, and ultimately relies on an overall internal analysis of the risk in the loan portfolio. Based on this analysis, provisions for loan losses are determined and recorded. The provision reflects an allowance methodology that is driven by risk ratings. The pace of loan downgrades continues to slow and an increasing number of loans are being upgraded. Bancorp intends to continue with its historically conservative stance toward credit quality, remaining cautious in assessing the potential risk in the loan portfolio. More information on this process can be found in the "Allowance for loan losses" section on page 33.
Non-performing loans decreased to $22.9 million at December 31, 2013 from $30.0 million at year-end 2012, primarily due to a decrease in non-accrual loans and loans classified as troubled debt restructurings (TDRs), reflecting a limited number of partial charge-offs of collateral-dependent loans. The ratio of non-performing loans to total loans was 1.33% at December 31, 2013, down from 1.90% at December 31, 2012. TDRs, which are currently accruing interest, decreased from $11.0 million at December 31, 2012 to $7.2 million at December 31, 2013, as two loans secured by commercial real estate totaling $2.9 million experienced foreclosure during 2013. Net charge-offs totaled 0.60% of average loans at year-end 2013, consistent with year-end 2012. See "Financial Condition-Non-performing Loans and Assets" for further discussion of non-performing loans. See "Financial Condition-Summary of Loan Loss Experience" for further discussion of loans charged off during the year.
Bancorp's loan portfolio is diversified with no significant concentrations of credit. Geographically, most loans are extended to borrowers in the metropolitan areas of Louisville, Indianapolis and Cincinnati. The adequacy of the allowance is monitored on an ongoing basis and it is the opinion of management that the balance of the allowance for loan losses at December 31, 2013 is adequate to absorb probable losses inherent in the loan portfolio as of the financial statement date. See "Financial Condition-Allowance for Loan Losses" for more information on the allowance for loan losses.
22 -------------------------------------------------------------------------------- Table of Contents Non-Interest Income and Non-Interest Expenses The following table provides a comparison of the components of non-interest income for 2013, 2012 and 2011. Below the table is a discussion of significant changes and trends.
2013/2012 2012/2011 (Dollars in thousands) 2013 2012 2011 Change % Change % Investment management and trust services $ 16,287 $ 14,278 $ 13,841 $ 2,009 14.1 % $ 437 3.2 % Service charges on deposit acccounts 8,986 8,516 8,348 470 5.5 168 2.0 Bankcard transaction revenue 4,378 3,985 3,722 393 9.9 263 7.1 Mortgage banking revenue 3,978 5,771 3,049 (1,793 ) (31.1 ) 2,722 89.3 Loss on sales of securities available for sale (5 ) - - (5 ) 100.0 - - Brokerage commissions and fees 2,159 2,593 2,219 (434 ) (16.7 ) 374 16.9 Bank owned life insurance income 1,031 1,006 1,019 25 2.5 (13 ) (1.3 ) Gain on acquisition 449 - - 449 100.0 - - Other 1,739 2,308 1,046 (569 ) (24.7 ) 1,262 120.7 $ 39,002 $ 38,457 $ 33,244 $ 545 1.4 % $ 5,213 15.7 % The largest component of non-interest income is investment management and trust revenue. The magnitude of investment management and trust revenue distinguishes Bancorp from other community banks of similar asset size. Along with the effects of improving investment market conditions in 2012 and 2013, this area of Bancorp continued to grow through attraction of new business and retention of existing business. Trust assets under management totaled $2.23 billion at December 31, 2013, compared to $1.96 billion at December 31, 2012. Investment management and trust services income, which constitutes an average of 40% of non-interest income, increased $2,009,000, or 14.1%, for 2013 compared to 2012, primarily due to an increased market value of assets under management, net new business, and, to a lesser extent, an increase in one-time executor fees. Recurring fees, which generally make up over 95% of the investment management and trust revenue, increased 12% for 2013, compared to 2012. Most recurring fees earned for managing accounts are based on a percentage of market value on a monthly basis.
While fees are based on market values, they typically do not fluctuate directly with the overall stock market. Accounts usually contain fixed income and equity asset classes, which generally react inversely to each other. Some revenues of the investment management and trust department, most notably executor, insurance, and some employee benefit plan-related fees, are non-recurring in nature and the timing of these revenues corresponds with the related administrative activities. Non-recurring fees increased $328,000 for 2013 compared to 2012. For 2013, 2012 and 2011 executor fees totaled approximately $437,000, $106,000 and $362,000, respectively.
Service charges on deposit accounts increased $470,000 or 5.5%, for the year ended December 31, 2013 compared to the same period a year ago. Service charge income is driven by transaction volume, which can fluctuate throughout the year, and increased in the latter half of 2013 primarily due to addition of accounts in the Oldham transaction in the second quarter. A significant component of service charges is related to fees earned on overdrawn checking accounts. While this source of income has experienced a modest increase over the past two years, management expects it to decline slightly in 2014 due to anticipated changes in customer behavior and increased regulatory restrictions.
Bankcard transaction revenue primarily represents income Bancorp derives from customers' use of debit cards. This category reflects a change in the manner in which bankcard revenue and expense are received and recorded by Bancorp, related to the selection of a new bankcard processor. Bancorp's new processor 23 -------------------------------------------------------------------------------- Table of Contents provided more detailed information regarding related income and expense. As a result, beginning in mid-2013, information previously recorded as net revenue has been grossed up to more accurately reflect income and expense. This more detailed information is not available for prior periods and thus impacts the comparability of the information on an absolute basis for revenue and expense.
It is, however, comparable on a net basis. Bankcard income, net of bankcard expenses which are recorded in data processing expenses, was $2,844,000, $2,896,000 and $2,734,000 for 2013, 2012 and 2011, respectively. The net decrease in 2013 primarily reflects a decrease in the rates received, partially offset by increased volume of transactions. Most of this revenue is interchange income based on rates set by service providers in a competitive market.
Beginning in October 2011, this rate was set by the Federal Reserve Board for banks with over $10 billion in assets. While this threshold indicates Bancorp will not be directly affected, this change has affected Bancorp as vendors gravitate to lower cost interchanges. While there are many uncertainties about its effect or ultimately when these changes may take place, the Dodd-Frank legislation will negatively affect this source of income. Volume, which is dependent on consumer behavior, is expected to increase at a slower pace.
However, management expects interchange rates to decrease, resulting in income from this source to remain consistent with levels experienced in 2013.
Mortgage banking revenue primarily includes gains on sales of mortgage loans.
Bancorp's mortgage banking department originates residential mortgage loans to be sold in the secondary market. Interest rates on the loans sold are locked with the borrower and investor prior to closing the loans, thus Bancorp bears no interest rate risk related to these loans. The department offers conventional, VA and FHA financing, for purchases and refinances, as well as programs for first time home buyers. Interest rates on mortgage loans directly impact the volume of business transacted by the mortgage banking division. Mortgage banking revenue decreased $1,793,000, or 31.1%, in 2013 compared to 2012. In the second quarter of 2013, market rates for mortgage loans increased, resulting in 85% lower volume of refinance activity in 2013 compared to 2012. Origination of loans for purchase of homes, however, has continued to rise, with the number of purchase loans increasing 13% in 2013 compared to 2012.
In the second quarter of 2013, Bancorp sold investments it held in obligations of state and political subdivisions with total par value of $685,000, generating a loss of $5,000. These securities, acquired in the Oldham transaction, were sold in the ordinary course of investment management because they did not meet Bancorp's current investment strategy. No securities were sold in 2012 or 2011.
Brokerage commissions and fees decreased $434,000, or 16.7%, in 2013 compared to 2012, corresponding to overall brokerage volume. In the second quarter of 2013, the departure of two brokers resulted in a decline of accounts, many of which included wrap fees. However, after consideration of related expenses, the decline in net income was approximately $100,000 compared to 2012. Brokerage commissions and fees earned consist primarily of stock, bond and mutual fund sales as well as wrap fees on accounts. Wrap fees are charges for investment programs that bundle together a suite of services, such as brokerage, advisory, research, and management, and based on a percentage of assets. Bancorp deploys its brokers primarily through its branch network, while larger managed accounts are serviced in the investment management and trust department.
Income related to bank-owned life insurance ("BOLI") was $1,031,000 in 2013 compared to $1,006,000 for 2012. BOLI represents the cash surrender value for life insurance policies on certain key employees who have provided consent for Bancorp to be the beneficiary of a portion of such policies. Any proceeds received under the policies and the related change in cash surrender value are recorded as non-interest income. This income helps offset the cost of various employee benefits.
The Oldham transaction has been accounted for using the acquisition method of accounting and, accordingly, assets acquired, liabilities assumed and consideration transferred were recorded at estimated fair value on the acquisition date. See Note 3 to Bancorp's consolidated financial statements for information relating to the acquisition. The fair value adjustments resulted in net assets acquired in excess of the consideration paid. Accordingly, a non-taxable gain of $449,000 was recognized.
Other non-interest income decreased $569,000, or 24.7%, during 2013 compared to 2012, primarily due to a $627,000 increase in the value of the domestic private investment fund in the first quarter of 2012. Management liquidated its investment in this fund effective March 31, 2012. This decrease was partially offset by a variety of other factors, none of which were individually significant.
24 -------------------------------------------------------------------------------- Table of Contents The following table provides a comparison of the components of non-interest expenses for 2013, 2012 and 2011. Below the table is a discussion of significant changes and trends.
2013/2012 2012/2011 (Dollars in thousands) 2013 2012 2011 Change % Change % Salaries and employee benefits $ 41,145 $ 37,960 $ 33,125 $ 3,185 8.4 % $ 4,835 14.6 % Net occupancy expense 5,615 5,651 5,192 (36 ) (0.6 ) 459 8.8 Data processing expense 6,319 5,278 5,014 1,041 19.7 264 5.3 Furniture and equipment expense 1,126 1,306 1,299 (180 ) (13.8 ) 7 0.5 FDIC insurance 1,431 1,494 1,655 (63 ) (4.2 ) (161 ) (9.7 ) Loss on other real estate owned 652 1,410 1,716 (758 ) (53.8 ) (306 ) (17.8 ) Acquisition costs 1,548 - - 1,548 100.0 - - Other 13,516 12,373 11,580 1,143 9.2 793 6.8 $ 71,352 $ 65,472 $ 59,581 $ 5,880 9.0 % $ 5,891 9.9 % * Ratio exceeds 100% Salaries and benefits are the largest component of non-interest expenses and increased $3,185,000 or 8.4% for 2013 compared to 2012, largely due to increased staffing levels, normal increases in salaries, higher health insurance costs, increased bonus accruals and stock-based compensation expense. Increased staffing levels included senior staff with higher per capita salaries in investment management and trust, lending and loan administration functions as well as staff increases resulting from the Oldham transaction. At December 31, 2013, Bancorp had 519 full-time equivalent employees compared to 495 at the same date in 2012 and 480 for 2011.
Net occupancy expense decreased $36,000 or 0.6% from 2012 to 2013, largely due to a $150,000 non-recurring rent refund on a leased facility which lowered rent expense in the first quarter of 2013, partially offset by increases in rent and depreciation expense attributable to four additional locations as a result of the Oldham transaction. At December 31, 2013 Bancorp had 34 banking center locations including the main office. In the second quarter of 2013, Bancorp closed one leased branch location in the Louisville MSA.
Data processing expense increased $1,041,000 or 19.7% from 2012 to 2013 due to several factors. In the third quarter of 2013, Bancorp incurred $144,000 data processing expense, as the Oldham customer account data was converted to Bancorp's system. The increase also reflected a $208,000 refund received from one vendor who provides data processing services for Bancorp, which was included in the 2012 amounts. Also included is $103,000 for reissuance of debit cards in the fourth quarter of 2013, an action related to the recent selection of a new bank card processor. As noted above during 2013, Bancorp began recording bank card revenue and expense gross; this information was previously conveyed net.
As a result, Bancorp recorded approximately $237,000 of data processing expense in 2013 due to the gross-up. This category also includes ongoing computer equipment maintenance costs related to investments in new technology needed to improve the pace of delivery channels and internal resources.
Furniture and equipment expense decreased $180,000 or 13.8% in 2013, as compared to 2012, due to a variety of factors, none of which is individually significant. Costs of capital asset additions flow through the statement of income over the lives of the assets in the form of depreciation expense.
FDIC insurance expense decreased $63,000, or 4.2% for the year ended December 31, 2013, as compared to the same period in 2012. The assessment is calculated and adjusted quarterly by the FDIC. The decline in expense is due primarily a reduction in the assessment rate, which was driven by improved credit metrics in 2013.
25 -------------------------------------------------------------------------------- Table of Contents Losses on other real estate owned (OREO) totaled $652,000 for the year ended December 31, 2013, compared to $1,410,000 for the same period in 2012. In 2013, Bancorp wrote off $365,000 of OREO, as the maximum regulatory holding period of 10 years was reached. During 2012, Bancorp took additional charge-downs on certain OREO to target a shorter timeframe for the opportunistic disposition of these properties, thus helping limit Bancorp's exposure to market risk. As levels of OREO decreased in 2013, related disposition costs also decreased.
In connection with the Oldham acquisition, Bancorp incurred expenses in the second quarter of 2013 related to executing the transaction and integrating and conforming acquired operations with and into Bancorp. Those expenses consisted largely of conversion of systems and/or integration of operations, professional services, costs related to termination of existing contractual arrangements of Oldham to purchase various services; initial marketing and promotion expenses designed to introduce Bancorp to its new customers; and printing, postage, supplies, and other costs of completing the transaction. A summary of acquisition costs, all recorded in the second quarter of 2013, included in the consolidated statement of income follows: (in thousands) Data conversion expenses $ 906 Consulting 262 Salaries and employee benefits 103 Legal 96 All other 181 Total acquisition costs $ 1,548 Other non-interest expenses increased $1,143,000, or 9.2% for the year ended December 31, 2013 compared to the same period of 2012. In conjunction with the redemption of its trust preferred securities in the fourth quarter of 2013, Bancorp wrote off the remaining $1,306,000 of debt issuance costs. Other increases included $392,000 in amortization of the core deposit intangible asset recorded as a result of the Oldham transaction, $256,000 increase in capital-based state taxes, $215,000 increase in mortgage servicing rights ("MSR") amortization, $219,000 of debit card losses, and $216,000 increase in advertising. Somewhat offsetting the increases in 2013 were a $564,000 decrease in legal and professional fees, a one-time decrease of $505,000 in marketing expense related to a debit card rewards program conversion, and decreases of $355,000 in OREO maintenance expenses. This category also includes printing, mail and telecommunications, none of which had individually significant variances.
Income Taxes A three year comparison of income tax expense and effective tax rate follows: (Dollars in thousands) 2013 2012 2011 Income tax expense $ 11,228 $ 9,634 $ 8,191 Effective tax rate 29.2 % 27.2 % 25.8 % The increase in the effective tax rate from 2012 to 2013 is primarily the result of reduced tax exempt interest in 2013 as well as the recognition of certain federal historic rehabilitation tax credits related to an investment in redevelopment of a Louisville landmark in 2012. The increase in income tax expense from 2011 to 2012 is the result of an adjustment of approximately $700,000 made in 2011 to Bancorp's deferred tax asset that relates to tax-advantaged investments that Bancorp has made in its primary market area over the years. For more information regarding income taxes and the effective tax rate see Note 8 to Bancorp's consolidated financial statements.
26 -------------------------------------------------------------------------------- Table of Contents Financial Condition Earning Assets and Interest Bearing Liabilities Summary information with regard to Bancorp's financial condition follows: 2013/2012 2012/2011 (Dollars in thousands) 2013 2012 2011 Change % Change % Average earning assets $ 2,096,088 $ 1,922,134 $ 1,809,043 $ 173,954 9.1 % $ 113,091 6.3 % Average interest bearing liabilities 1,582,591 1,488,939 1,456,866 93,652 6.3 32,073 2.2 Average total assets 2,232,868 2,070,967 1,959,609 161,901 7.8 111,358 5.7 Total year end assets 2,389,262 2,148,262 2,053,097 241,000 11.2 % 95,165 4.6 % Bancorp has experienced growth in earning assets over the last several years primarily in the area of loans. From 2012 to 2013, average loans increased 7.2%, or $110.2 million, compared to 2.6% or $39.3 million from 2011 to 2012.
Record loan production of approximately $489 million due to increased calling efforts was largely offset by loan payoffs, including the effects of normal payoffs and paydowns and increased competition from banks and non-bank financial firms. Average securities available for sale increased $75.7 million, or 29.0% from 2012 to 2013, compared to $47.5 million, or 22.2% from 2011 to 2012 as Bancorp deployed funds from deposit growth into longer-term earning assets.
The increase in average interest bearing liabilities from 2012 to 2013 occurred primarily in money market and demand deposits as clients have excess cash and few short-term investment alternatives in the current environment. Average total interest bearing deposit accounts increased 9.2% and non-interest bearing deposit accounts increased 18.3% in 2013. Time deposits decreased 4.9% or $18.7 million in 2013, as Bancorp intentionally did not renew higher cost deposits and customers migrated from time deposits to demand deposits due to low rates.
Bancorp continued to utilize fixed rate advances from the FHLB during 2013 as they compared favorably to similar term time deposits. Bancorp had an average of $32.5 million in outstanding FHLB advances in 2013 compared to $60.1 million and $60.4 million in 2012 and 2011, respectively. In the fourth quarter of 2012, Bancorp prepaid $30 million of fixed rate advances, resulting in $1.1 million in prepayment penalties, but results in savings of approximately $2.1 million in interest expense over the next six years. At December 31, 2013 and 2012, federal funds purchased from correspondent banks totaled $55.3 million and $16.6 million, respectively.
27 -------------------------------------------------------------------------------- Table of Contents Average Balances and Interest Rates - Taxable Equivalent Basis Year 2013 Year 2012 Year 2011 Average Average Average Average Average Average(Dollars in thousands) balances Interest rate balances Interest rate balances Interest rate Earning assets Federal funds sold $ 99,381 $ 295 0.30 % $ 108,828 $ 320 0.29 % $ 86,600 $ 255 0.29 % Mortgage loans held for sale 5,885 219 3.72 % 9,191 344 3.74 % 5,394 231 4.28 % Securities Taxable 281,734 5,836 2.07 % 210,948 5,419 2.57 % 163,230 4,954 3.03 % Tax-exempt 55,385 1,643 2.97 % 50,430 1,691 3.35 % 50,644 1,903 3.76 % FHLB stock and other securities 6,916 263 3.80 % 6,117 238 3.89 % 5,900 220 3.73 % Loans, net of unearned income 1,646,787 79,216 4.81 % 1,536,620 80,592 5.24 % 1,497,275 80,006 5.34 % Total earning assets 2,096,088 87,472 4.17 % 1,922,134 88,604 4.61 % 1,809,043 87,569 4.84 % Less allowance for loan losses 32,282 31,890 27,950 2,063,806 1,890,244 1,781,093 Non-earning assets Cash and due from banks 33,888 31,695 27,240 Premises and equipment 38,691 37,634 34,589 Accrued interest receivable and other assets 96,483 111,394 116,687 Total assets $ 2,232,868 $ 2,070,967 $ 1,959,609 Year 2013 Year 2012 Year 2011 Average Average Average Average Average Average (Dollars in thousands) balances Interest rate balances Interest rate balances Interest rate Interest bearing liabilities Deposits Interest bearing demand deposits $ 392,939 $ 388 0.10 % $ 317,017 $ 514 0.16 % $ 281,566 $ 600 0.21 % Savings deposits 96,515 39 0.04 % 78,640 61 0.08 % 70,290 109 0.16 % Money market deposits 585,512 1,228 0.21 % 539,395 1,797 0.33 % 501,792 2,601 0.52 % Time deposits 364,347 3,356 0.92 % 383,008 4,794 1.25 % 418,750 6,795 1.62 % Securities sold under agreements to repurchase 60,737 146 0.24 % 59,861 180 0.30 % 61,595 253 0.41 % Federal funds purchased and other short-term borrowings 19,546 32 0.16 % 19,431 31 0.16 % 21,537 38 0.18 % FHLB advances 32,518 887 2.73 % 60,113 2,461 4.09 % 60,436 1,460 2.42 % Long-term debt 30,477 3,090 10.14 % 31,474 3,113 9.89 % 40,900 3,451 8.44 % Total interest bearing liabilities 1,582,591 9,166 0.58 % 1,488,939 12,951 0.87 % 1,456,866 15,307 1.05 % Non-interest bearing liabilities Non-interest bearing demand deposits 404,113 341,534 277,310 Accrued interest payable and other liabilities 26,057 42,943 45,795 Total liabilities 2,012,761 1,873,416 1,779,971 Stockholders' equity 220,107 197,551 179,638 Total liabilities and stockholders' equity $ 2,232,868 $ 2,070,967 $ 1,959,609 Net interest income $ 78,306 $ 75,653 $ 72,262 Net interest spread 3.59 % 3.74 % 3.79 % Net interest margin 3.74 % 3.94 % 3.99 % Notes: † † Yields on municipal securities have been computed on a fully tax-equivalent basis using the federal income tax rate of 35%.
† † The approximate tax-equivalent adjustments to interest income were $1,008,000, $1,703,000 and $1,530,000 for the years ended December 31, 2013, 2012 and 2011, respectively.
† † Average balances for loans include the principal balance of non-accrual loans and exclude participation loans accounted for as secured borrowings.
† † Loan interest income includes loan fees and is computed on a fully tax-equivalent basis using the federal income tax rate of 35%. Loan fees, net of deferred costs, included in interest income amounted to $1,390,000, $1,916,000 and $585,000 in 2013, 2012 and 2011, respectively. For 2012, $1,060,000 of the loans fees represented the prepayment penalty on a tax-equivalent basis of one loan payoff.
28 -------------------------------------------------------------------------------- Table of Contents Securities The primary purpose of the securities portfolio is to provide another source of interest income, as well as liquidity management. In managing the composition of the balance sheet, Bancorp seeks a balance between earnings sources and credit and liquidity considerations.
Securities available for sale include securities that may be sold in response to changes in interest rates, resultant prepayment risk and other factors related to interest rate and prepayment risk changes. Securities available for sale are carried at fair value with unrealized gains or losses, net of tax effect, included in stockholders' equity.
The carrying value of securities available for sale is summarized as follows: December 31 (In thousands) 2013 2012 U.S. Treasury and other U.S. government obligations $ 110,000 $ 98,000 Government sponsored enterprise obligations 137,845 85,748 Mortgage-backed securities - government agencies 172,693 140,881 Obligations of states and political subdivisions 69,493 60,793 Trust preferred securities of financial institutions - 1,018 $ 490,031 $ 386,440 There were no securities held to maturity as of December 30, 2013, 2012 or 2011.
The maturity distribution and weighted average interest rates of securities available for sale at December 31, 2013, are as follows: After one but within After five but within Within one year five years ten years After ten years(Dollars in thousands) Amount Rate Amount Rate Amount Rate Amount Rate U.S. Treasury and other U.S. government obligations $ 110,000 -0.01 % $ - - $ - - $ - - Government sponsored enterprise obligations 36 - 95,742 1.80 % 10,611 1.65 % 31,456 2.35 % Mortgage-backed securities - government agencies 70 - 524 1.74 % 29,543 1.82 % 142,556 2.51 % Obligations of states and political subdivisions 10,448 1.58 % 33,956 1.63 % 25,089 2.94 % - - $ 120,554 0.12 % $ 130,222 1.75 % $ 65,243 2.22 % $ 174,012 2.48 % The $110 million of U.S. Treasury securities consisted of short-term treasury bills, which matured in January 2014, purchased over year-end as a tax strategy. Tax savings exceeded lost principal generated by negative yield on these securities.
29 -------------------------------------------------------------------------------- Table of Contents Loan Portfolio Bancorp's primary source of income is interest on loans. The composition of loans as of the end of the last five years follows: December 31 (In thousands) 2013 2012 2011 2010 2009 Commercial and industrial $ 510,739 $ 426,930 $ 393,729 $ 343,956 $ 336,889 Construction and development, excluding undeveloped land 91,719 85,456 116,622 131,346 190,622 Undeveloped land (1) 37,871 45,797 31,015 28,136 14,031 Real estate mortgage: Commercial investment 430,047 414,084 399,655 343,163 326,421 Owner occupied commercial 329,422 304,114 297,121 336,032 230,001 1-4 family residential 183,700 166,280 154,565 157,983 147,342 Home equity - first lien 40,251 39,363 38,637 39,449 41,644 Home equity - junior lien 63,403 65,790 76,687 91,813 108,398 Subtotal: Real estate mortgage 1,046,823 989,631 966,665 968,440 853,806 Consumer 34,198 36,780 36,814 36,547 40,114 $ 1,721,350 $ 1,584,594 $ 1,544,845 $ 1,508,425 $ 1,435,462 -------------------------------------------------------------------------------- (1) Undeveloped land consists of land initially acquired for development by the borrower, but for which no development has taken place.
In the fourth quarter of 2013, as a result of analyses of non-performing loan metrics, Bancorp expanded the classifications for loans to include undeveloped land, which was previously recorded within construction and development loans.
The increases in the commercial and industrial and commercial real estate categories are the result of a consistent relationship-driven business strategy to serve existing and new clients in Bancorp's local markets. The decrease in the construction and development category since 2009 reflects migration of loan types as project completions resulted in permanent financing. Bancorp's focus has not been on housing and commercial construction lending, as both are sources of increased credit risk in the current environment.
Junior lien home equity loans, which comprise 4% of the loan portfolio at December 31, 2013, are typically underwritten with consideration of the borrower's overall financial strength as a primary payment source, with some reliance on the value of the collateral. The overall level of home equity junior liens as a percentage of the overall portfolio and the level of related outstanding commitments have been declining over the last several years. Demand has declined as consumers push to refinance entire debt into first-lien position loans at historic low rates. Bancorp continues to aggressively market this product.
Bancorp occasionally enters into loan participation agreements with other banks to diversify credit risk. For certain sold participation loans, Bancorp has retained effective control of the loans, typically by restricting the participating institutions from pledging or selling their share of the loan without permission from Bancorp. US GAAP requires the participated portion of these loans to be recorded as secured borrowings. These participated loans are included in the commercial and industrial and real estate mortgage loan totals above, and a corresponding liability is recorded in other liabilities. At December 31, 2013 and 2012, the total participated portions of loans of this nature were $9.4 million and $7.7 million respectively.
30 -------------------------------------------------------------------------------- Table of Contents The following tables detail the amounts of commercial and industrial loans, and construction and development loans, including undeveloped land, at December 31, 2013 which, based on remaining scheduled repayments of principal, are due in the periods indicated. Also shown are the commercial and industrial loans due after one year classified according to sensitivity to changes in interest rates.
Maturing After one but (In thousands) Within one year within five years After five years Total Commercial and industrial $ 194,697 $ 233,449 $ 82,593 $ 510,739 Construction and development including undeveloped land 49,124 49,837 30,629 129,590 Interest SensitivityCommercial and industrial loans Fixed rate Variable rate (In thousands) Due after one but within five years $ 173,323 $ 60,126 Due after five years 67,572 15,021 $ 240,895 $ 75,147 Non-performing Loans and Assets Information summarizing non-performing assets, including non-accrual loans follows: December 31 (Dollars in thousands) 2013 2012 2011 2010 2009 Non-accrual loans $ 15,258 $ 18,360 $ 18,737 $ 14,388 $ 10,455 Troubled debt restructuring 7,249 10,969 3,402 2,882 753 Loans past due 90 days or more and still accruing 437 719 1,160 2,044 893 Non-performing loans 22,944 30,048 23,299 19,314 12,101 Foreclosed property 5,592 7,364 7,773 5,445 1,616 Non-performing assets $ 28,536 $ 37,412 $ 31,072 $ 24,759 $ 13,717 Non-performing loans as a percentage of total loans 1.33 % 1.90 % 1.51 % 1.28 % 0.84 % Non-performing assets as a percentage of total assets 1.19 % 1.74 % 1.51 % 1.30 % 0.77 % Allowance for loan loss as a percentage of non- performing loans 124 % 106 % 128 % 132 % 165 % At December 31, 2013, loans accounted for as TDR included those for which there had been modifications from original terms due to bankruptcy proceedings, modifications of amortization periods or temporary suspension of principal payments due to customer financial difficulties, and limited forgiveness of principal. To the extent that Bancorp chooses to work with borrowers by providing reasonable concessions, rather than initiating collection, this would result in an increase in loans accounted for as TDR. The decrease in TDRs 31 -------------------------------------------------------------------------------- Table of Contents from 2012 to 2013 is primarily due to two loans secured by commercial real estate totaling $2.9 million which experienced foreclosure and moved to OREO during 2013. Loans accounted for as TDR, which have not defaulted, are individually evaluated for impairment and at December 31, 2013, had a total allowance allocation of $942,000, compared to $295,000 at December 31, 2012.
The following table sets forth the major classifications of non-accrual loans: Non-accrual loans by type December 31, 2013 December 31, 2012 (in thousands) Commercial and industrial $ 846 $ 1,554 Construction and development, excluding undeveloped land 26 551 Undeveloped land 7,340 10,312 Real estate mortgage - commercial investment 1,921 2,077 Real estate mortgage - owner occupied commercial 2,582 1,529 Real estate mortgage - 1-4 family residential 2,391 2,278 Home equity 152 55 Consumer - 4 Total $ 15,258 $ 18,360 Bancorp has two relationships, both in its primary market, who account for $7.9 million or 52% of total non-accrual loans at December 31, 2013. Each of these loans is secured predominantly by commercial or residential real estate, and management estimates minimal loss exposure after consideration of collateral.
The remaining balance of non-accrual loans, totaling $7.4 million, is comprised of a larger number of borrowers with smaller balances. Each non-accrual loan is individually evaluated for impairment in conjunction with the overall allowance methodology.
Loans are placed in a non-accrual income status when the prospects for recovering both principal and accrued interest are considered doubtful or when a default of principal or interest has existed for 90 days or more unless such a loan is well secured and in the process of collection. Interest income recorded on non-accrual loans was $185,000, $157,000, and $391,000 for 2013, 2012, and 2011, respectively. Interest income that would have been recorded if non-accrual loans were on a current basis in accordance with their original terms was $1,248,000, $1,167,000, and $1,104,000 for 2013, 2012, and 2011, respectively.
In addition to the non-performing loans discussed above, there were loans, which are accruing interest, for which payments were current or less than 90 days past due where borrowers are experiencing significant financial difficulties. These potential problem loans totaled approximately $22,262,000, $38,957,000, and $46,148,000 at December 31, 2013, 2012, and 2011, respectively. These relationships are monitored closely for possible future inclusion in non-performing loans. Management believes it has adequately reflected the exposure in these loans in its determination of the allowance for loan losses.
Non-performing assets as a percentage of total assets decreased 55 basis points from 2012 to 2013, reflecting decreases in non-accrual loans, loans classified as troubled debt restructuring, and foreclosed property. At December 31, 2013 and December 31, 2012, the carrying value of other real estate owned was $5.6 million and $7.4 million, respectively. In 2013, Bancorp recorded impairment charges totaling $904,000, compared to $1,479,000 in 2012 and $1,737,000 in 2011.
32 -------------------------------------------------------------------------------- Table of Contents Allowance for Loan Losses An allowance for loan losses has been established to provide for probable losses on loans that may not be fully repaid. The allowance for loan losses is increased by provisions charged to expense and decreased by charge-offs, net of recoveries. Loans are typically charged off when management deems them uncollectible and after underlying collateral has been liquidated; however, collection efforts continue and future recoveries may occur. Periodically, loans are partially charged off to the net realizable value based upon evaluation of related collateral, including Bancorp's bias for resolution.
Bancorp's lending policies and procedures center on controlling credit risk and include procedures to identify and measure this risk. These procedures begin with lenders assigning a risk rating to each of their credits, and this rating is confirmed in the loan approval process. Internal loan review, through a year-round process of examining individually significant obligor relationships as well as a sample of each lender's portfolio, tests the reliability of these risk assessments. Additionally, a review of this process is an integral part of regulatory bank examinations.
Adversely rated credits are included on a loan watch list. This list also includes loans requiring closer monitoring due to borrower's circumstances.
However, these loans have generally not reached a level of adversity which would cause them to be criticized credits by regulators. Loans are added to the watch list when circumstances are detected which might affect the borrower's ability to comply with terms of the loan. This could include any of the following: † Delinquency of a scheduled loan payment, † † Severe deterioration in the borrower's or guarantor's financial condition identified in a review of periodic financial statements, † † Decrease in the value of collateral securing the loan, or † † Change in the economic environment in which the borrower operates.
Loans on the watch list require detailed status reports, including recommended corrective actions, prepared periodically by the responsible loan officer. These reports are reviewed by management. The watch list is also discussed in quarterly meetings with Bancorp's Executive Loan Committee.
Changes in loan risk ratings are typically initiated by the responsible loan officer, but may also be initiated by internal loan review or Bancorp's Loan Committees at any time.
In determining the allowance and related provision for loan losses, these principal elements are considered: † Specific allocations are based upon probable losses on individually evaluated impaired loans. These loans are measured based on the present value of future cash flows discounted at the loans' effective interest rate or at the estimated fair value of the loans' collateral, if applicable. Other objective factors such as payment history and financial condition of the borrower or guarantor may be used as well.
† † Allocations for individually significant loans not defined as impaired are based on estimates needed for pools of loans with similar risk based upon Bancorp's historical net loss percentages by loan type.
† † Additional allowance allocations based on subjective factors not necessarily associated with a specific credit or loan category and represent management's effort to ensure that the overall allowance for loan losses appropriately reflects a margin for the imprecision necessarily inherent in the estimates of credit losses. Management considers a number of subjective factors, including local and general economic business factors and trends and portfolio concentrations.
Based on this quantitative and qualitative analysis, provisions are made to the allowance for loan losses. Such provisions are reflected as a charge against current earnings in Bancorp's consolidated statements of income.
The allocation of the allowance for loan losses by loan category is a result of the analysis above. The same procedures used to determine requirements for the allowance for loan losses establish the distribution of the allowance by loan category. The distribution of the allowance will change from period to period due to changes in the identified risk in each loan in the portfolio, changes in the aggregate loan balances by loan 33 -------------------------------------------------------------------------------- Table of Contents category, and changes in management's view of the subjective factors noted above. Although the allowance for loan losses is comprised of specific and general allocations the entire allowance is available to absorb any credit losses.
Historical net loss percentages are updated quarterly based on actual losses experienced by each loan type. The reallocations among different categories of loans between periods are the result of the redistribution of the individual loans that comprise the aggregate portfolio as described above. However, the perception of risk with respect to particular loans within the portfolio will change over time as a result of the characteristics and performance of those loans, overall economic and market trends, and the actual and expected trends in non-performing loans.
Prior to September 30, 2013, Bancorp utilized the sum of all allowance amounts derived as described above, including a reasonable unallocated allowance, as an indicator of the appropriate level of allowance for loan and lease losses.
During the third quarter of 2013, Bancorp refined its allowance calculation whereby it "allocated" the portion of the allowance that was previously deemed to be unallocated allowance based on management's determination of the appropriate qualitative adjustment. This refined allowance calculation includes specific allowance allocations to loan portfolio segments at December 31, 2013 for qualitative factors including, among other factors, (i) national and local economic and business conditions, (ii) the quality and experience of lending staff and management, (iii) changes in lending policies and procedures, (iv) changes in volume and severity of past due loans, classified loans and non-performing loans, (v) potential impact of any concentrations of credit, (vi) changes in the nature and terms of loans such as growth rates and utilization rates, (vii) changes in the value of underlying collateral for collateral-dependent loans, considering Bancorp's disposition bias, and (viii) the effect of other external factors such as the legal and regulatory environment. Bancorp may also consider other qualitative factors in future periods for additional allowance allocations, including, among other factors, changes in Bancorp's loan review process. Changes in the criteria used in this evaluation or the availability of new information could cause the allowance to be increased or decreased in future periods. In addition, bank regulatory agencies, as part of their examination process, may require adjustments to the allowance for loan and lease losses based on their judgments and estimates.
The adequacy of the allowance for loan losses is monitored by the internal loan review staff and reported quarterly to the Executive Loan Committee and the Audit Committee of the Board of Directors. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the adequacy of Bancorp's allowance for loan losses. Such agencies may require Bancorp to make additional provisions to the allowance based upon their judgments about information available to them at the time of their examinations.
Management believes that the allowance for loan losses is adequate to absorb probable inherent losses on existing loans that may become uncollectible. See "Provision for Loan Losses" for further discussion of the allowance for loan losses.
34 -------------------------------------------------------------------------------- Table of Contents Summary of Loan Loss Experience The following table summarizes average loans outstanding, changes in the allowance for loan losses arising from loans charged off and recoveries on loans previously charged off by loan category and additions to the allowance charged to expense.
Year ended December 31 (Dollars in thousands) 2013 2012 2011 2010 2009 Average Loans $ 1,656,777 $ 1,563,918 $ 1,529,556 $ 1,469,116 $ 1,391,644 Balance of allowance for loan losses at beginning of year $ 31,881 $ 29,745 $ 25,543 $ 20,000 $ 15,381 Loans charged off Commercial and industrial 457 4,523 1,015 1,418 4,904 Construction and development excluding undeveloped land 25 149 1,502 1,461 273 Undeveloped land 7,961 1,577 600 750 1,100 Real estate mortgage 2,758 3,451 5,331 2,450 1,765 Consumer 763 798 673 687 1,075 Total loans charged off 11,964 10,498 9,121 6,766 9,117 Recoveries of loans previously charged off Commercial and industrial 569 84 108 115 57 Construction and development excluding undeveloped land 163 - - 26 2 Undeveloped land 81 - - - - Real estate mortgage 584 249 158 163 392 Consumer 658 801 457 536 510 Total recoveries 2,055 1,134 723 840 961 Net loans charged off 9,909 9,364 8,398 5,926 8,156 Additions to allowance charged to expense 6,550 11,500 12,600 11,469 12,775 Balance at end of year $ 28,522 $ 31,881 $ 29,745 $ 25,543 $ 20,000 Ratio of net charge-offs during year to average loans 0.60 % 0.60 % 0.55 % 0.40 % 0.59 % See "Provision for Loan Losses" for discussion of the provision for loan losses and 2013 charge-offs.
35 -------------------------------------------------------------------------------- Table of Contents The following table sets forth the allocation of the allowance for loan losses for the loan categories shown. Although specific allocations exist, the entire allowance is available to absorb losses in any particular loan category.
December 31 (In thousands) 2013 2012 2011 2010 2009 Commercial and industrial $ 7,644 $ 5,949 $ 7,364 $ 2,796 $ 4,091 Construction and development excluding undeveloped land 2,555 1,638 3,536 3,630 1,098 Undeveloped land 5,376 2,898 10 - 420 Real estate mortgage 12,604 14,288 11,182 12,203 6,513 Consumer 343 362 540 623 947 Unallocated - 6,746 7,113 6,291 6,931 $ 28,522 $ 31,881 $ 29,745 $ 25,543 $ 20,000 Changes in the allocation of the allowance from year to year in various categories are influenced by the level of net charge-offs in the respective categories and other factors including, but not limited to, an evaluation of the impact of current economic conditions and trends, risk allocations tied to specific loans or groups of loans and changes in qualitative allocations.
Management believes that allocations for each loan category are reflective of the risk inherent in the portfolio.
Selected ratios relating to the allowance for loan losses follow: Years ended December 31 2013 2012 2011 Provision for loan losses to average loans 0.40 % 0.74 % 0.82 % Net charge-offs to average loans 0.60 % 0.60 % 0.55 % Allowance for loan losses to average loans 1.72 % 2.04 % 1.94 % Allowance for loan losses to year end loans 1.66 % 2.01 % 1.93 % Deposits Bancorp's core deposits consist of non-interest and interest bearing demand deposits, savings deposits, certificates of deposit under $250,000 and IRAs.
These deposits, along with other borrowed funds, are used by Bancorp to support its asset base. By adjusting rates offered to depositors, Bancorp is able to influence the amounts of deposits needed to meet its funding requirements.
Average amounts of deposits in Bancorp and average rates paid on such deposits for the years indicated are summarized as follows: Years ended December 31 2013 2012 2011 Average Average Average Average Average Average (Dollars in thousands) balance rate balance rate balance rate Non-interest bearing demand deposits $ 404,113 - $ 341,534 - $ 277,310 - Interest bearing demand deposits 392,939 0.10 % 317,017 0.16 % 281,566 0.21 % Savings deposits 96,515 0.04 % 78,640 0.08 % 70,290 0.16 % Money market deposits 585,512 0.21 % 539,395 0.33 % 501,792 0.52 % Time deposits 364,347 0.92 % 383,008 1.25 % 418,750 1.62 % $ 1,843,426 $ 1,659,594 $ 1,549,708 36 -------------------------------------------------------------------------------- Table of Contents Maturities of time deposits of $250,000 or more outstanding at December 31, 2013, are summarized as follows: (In thousands) Amount 3 months or less $ 8,634 Over 3 through 6 months 4,860 Over 6 through 12 months 9,959 Over 12 months 17,151 $ 40,604 Securities Sold Under Agreement to Repurchase Securities sold under agreements to repurchase represent excess funds from commercial customers as part of a cash management service. These agreements generally have maturities of one business day from the transaction date.
Bancorp considers these core fundings since they represent excess cash balances of full relationship business customers.
Information regarding securities sold under agreements to repurchase follows: Years ended December 31 2013 2012 2011 (Dollars in thousands) Amount Rate Amount Rate Amount Rate Securities sold under agreements to repurchase Year end $ 62,615 0.23 % $ 59,045 0.28 % $ 66,026 0.30 % Average during year 60,737 0.24 % 59,861 0.30 % 61,595 0.41 % Maximum month end balance during year $ 68,383 $ 64,582 $ 69,818 Subordinated Debentures Subordinated debentures are classified as long term debt. In light of pressures on the economy and uncertainties in the banking industry, S.Y. Bancorp further strengthened its balance sheet during 2008 with the sale of $30,000,000 of 10% cumulative trust preferred securities in an over-subscribed public offering.
The trust preferred securities, which qualified as Tier 1 capital, were callable by Bancorp on or after December 31, 2013. On December 31, 2013, Bancorp redeemed these securities at par value. Remaining unamortized issuance costs of $1,306,000 were recognized as non-interest expense in the fourth quarter of 2013.
Also in 2008, Bancorp issued $10 million of subordinated debt, with a 10 year maturity, and a call option to Bancorp two years after issuance. In 2012, Bancorp exercised its call option and prepaid the subordinated debt without penalty. See Note 12 to Bancorp's consolidated financial statements for further information regarding subordinated debentures.
Liquidity The role of liquidity management is to ensure funds are available to meet depositors' withdrawal and borrowers' credit demands while at the same time maximizing profitability. This is accomplished by balancing changes in demand for funds with changes in the supply of those funds. Liquidity is provided by short-term liquid assets that can be converted to cash, investment securities available for sale, various lines of credit available to Bancorp, and ability to attract funds from external sources, principally deposits.
37 -------------------------------------------------------------------------------- Table of Contents Management believes it has the ability to increase deposits at any time by offering rates slightly higher than market rates.
Bancorp's Asset/Liability Committee is primarily made up of senior management and has direct oversight responsibility for Bancorp's liquidity position and profile. A combination of daily, weekly and monthly reports provided to management detail the following: internal liquidity metrics, composition and level of the liquid asset portfolio, timing differences in short-term cash flow obligations, and exposure to contingent draws on Bancorp's liquidity.
Bancorp's most liquid assets are comprised of cash and due from banks, available for sale marketable investment securities and federal funds sold. Federal funds sold totaled $36.3 million at December 31, 2013. These investments normally have overnight maturities and are used for general daily liquidity purposes. The fair value of the available for sale investment portfolio was $490.0 million at December 31, 2013. The portfolio includes maturities of approximately $120.2 million over the next twelve months, including $110 million of short-term securities which matured in January 2014. Combined with federal funds sold, these offer substantial resources to meet either new loan demand or reductions in Bancorp's deposit funding base. Bancorp pledges portions of its investment securities portfolio to secure public fund deposits, cash balances of certain investment management and trust accounts, and securities sold under agreements to repurchase. At December 31, 2013, total investment securities pledged for these purposes comprised 50% of the available for sale investment portfolio, leaving $246.6 million of unpledged securities.
Bancorp has a large base of core customer deposits, defined as demand, savings, and money market deposit accounts. At December 31, 2013, such deposits totaled $1.631 billion and represented 82% of Bancorp's total deposits. Because these core deposits are less volatile and are often tied to other products of Bancorp through long lasting relationships they do not put heavy pressure on liquidity.
However, many of Bancorp's overall deposit balances are historically high. When market conditions improve, these balances will likely decrease, putting some strain on Bancorp's liquidity position. As of December 31, 2013, Bancorp had only $4.3 million or 0.2% of total deposits, in brokered deposits, which are predominantly comprised of Certificate of Deposit Account Registry Service (CDARs) deposits, a program which allows Bancorp to offer FDIC insurance up to $50 million in deposits per customer through reciprocal agreements with other network participating banks.
Other sources of funds available to meet daily needs include the sales of securities under agreements to repurchase. Also, Bancorp is a member of the FHLB of Cincinnati. As a member of the FHLB, Bancorp has access to credit products of the FHLB. Bancorp views these borrowings as a low cost alternative to other time deposits. At December 31, 2013, the amount of available credit from the FHLB totaled $361 million. See Note 11 to Bancorp's consolidated financial statements for further information regarding advances from the Federal Home Loan Bank. Also, Bancorp has available federal funds purchased lines with correspondent banks totaling $45 million. Bancorp also is eligible to borrow from the Federal Reserve Bank of St. Louis based upon value of posted collateral.
Over the normal course of business, Bancorp enters into certain forms of off-balance sheet transactions, including unfunded loan commitments and letters of credit. These transactions are managed through Bancorp's various risk management processes. Management considers both on-balance sheet and off-balance sheet transactions in its evaluation of Bancorp's liquidity.
Sources and Uses of Cash Cash flow is provided primarily through financing activities of Bancorp which include raising deposits and borrowing of funds from institutional sources such as advances from FHLB and fed funds purchased as well as scheduled loan repayments. These funds are then primarily used to facilitate investment activities of Bancorp which include making loans and purchasing securities for the investment portfolio. Another important source of cash is from the net income of the Bank from operating activities. As discussed in Note 17 to Bancorp's consolidated financial statements, as of January 1 of any year the Bank may pay dividends in an amount equal to the Bank's net income of the prior two years less any dividends paid for the same two years. Regulatory approval is required for dividends exceeding these amounts. Prior to declaration of dividends, management considers the effect such payments will have on total stockholders' equity and capital 38 -------------------------------------------------------------------------------- Table of Contents ratios. For more specific information, see the consolidated statement of cash flows in Bancorp's consolidated financial statements.
Commitments In the normal course of business, Bancorp is party to activities that contain credit, market and operational risk that are not reflected in whole or in part in Bancorp's consolidated financial statements. Such activities include: traditional off-balance sheet credit-related financial instruments, commitments under operating leases and long-term debt.
Bancorp provides customers with off-balance sheet credit support through loan commitments and standby letters of credit. Summarized credit-related financial instruments, including both commitments to extend credit and letters of credit at December 31, 2013 are as follows: Amount of commitment expiration per period Less than 1-3 3-5 Over 5 (In thousands) Total 1 year Years Years Years Unused loan commitments $ 454,290 $ 289,509 $ 72,816 $ 58,023 $ 33,942 Standby letters of credit 15,224 12,664 2,509 51 - Since some of the unused commitments are expected to expire or may not be fully used, the total amount of commitments in the preceding table does not necessarily represent future cash requirements.
In addition to owned banking facilities, Bancorp has entered into long-term leasing arrangements for certain branch facilities. Bancorp also has required future payments for a defined benefit retirement plan, long-term debt and the maturity of time deposits. In 2009, Bancorp executed an agreement to acquire marketing rights for a sports and entertainment venue. Bancorp receives revenue from the relationship which offsets a portion of the expenses over the term of the agreement. See Note 11, Note 15 and Note 18 to Bancorp's consolidated financial statements for further information on Federal Home Loan Bank advances, the defined benefit retirement plan and operating leases.
Required payments under such commitments at December 31, 2013 are as follows: Payments due by period Less than 1-3 3-5 Over 5 (In thousands) Total 1 year Years Years Years Operating leases $ 8,628 $ 1,594 $ 2,591 $ 2,190 $ 2,253 Defined benefit retirement plan 3,866 84 168 168 3,446 Time deposit maturities 349,958 228,459 101,842 19,657 - Federal Home Loan Bank advances 34,329 10,179 20,340 353 3,457 Other 2,400 400 800 800 400 Capital Information pertaining to Bancorp's capital balances and ratios follows: Years ended December 31 (Dollars in thousands, except share data) 2013 2012 2011 Stockholders' equity $ 229,444 $ 205,075 $ 187,686 Dividends per share 0.81 0.77 0.72 Tier 1 risk-based capital 12.29 % 13.17 % 12.77 % Total risk-based capital 13.54 % 14.42 % 14.63 % Leverage ratio 9.75 % 10.79 % 10.53 % 39 -------------------------------------------------------------------------------- Table of Contents Since 2008, Bancorp has had no share buyback plan, choosing instead to continue to grow its capital in the face of uncertain economic times and regulatory environment. S.Y. Bancorp increased its cash payout to stockholders during 2013 to an annual dividend of $0.81, up from $0.77 per share in 2012. This represents a payout ratio of 42.41% based on basic EPS and an annual yield of 2.63% based upon an annualized fourth quarter dividend rate and year-end closing stock price.
Bank holding companies and their subsidiary banks are required by regulators to meet risk-based capital standards. These standards, or ratios, measure the relationship of capital to a combination of balance sheet and off-balance sheet risks. The value of both balance sheet and off-balance sheet items are adjusted to reflect credit risks. Bancorp issued $12.2 million of common stock during 2013 for the Oldham transaction. On December 31, 2013, Bancorp redeemed at par all of its 10% fixed-rate cumulative trust preferred securities, or $30 million. The redemption caused capital ratios to fall somewhat at December 31, 2013, compared with those of December 31, 2012, but all ratios remain well above regulatory thresholds. The increase in Tier 1 risk-based and leverage capital ratios from 2011 to 2012 resulted largely from the growth of retained earnings.
The total risk-based capital ratio declined slightly from 2011 to 2012, as a result of Bancorp's first quarter 2012 prepayment of $10 million of subordinated debentures that qualified as Tier 2 capital. See Note 12 to Bancorp's consolidated financial statements for more detail regarding the subordinated debenture component of capital. Note 22 to the consolidated financial statements provides more details of regulatory capital requirements, as well as capital ratios of Bancorp and the Bank. Bancorp and the Bank exceed regulatory capital ratios required to be well capitalized. Management considers the effects of growth on capital ratios as it contemplates plans for expansion.
One component of equity is accumulated other comprehensive income (loss) which, for Bancorp, consists of net unrealized gains or losses on securities available for sale and a minimum pension liability, both net of taxes. Accumulated other comprehensive (loss) income was ($2,217,000) and $5,421,000 at December 31, 2013 and 2012, respectively. The $7,638,000 decrease is primarily a reflection of the effect of the changing interest rate environment during fiscal year 2013 on the valuation of Bancorp's portfolio of securities available for sale.
The following table presents various key financial ratios: Years ended December 31 2013 2012 2011 Return on average assets 1.22 % 1.25 % 1.20 % Return on average stockholders' equity 12.34 % 13.06 % 13.14 % Dividend payout ratio, based on basic EPS 42.41 % 41.40 % 42.11 % Average stockholders' equity to average assets 9.86 % 9.54 % 9.17 % Fair Value Measurements Bancorp follows the provisions of authoritative guidance for fair value measurements. This guidance is definitional and disclosure oriented and addresses how companies should approach measuring fair value when required by US GAAP. It prescribes various disclosures about financial statement categories and amounts which are measured at fair value, if such disclosures are not already specified elsewhere in US GAAP.
Authoritative guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between participants at the measurement date. The guidance, which requires fair value measurements to be classified as Level 1 (quoted prices), Level 2 (based on observable inputs) or Level 3 (based on unobservable, internally-derived inputs), is discussed in more detail in Note 19 to the consolidated financial statements.
40 -------------------------------------------------------------------------------- Table of Contents Bancorp's investment securities available for sale and interest rate swaps are recorded at fair value on a recurring basis. Other accounts including mortgage loans held for sale, mortgage servicing rights, impaired loans and other real estate owned may be recorded at fair value on a non-recurring basis, generally in the application of lower of cost or market adjustments or write-downs of specific assets.
The portfolio of investment securities available for sale is comprised of U.S.
Treasury and other U.S government obligations, debt securities of U.S.
government-sponsored corporations, mortgage-backed securities and obligations of state and political subdivisions. Trust preferred securities are priced using quoted prices of identical securities in an active market. These measurements are classified as Level 1 in the hierarchy above. All other securities are priced using standard industry models or matrices with various assumptions such as yield curves, volatility, prepayment speeds, default rates, time value, credit rating and market prices for the instruments. These assumptions are generally observable in the market place and can be derived from or supported by observable data. These measurements are classified as Level 2 in the hierarchy above.
Interest rate swaps are valued using primarily Level 2 inputs. Fair value measurements are obtained from an outside pricing service. Prices obtained are generally based on dealer quotes, benchmark forward yield curves, and other relevant observable market data. For purposes of potential valuation adjustments to derivative positions, Bancorp evaluates the credit risk of its counterparties as well as its own credit risk. To date, Bancorp has not realized any losses due to a counterparty's inability to perform and the change in value of derivative assets and liabilities attributable to credit risk was not significant during 2013.
Mortgage loans held for sale are recorded at the lower of cost or market value.
The portfolio is comprised of residential real estate loans and fair value is based on specific prices of underlying contracts for sales to investors. These measurements are classified as Level 2.
MSRs, carried in other assets, are recorded at fair value upon capitalization, are amortized to correspond with estimated servicing income, and are periodically assessed for impairment based on fair value at the reporting date.
Fair value is based on a valuation model that calculates the present value of estimated net servicing income. The model incorporates assumptions that market participants would use in estimating future net servicing income. These measurements are classified as Level 3. At December 31, 2013 and 2012 there was no valuation allowance for MSRs, as fair value exceeded carrying value.
Other real estate owned, which is carried in other assets at the lower of cost or fair value, is periodically assessed for impairment based on fair value at the reporting date. Fair value is determined from external appraisals using judgments and estimates of external professionals. Many of these inputs are not observable and, accordingly, these measurements are classified as Level 3. At December 31, 2013 and December 31, 2012, the carrying value of other real estate owned was $5,590,000 and $7,364,000, respectively.
Loans are measured for impairment and, if indicated, a specific allocation is established based on the value of underlying collateral. Impaired loans include non-accrual loans and loans accounted for as troubled debt restructuring. For impaired loans, fair value is calculated as the carrying value of loans with a specific valuation allowance, less the specific allowance. At December 31, 2013 and December 31, 2012, carrying value of impaired loans was $9,129,000 and $11,625,000, respectively. These measurements are classified as Level 3.
See Note 19 to Bancorp's consolidated financial statements for details of fair value measurements.
Non-GAAP Financial Measures In addition to capital ratios defined by banking regulators, Bancorp considers various ratios when evaluating capital adequacy, including tangible common equity to tangible assets, and tangible common equity per share, all of which are non-GAAP measures. Bancorp believes these ratios are important because of their widespread use by investors as means to evaluate capital adequacy, as they reflect the level of capital 41 -------------------------------------------------------------------------------- Table of Contents available to withstand unexpected market conditions. Because US GAAP does not include capital ratio measures, there are no US GAAP financial measures comparable to these ratios.
The following table reconciles Bancorp's calculation of the measures to amounts reported under US GAAP.
December 31, (in thousands, except per share data) 2013 2012 Total equity $ 229,444 $ 205,075 Less core deposit intangible (2,151 ) - Less goodwill (682 ) (682 ) Tangible common equity $ 226,611 $ 204,393 Total assets $ 2,389,262 $ 2,148,262 Less core deposit intangible (2,151 ) - Less goodwill (682 ) (682 ) Total tangible assets $ 2,386,429 $ 2,147,580 Total shareholders' equity to total assets 9.60 % 9.55 % Tangible common equity ratio 9.50 % 9.52 % Number of outstanding shares 14,609 13,915 Book value per share $ 15.71 $ 14.74 Tangible common equity per share 15.51 14.69 The following table provides a reconciliation of net interest margin in accordance with US GAAP to normalized net interest margin. Bancorp provides this information to illustrate the trend in net interest margin sequentially from 2011 through 2013 and to show the impact of prepayment fees and late charges on net interest margin.
Reconciliation of Net Interest Margin to Normalized 2013 2012 2011 Net interest margin 3.74 % 3.94 % 3.99 % Prepayment penalties / late charges (0.08 ) (0.06 ) 0.02 Normalized net interest margin 3.66 % 3.88 % 4.01 % The following table provides a reconciliation of net income and earnings per diluted share to adjusted net income and adjusted earnings per diluted share, both non-GAAP measures. Bancorp provides non-GAAP earnings information to improve the comparability of its results and provide additional insight into the strength of Bancorp's operations.
42 -------------------------------------------------------------------------------- Table of Contents Reconciliation of Net Income and Earnings per share (amounts in thousands, net of tax) 2013 2012 2011 Net income as reported $ 27,170 $ 25,801 $ 23,604 Write-off of debt issuance costs 835 - - Acquisition costs, net of gain on acquisition 613 - - Other (331 ) - - Adjusted net income $ 28,287 $ 25,801 $ 23,604 2013 2012 2011Earnings per diluted share, as reported $ 1.89 $ 1.85 $ 1.71 Write-off of debt issuance costs 0.06 - - Acquisition costs, net of gain on acquisition 0.04 - - Other (0.02 ) - - Adjusted earnings per diluted share $ 1.97 $ 1.85 $ 1.71 Recently Issued Accounting Pronouncements In February 2013, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income, which requires entities to disclose additional information about items reclassified out of accumulated other comprehensive income (AOCI). The ASU requires disclosures of changes of AOCI balances by component in the financial statements or the footnotes, and it requires significant items reclassified out of AOCI to be disclosed on the face of the income statement or as a separate footnote. The ASU is effective for fiscal years and interim periods beginning after December 15, 2012. The adoption of ASU 2013-02 did not have an impact on Bancorp's financial statements.
In January 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-01, Investments - Equity Method and Joint Ventures - Accounting for Investments in Qualified Affordable Housing Projects, which allows investors in qualified affordable housing projects through limited liability entities that meet specified conditions to recognize the amortization of the investments as a component of income tax expense. Under the proportional amortization method, as defined in the ASU, the cost of the investments will be amortized in proportion to (and over the same period as) the total expected tax benefits, including the tax credits and other tax benefits, as they are realized on the tax return. The ASU is required to be applied retrospectively, for those investors electing the proportional amortization method. However, if an investor uses the effective yield method to account for its investments in qualified affordable housing projects, it may continue to apply the effective yield method for those preexisting investments. The ASU is effective for annual and interim periods beginning after December 15, 2014.
Because Bancorp accounts for its investments in affordable housing projects under the effective yield method, the adoption of ASU 2014-01 is not expected to have a material impact on Bancorp's operations or financial statements.
In January 2014, the FASB issued ASU No. 2014-04, Receivables-Troubled Debt Restructurings by Creditor, which clarifies in-substance foreclosures by defining when a creditor should be considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan. The ASU also requires disclosure of amount of foreclosed residential real estate properties and of the recorded investment in consumer mortgage loans secured by residential real estate properties that are in the process of 43 -------------------------------------------------------------------------------- Table of Contents foreclosure. The ASU is effective for annual and interim periods beginning after December 15, 2014. The adoption of ASU 2014-04 is not expected to have an impact on Bancorp's operations. The adoption of ASU 2014-04 is expected to result in additional disclosures in Bancorp's financial statements.
In January 2014, five federal agencies approved an interim final rule to permit banking entities to retain interests in certain collateralized debt obligations backed primarily by trust preferred securities ("TruPS CDOs") as they are deemed exempt from the investment prohibitions of section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, known as the Volcker rule. Because Bancorp does not have any investments in TRuPS CDOs, the interim final rule will not have an impact on Bancorp's operations or financial statements.
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