Item 1. Descrpition ofBusiness
The Company and the Bank. The sole business of Commonwealth Bankshares, Inc. (the "Company") is to serve as a holding company for Bank of the Commonwealth (the "Bank"). The Company was incorporated as a Virginia corporation on June 6, 1988, and on November 7, 1988 it acquired the Bank.
Bank of the Commonwealth was formed on August 28, 1970 under the laws of Virginia. Since the Bank opened for business on April 14, 1971, its main banking and administrative office has been located in Norfolk. The Bank opened two branches in Norfolk in 1979 and four branches in Virginia Beach in 1975, 1982, 1983 and 1996.
Principal Market Area. The Bank concentrates its marketing efforts in the cities of Norfolk, Virginia Beach, Portsmouth and Chesapeake, Virginia. The Company's present intention is to continue concentrating its banking activities in its current market, which the Company believes is an attractive area in which to operate.
Banking Service. Through its network of banking facilities, the Bank provides a wide range of commercial banking services to individuals and small and medium-sized businesses. The Bank conducts substantially all of the business operations of a typical independent, commercial bank, including the acceptance of checking and savings deposits, and the initiating of commercial, real estate, personal, home improvement, automobile and other installment and term loans. The Bank also offers other related services, such as trust, travelers' checks, safe deposit, lock box, depositor transfer, customer note payment, collections, notary public, escrow, drive-in facility and other customary banking services.
Competition
The Bank encounters strong competition for its banking services within its primary market area. There are thirteen commercial banks actively engaged in business in the cities of Norfolk, Virginia Beach, Portsmouth and Chesapeake, Virginia, including six major state-wide banking organizations. The Bank is the oldest independent bank in its market area. Finance companies, mortgage companies, credit unions and savings and loan associations also compete with the Bank for loans and deposits. In addition, in some instances, the Bank must compete for deposits with money market mutual funds that are marketed nationally. Most of the Bank's competitors have substantially greater resources than the Bank.
Employees
As of December 31, 1996, the Bank had 44 full-time and 21 part-time employees. Management of the Company and the Bank considers its relations with employees to be excellent. No employees are represented by a union or any similar group, and the Bank has never experienced any strike or labor dispute.
Regulation and Supervision Commonwealth Bankshares, Inc.
In order to acquire the shares of the Bank and thereby become a bank holding company within the meaning of the Bank Holding Act, the Company was required to obtain approval from, and register as a bank holding company with the Federal Reserve Board (the "Board"), and it is subject to ongoing regulation, supervision and examination by the Board. As a condition to its approval, the Board required the Company to agree that it would obtain approval of the Federal Reserve Bank of Richmond prior to incurring any indebtedness. The Company is required to file with the Board periodic and annual reports and other information concerning its own business operations and those of its subsidiaries. In addition, the Bank Holding Company Act requires a bank holding company to obtain Board approval before it acquires, directly or indirectly, ownership or control of any voting shares of a second or subsequent bank if, after such acquisition, it would own or control more than 5% of such shares, unless it already owns or controls a majority of such voting shares. Board approval must also be obtained before a bank holding company acquires all or substantially all of the assets of another bank or merges or consolidates with another bank holding company. Any acquisition by a bank holding company of more than 5% of the voting shares, or of all or substantially all of the assets, of a bank located in another state may not be approved by the Board unless such acquisition is specifically authorized by the laws of that second state.
A bank holding company is prohibited under the Bank Holding Company Act, with limited exceptions, from acquiring or obtaining direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank, or from engaging in any activities other than those of banking or of managing or controlling banks or furnishing services to or performing services for its subsidiaries. An exception to these prohibitions permits a bank holding company to engage in, or acquire an interest in a company which engages in, activities which the Board, after due notice and opportunity for hearing, by regulation or order has determined is so closely related to banking or of managing or controlling banks as to be proper incident thereto. A number of such activities have been determined by the Board to be permissible.
A bank holding company may not, without providing prior notice to the Board, purchase or redeem its own stock if the gross consideration to be paid, when added to the net consideration paid by the company for all purchases or redemptions by the company of its equity securities within the preceding 12 months, will equal 10% or more of the company's consolidated net worth.
The ability of the Company to pay dividends depends upon the amount of dividends declared by the Bank. Regulatory restrictions exist with respect to the Bank's ability to pay dividends. See Note 17 to Consolidated Financial Statements.
The Bank
The Bank, as a member bank of the Federal Reserve System, is subject to regulation and examination by the Virginia State Corporation Commission and the Board. In addition, the Bank is subject to the rules and regulations of the Federal Deposit Insurance Corporation, which currently insures the deposits of each member bank to a maximum of $100,000 per depositor.
The commercial banking business is affected by the monetary policies adopted by the Board. Changes in the discount rate on member bank borrowing, availability of borrowing at the "discount window," open market operations, the imposition of any changes in reserve requirements against member banks' deposits and certain borrowing by banks and their affiliates, and the limitation of interest rates which member banks may pay on deposits are some of the instruments of monetary policy available to the Board. Taken together, these controls give the Board a significant influence over the growth and profitability of all banks. Management of the Bank is unable to predict how the Board's monetary policies (or the fiscal policies or economic controls imposed by Federal or state governments) will affect the business and earnings of the Bank or the Company, or what those policies or controls will be.
The references in this section to various aspects of supervision and regulation are brief summaries which do not purport to be complete and which are qualified in their entirety by reference to applicable laws, rules and regulations.
Distribution of Assets, Liabilities and Shareholders' Equity; Interest Rates and Interest Differential
(1) Tax equivalent adjustments (using 34% federal tax rates) have been made in calculating yields on tax-free loans and investments. Virginia banks are exempt from state income tax. (2) For the purposes of these computations, nonaccruing loans are included in the daily average loan amounts outstanding.
Distribution of Assets, Liabilities and Shareholders' Equity; Interest Rates and Interest Differential continued. . .
As the largest component of income, net interest income represents the amount that interest and fees earned on loans and investments exceeds the interest costs of funds used to support these earning assets. Net interest income is determined by the relative levels, rates and mix of earning assets and interest-bearing liabilities. The following table attributes changes in net interest income either to changes in average volume or to changes in interest due to both rate and volume has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.
Investment Portfolio
The following table shows the book value (carrying value) of the Company's investment securities at December 31 of the years indicated below.
The maturity distribution, par value, market value, and yield of the investment portfolio at December 31, 1996, is presented in the following table.
December 31, 1996 --------------------------------- Par Value Market Value Yield --------- ------------ ----- (Dollars in thousands)
Within 3 months .......................... $ 1,850 $ 1,848 5.61% After 3 but within 6 months .............. 250 251 5.84 After 6 but within 12 months ............. -- -- -- After 1 but within 5 years ............... 6,182 6,075 6.19 After 5 but within 10 years .............. 8,911 8,744 6.16 After 10 years ........................... 6,300 6,318 6.96 Other Securities ....................... 7 7 -- Federal Reserve Bank Stock ............... 144 144 6.00 ------- ------- ----
$23,644 $23,387 6.47% ======= ======= ====
Loan Portfolio:
The table below classifies loans, net of unearned income, by major category and percentage distribution at December 31 for each of the past three years:
The following table shows the maturity of loans outstanding as of December 31, 1996. Also provided are the amounts due after one year classified according to the sensitivity to changes in interest rates. Loans are classified based upon the period in which the final payment is due.
December 31, 1996 ---------------------------------------------------- Maturing ---------------------------------------------------- After One Within But Within After One Year Five Years Five Years Total -------- ---------- ---------- ----- (In thousands) Commercial ......... $ 4,372 $ 4,203 $ 2,505 $11,080 Commercial mortgage 12,853 11,706 6,105 30,664 Residential Mortgage 3,696 8,513 4,997 17,206 Installment loans to individuals .... 1,580 1,816 1,040 4,436 Other .............. 1,121 1,327 -- 2,448 TOTAL ------- ------- ------- ------- . .................. $23,622 $27,565 $14,647 $65,834 ======= ======= ======= =======
Loans maturing after one year with: Fixed interest rates . . . . . . . . $ 8,238 $13,448 Variable interest rates . . . . . . 19,397 1,239 -------- ------- TOTAL . . . . . . . . . . . . . $27,635 $14,687 ======== =======
Non-performing Loans:
Non-performing loans consist of loans accounted for on a non-accrual basis (as judgementally determined by management based upon anticipated realization of interest income) and loans which are contractually past due 90 days or more as interest and/or principal payments. The following table presents information concerning non-performing loans for the periods indicated:
It is management's practice to cease accruing interest on loans when payments are 120 days delinquent. However, management may elect to continue the accrual of interest when the estimated net realizable value of collateral is sufficient to cover the principal balance and accrued interest, and the loan is in the process of collection.
Interest which would have been recorded on non-accrual loans under the contractual terms was approximately $202,000 and $175,000 in 1996 and 1995, respectively. Interest actually recorded on these loans was approximately $102,000 and $59,000 in 1996 and 1995, respectively.
Summary of Loan Loss Experience:
The allowance for loan losses is increased by the provision for loan losses and reduced by loans charged off, net of recoveries. The allowance for loan losses is established and maintained at a level judged by management to be adequate to cover any anticipated loan losses to be incurred in the collection of outstanding loans. In determining the adequate level of the allowance for loan losses, management considers the following factors: (a) loan loss experience; (b) problem loans, including loans judged to exhibit potential charge-off characteristics, loans on which interest is no longer being accrued, loans which are past due and loans which have been classified in the most recent regulatory examination; and (c) anticipated economic conditions and the potential impact these conditions may have on individual classifications of borrowers.
The following table presents the Company's loan loss experience for the past five years:
ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES:
The following table provides an allocation of the allowance for loan losses as of December 31, 1996:
Year Ended December 31, 1996 ---------------------------- Percent of Loans on each category Amount to total loans ------ -------------- (Dollars in Thousands)
Commercial . . . . . . . . . . . . . . . . . . . $12 16.83% Commercial Mortgage . . . . . . . . . . . . . . 249 46.58 Residential Mortgage . . . . . . . . . . . . . . 26 26.13 Installment Loans to Individuals . . . . . . . . 10 6.74 Other . . . . . . . . . . . . . . . . . . . . . . 20 3.72 Unallocated . . . . . . . . . . . . . . . . . . . 615 N/A ----- ------
Total $932 100.00% ===== ======
Deposits:
The breakdown of deposits at December 31 for the years indicated is as follows:
The average daily amount of deposits and rates paid on such deposits is summarized for the periods indicated in the following table:
Remaining maturities of certificates $100,000 or more at December 31, 1996 as follows (in thousands):
Maturity
3 months or less . . . . . . . . . . . $3,154 Over 3 through 12 months . . . . . 969 Over 12 months . . . . . . . 1,173 ------ $5,296
Interest Rate Sensitivity Analysis:
The following table provides the maturities of investment securities, loans, and deposits at December 31, 1996, and measures the interest rate sensitivity gap for each range of maturity indicated:
Return on Equity and Assets
The following table highlights certain ratios for the periods indicated:
Item 2.
Item 2. Description of Properties
The headquarters building (the "Headquarters") of the Corporation and the Bank, located at the corners of Freemason and Boush Streets, Norfolk, Virginia, were completed in 1986 and is a three story building of masonry construction, with approximately 21,000 square feet of floor space. The Bank utilizes two floors and leases the third floor to others. The office operates nine teller windows, including two drive-up facilities, one walk-up facility and a 24 hour teller machine.
The Bank has entered into a lease with Boush Bank Building Associates, a limited partnership (the "Partnership"), to rent the Headquarters. The lease requires the Bank to pay all taxes, maintenance and insurance. The term of the lease is twenty-three years and eleven months, and began on December 19, 1984. In connection with this property, the lessor has secured financing in the form of a $1,600,000 industrial development revenue bond from the Norfolk Redevelopment and Housing Authority payable in annual installments, commencing on January 1, 1987, at amounts equal to 3% of the then outstanding principal balance through the twenty-fifth year, when the unpaid balance will become due. Interest on this bond is payable monthly, at 68.6% of the prime rate of Crestar Bank in Richmond, Virginia. Monthly rent paid by the Bank is equal to interest on the above bond, plus any interest associated with secondary financing provided the lessor by the Bank. The Bank has the right to purchase, at its option, an undivided interest in the property at undepreciated original cost, and is obligated to purchase in each January after December 31, 1986 an undivided interest in an amount equal to 90% of the legal amount allowed by banking regulations for investments in fixed properties, unless the Bank's return on average assets is less than seven-tenths of one percent. Under this provision the Bank purchased 19.7% of this property for $362,201 in 1987. At the time of the 1987 purchase the Bank assumed $305,744 of the above-mentioned bond. Pursuant to the purchase option contained in the lease agreement, the Bank recorded an additional interest of $637,410 (34.7%) in the leased property as of December 31, 1988 by assuming a corresponding portion ($521,888) of the unpaid balance of the related revenue bond and applying the difference of $115,522 to amounts due from the lessor.
Accordingly the Bank now owns 54.4%, of the Headquarters property. No purchases have been made after 1988.
The general partner of the Partnership is Boush Bank Building Corporation. All of the limited partners of the Partnership, namely Messrs. Woodard, Burton and Kellam, are directors of the Bank and the Corporation. The terms of the lease are not less favorable than could be obtained from a non-related party.
Prior to executing the lease, the shareholders of the Bank owning a majority of Bank common stock, consented to the foregoing lease. Additionally, formal shareholder approval of the lease, due to the above described interest of the Bank's directors, was obtained during the Bank's 1985 Annual Meeting of Shareholders.
The Bank operates a branch office in Norfolk at 4101 Granby Street and four branches in Virginia Beach at 225 South Rosemont Road, 2712 North Mall Drive, 1124 First Colonial Road and 1870 Kempsville Road.. One of the locations is owned by the Bank and the remaining four are leased under long-term operating leases with renewal options, at total annual rentals of approximately $103,000 paid to unrelated parties.
Item 3.
Item 3. Legal Proceedings
None
Item 4.
Item 4. Submission of Matters to a Vote of Securities Holders
None
PART II
Item 5.
Item 5. Market for Common Equity and Related Stockholder Matters
The Corporation's Articles of Incorporation were amended at the 1996 Annual Meeting of Shareholders to authorize the issuance of up to 5,000,000 shares of Common Stock, par value $2.50 per share, 947,501 shares of which are issued and outstanding. In addition, the Corporation has 300,000 shares of authorized but unissued preferred stock, par value $25 per share.
The Corporation's Common Stock is not listed on an exchange or traded through an interdealer quotation system, however, shares are traded in the over-the-counter market. Anderson & Strudwick, Inc., a member of the New York Stock Exchange, is an "active market maker" in the Common Stock of the Corporation. Anderson & Strudwick, Inc. maintains offices in Richmond, Charlottesville, Fredericksburg, Lynchburg and Norfolk, Virginia. The table below describes trades quoted by Anderson & Strudwick, Inc. during 1995 and 1996. There may have been other transactions at other prices not known to the Corporation.
There were no cash dividends declared during the past five years. The Corporation issued a five (5%) percent stock dividend during the first quarter of 1994 and six (6%) percent stock dividend during the first quarter of 1995, and 1996. In addition, the Board of Directors of the Corporation declared a six (6%) stock dividend in February 1997, payable to shareholders of record on March 31, 1997, which will be distributed April 30, 1997.
The Corporation's Board of Directors determines whether to declard dividends and the amount of any dividends declared. Such determinations by the Board take into account the Corporation's financial condition, results of operations, and other relevant factors. The declaration, amount and timing of future dividends will be determined by the Board of Directors after a review of the Corporation's operations and will be dependent upon, amoung other factors, the Corporation's incme, operating costs, overall financial condition and capital requirements and upon general business conditions. The Corporation's only source of funds for cash dividends will be dividends paid to the Corporation by the Bank, which is subject to regulatory restrictions.
Common Stock Prices
1996 1995 ---- ---- High Low High Low ---- --- ---- ---
First Quarter $ 9.910 $ 8.020 $ 8.140 $ 7.781
Second Quarter 10.250 8.750 8.500 7.250
Third Quarter 10.500 9.000 9.250 7.500
Fourth Quarter 11.000 10.000 10.000 8.500
The foregoing over-the-counter market quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not necessarily represent actual transactions.
At February 28, 1997, there were approximately 524 record holders of the Corporation's common stock (based on the number of record holders as of the date).
Item 6.
Item 6. Selected Consolidated Financial Data
The following table sets forth certain selected consolidated financial data for the past five years.
(1) Adjusted to reflect 1996, 1995 and 1994 stock dividends.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF OPERATIONS AND FINANCIAL CONDITION
This section of the Annual Report should be read in conjunction with the statistical information, Financial Statement and related Notes and the selected financial data appearing elsewhere in the Report.
In addition to historical information, the following discussion contains forward looking statements that are subject to risks and uncertainties that could cause Commonwealth's actual results to differ materially from those anticipated. These forward looking statements include, but are not limited to, statements regarding management's expectations that the Bank will continue to experience growth in core operating earnings, improved credit quality and increased service fee income, and that Commonwealth may pay cash dividends in the future. Readers are cautionied not to place undue reliance on these forward looking statements, which reflect management's analysis only as of the date hereof.
NEW ACCOUNTING STANDARDS
In March 1995 the FASB issued Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," which requires certain assets to be reduced in value whenever events or changes in circumstances indicate that the carrying value of those assets may not be recoverable. The Statement is required to be applied for years beginning after December 15, 1995. The Bank adopted this new accounting standard as of December 31, 1996 and there was no material impact on the consolidated financial statements.
Financial Condition and Results of Operations Commonwealth Bankshares, Inc. and Subsidiary
This commentary provides an overview of Commonwealth Bankshares Inc.'s financial condition, changes in financial condition and results of operations for the years 1994 through 1996. The following discussions should assist readers in their analysis of the accompanying consolidated financial statements and supplemental financial information. It should be read in conjunction with the statistical information.
Earnings Overview
Net income in 1996 of $836.4 thousand represented a modest increase over the $835.5 thousand reported for the year 1995. This earning record reflects the Bank's continued growth in core operating earnings and improved credit quality and positive trends which are expected to continue into 1997.
Net income for 1995 of $835.5 thousand represented an increase of 2.6% over the $814.1 thousand reported in 1994. This was primarily due to a growth in core earnings and a decrease in the provision for loan losses.
Commonwealth's core earnings, defined by the Corporation as pre-tax earning exclusive of the provision for loan losses and nonrecurring items such as securities gains, have improved steadily since 1992.
The key profitability measures of return on average assets (ROA) and return on average total shareholders' equity (ROE) reflected a decline in 1996 over 1995 as a result of the opening of the Bank's sixth branch office location, full staffing of the Bank's newly established trust department, and the implementation of new technological innovations, the planning for a more sophisticated customer information system, the implementation of telephone banking during the first quarter of 1996, and the expenses incurred for expansion of the Bank's home banking system scheduled for the second quarter of 1997. ROA equalled .79% in 1996 compared with .94% in 1995. ROE equaled 8.85% in 1996 compared with 10.17% in 1995. ROA and ROE were similary affected in 1995 as compared with 1994. These ratios, along with other significant earnings and balance sheet information for each of the years in the five-year period ended December 31, 1996, are shown in Table 1 as follows:
Table 1 - Selected Financial Information
Earnings per share were relatively unchanged when comparing 1996 to 1995. In 1995 earnings per share represented a 2.2% increase over 1994. Significant items affecting the change in earnings per share for 1996, 1995 and 1994 are summarized as follows:
1996 1995 vs. vs. 1995 1994 ---- ----
o Interest on loans and investments and loan fees 12.9% increase 17.6% increase
o Interest on deposits and funds purchased 15.7% increase 36.9% increase
o Net interest income 9.8% increase 1.5% increase
o Provision for loan losses 99.0% decrease 48.0% decrease
o Other income 7.5% increase 8.5% increase
Net Interest Income and Net Interest Margin
Net interest income, the largest contributor to Commonwealth's earnings, is defined as the difference between income on assets and the cost of funds supporting those assets. Earning assets are composed primarily of loans and securities while deposits and short-term borrowings represent the major portion of interest-bearing liabilities. Variations in the volume and mix of these assets and liabilities, as well as changes in the yields earned and rates paid, are determinants in changes in net interest income.
Net interest income increased $316 thousand or 9.8% in 1996 to $3.5 million, compared to an increase of $47.9 thousand or 1.5% in 1995, or to $3.3 million when compared with the $3.18 million reported in 1994. This improved performance in 1996 was primarily the result of an increase in interest income on loans and investments brought about by an increase in the volume of loans and investment securities outstanding, in spite of the increase in interest paid on deposits, as deposits grew and repriced during the year. In 1995, the improved performance over 1994 was attributable to a much greater increase in interest income on loans and investments than the increase interest paid on deposits.
The net interest margin for 1996 was 3.75% compared to 3.92% for 1995. The decline was primarily attributable to a 0.5% increase in the cost of deposits for 1996 as compared to 1995. Similarly, the net interest margin for 1995 declined from the 4.53% reported in 1994. Again the decline was primarily attributable to a 19.0% increase in the cost of deposits for 1995 as compared to 1994. The performance reported herein is reflected in Commonwealth's earning assets yield which declined 55 basis points to 8.13% in 1996 compared with 13 basis points to 8.68% in 1995 from the 8.55% reported in 1994. Commonwealth's average cost of deposits increased 72 basis points in 1995 from 1994 to 4.50%, and 2 basis points in 1996 from 1995 to 4.52%.
A substantial decrease in nonperforming assets of $1.36 million to $3.96 million will result in a favorable impact on the net interest margin during future periods since the major reductions in nonperforming assets occurred at year end in 1996. An increase in nonperforming loans of $392 thousand to $2.25 million resulted in an unfavorable impact on the net interest margin during 1995. Without this increase additional income under the contractual terms of the credits would have been recorded in the amount of $115.9 thousand on all nonperforming loans during 1995.
Decreased nonperforming loans in 1994 had a favorable impact on the net interest margin. Additional income of approximately $86.0 thousand for 1994, would have been realized had all nonperforming loans performed as originally expected.
Average interest earning assets increased $16.3 million in 1996 as compared with an increase of $11.0 million in 1995 and $3.26 million in 1994. Average net loans increased $6.3 milion in 1996 as compared with an increase of $6.9 million in 1995 and $5.35 million in 1994. Average investment securities increased by $7.6 million during 1996 compared with an increase of $2.0 million during 1995 and $934 thousand in 1994.
Provision and Allowance for Loan Losses
The provision for loan losses is the annual cost of maintaining an allowance for inherent credit losses. The amount of the provision each year and the level of the allowance are matters of judgement and are impacted by many factors, including actual credit losses during the period, the prospective view of credit losses, loan performance measures and trends (such as delinquencies and charge-offs), and other factors, both internal and external that may affect the quality and future loss experience of the credit portfolio.
On a quarterly basis, Commonwealth's management evaluates the adequacy of the allowance for loan losses, and, based on such review, establishes the amount of the provision for loan losses. For large commercial and real estate exposures, a detailed loan-by-loan review is performed. The remainder of the commercial and real estate portfolio is analyzed utilizing a formula-based determination of the allowance. The formula is impacted by the risk rating of the loan, historical losses and expectations. Loan loss allowances for the various consumer credit portfolios are based on historical and anticipated losses and the current and projected characteristics of the various portfolios. In addition, consideration of factors such as economic conditions, underwriting standards, and compliance and credit administration practices may impact the level of inherent credit loss. Management's evaluation and resulting provision and allowance decisions are reviewed by the Board of Directors quarterly.
A strengthening economy, combined with the Corporation's continued loan workout activities resulted in a reduction in the provision for loan losses during 1996. The Corporation made provisions for loan losses of $0.5 thousand in 1996 down $52.4 thousand from the $52.9 thousand reported in 1995. This followed a $48.8 thousand or 47.9% reduction in the provision in 1995 over 1994. Details of the activity in the allowance for loan losses for the past three years are shown in Note 5 to the Consolidated Financial Statement.
Net charge-offs during 1996 amounted to $325 thousand compared with a modest $5 thousand reported in 1995. Charge-offs in 1995 were down $18 thousand or 78.3% from 1994. 1994 net charge-offs of $23 thousand were down $50 thousand or 68.5% from the prior year. The level of charge-offs during 1996 reflected losses sustained, which were primarily attributable to the Bank's relationship with one borrower, a relationship which has been in a workout position for an extended period of time. Current expectations are that total net charge-offs in 1997 will be substantially reduced from the levels reached during 1996. This expectation is based upon assumptions regarding the general economic climate in Commonwealth's trade area and the performance characteristics of the loan portfolio, including Commonwealth's continued success in working out remaining nonperforming loans. Changes in these conditions could warrant different results.
The allowance for loan losses at December 31, 1996 was $932 thousand compared with $1.256 million at December 31, 1995. This represented 1.41% of year-end gross loans at December 31, 1996 compared with 2.04% of year-end gross loans at December 31, 1995. At December 31, 1994 the allowance equalled $1.208 million, representing 2.2% of year-end gross loans.
The tables on the following pages provide an analysis of the activity in the Corporation's nonperforming assets and allowance for loan losses for each of the last five years. Based on current expectations relative to portfolio characteristics and performance measures including loss projections, management considers the level of the allowance to be adequate.
Nonperforming loans at December 31, 1996 increased $392 thousand and at year end equalled $2.2 million. Nonperforming loans continue to be centered in a relatively small number of loans with large balances. Based on the Bank's current workout plans, we expect to return each of these loans to an accrual status during 1997 with minimum loss to the Bank. Each of the loans are fully secured and represent minimal risk. Nonperforming loan levels at December 31, 1995 increased $942 thousand from December 31, 1994.
The Corporation continues to allocate significant resources to the expedient disposition and collection of nonperforming and other lower quality assets. As a part of this workout process, the Corporation routinely re-evaluates all reasonable alternatives, including the sale of these assets. Individual action plans have been developed for each nonperforming asset.
The amount of loans past due 90 days or more that were not classified as nonaccrued loans totaled $180 thousand at December 31, 1996, and $198 thousand at December 31, 1995 and $106 thousand at December 31, 1994.
The following table reflects the trends discussed herein:
ASSET QUALITY REVIEW AND CREDIT RISK MANAGEMENT
In conducting business activities, the Corporation is exposed to the possibility that borrowers or counterparties may default on their obligations to the Corporation. Credit risk arises through the extension of loans, leases, certain securities, and financial guarantees. To manage this risk, the Corporation establishes policies and procedures to manage both on and off-balance sheet risk and communicates and monitors the application of these policies and procedures throughout the Corporation.
Loan Portfolio
The Corporation's credit risk is centered in its loan portfolio which on December 31, 1996 totaled $66.0 million, or 69.2% of total earning assets. The Corporation's overall objective in managing loan portfolio risk is to minimize the adverse impact of any single event or set of occurrences. To achieve this objective, the Corporation strives to maintain a loan portfolio that is diverse in terms of loan type, industry concentration, geographic distribution and borrower concentration.
For commercial loans, loan officers prepare proposals supporting the extension of credit. These proposals contain an analysis of the borrower and an evaluation of the ability of the borrower to repay the potential credit. The proposals are subject to varying levels of approval by senior line and credit policy management prior to the extension of credit. Commercial loans receive an initial risk rating by the originating loan officer. This rating is based on the amount of credit risk inherent in the loan and is reviewed for appropriateness by senior line and credit policy management. Credits are monitored by line and credit policy personnel for deterioration in a borrower's financial condition which would impact the borrower's ability to repay the credit. Risk ratings are adjusted as necessary.
For consumer loans, approval and funding is conducted in various locations with the major number of loans being approved at the Corporation's headquarters facility.
An independent credit review group conducts ongoing reviews of the loan portfolio, reexamining on a regular basis risk assessments for loans and overall compliance with policy.
To limit credit exposure, the Corporation obtains collateral to support credit extensions and commitments when deemed necessary. The most significant categories of collateral are real and personal property, cash on deposit and marketable securities. The Corporation obtains real property as security for some loans that are made on the basis of the general creditworthiness of the borrower and whose proceeds were not used for real estate-related purposes.
Senior level management is devoted to the management and/or collection of certain nonperforming assets as well as certain performing loans. Aggressive collection strategies and a proactive approach to managing overall credit risk has expedited the Corporation's disposition, collection and renegotiation of nonperforming and other lower-quality assets and allowed loan officers to concentrate on generating new business.
As the volume of past due loans declines, it is anticipated that the level of nonaccrual loans will be reduced. It should be noted that of all loans on nonaccrual, the majority are making regular monthly payments. One loan is self-liquidating and payments are being received from the assignment of commissions, one loan is in the process of being purchased by the Small Business Administration, and the others are for the most part fully secured with workout arrangements currently in place.
If nonaccruing loans had been performing fully, these loans would have contributed an additional $100 thousand in 1996, $115.9 thousand to interest income in 1995, and $86 thousand in 1994.
The Corporation's Other Real Estate Owned (OREO) at December 31, 1996 declined substantially to $1.7 million from the $3.5 million reported at December 31, 1995. At December 31, 1994 other real estate owned equalled $3.4 million. Of the $1.7 million, three of the properties representing $737 thousand are generating income under operating leases. The balance representing $982 thousand are in various stages of liquidation.
During the last three years, there have been additions to and liquidations of other real estate owned. Properties acquired during 1996 equalled $603 thousand compared with $680 thousand during 1995 and $634 thousand in 1994. Proceeds from the properties disposed of during 1996 equalled $2.6 million compared with $638 thousand in 1995 and $904 thousand in 1994.
During 1996, there was a net loss on the sale of other real estate of $12.7 thousand compared with a net gain equalling $8.7 thousand in 1995, a net loss of $11.1 thousand in 1994.
The Bank has developed individual action plans for each property for the ultimate liquidation of these properties. The objectives are diligently pursued by management and reviewed with the Board of Directors monthly.
Other Income
Total other income increased 7.5% in 1996 following a 8.5% increase in 1995 and a 9.4% decrease in 1994. The increases in 1996 were attributable principally to:
o gain in the sale of fixed assets of $65.3 thousand.
o $12.1 thousand increase in income generated from properties held by the Bank for sale.
o n increase in other miscellaneous income items of $28 thousand.
In 1995 the increases were attributable to:
o A gain in the sale of small business administration loans which equalled $17.8 thousand.
o A gain in the sale of securities available for sale of $28.4 thousand compared with a loss of $9.2 thousand in 1994.
o A gain in the sale of Other Real Estate Owned of $8.7 thousand compared with a loss of $11.2 thousand in 1994.
In each of the three years mentioned, income from OREO properties equalled $218.6, $208.9, and $224.0 thousand, respectively.
The income achieved in service charges and commissions and fees on deposits, are indicative of the recent trend in commercial banking to generate additional income from services not related to the lending function.
Other Expense
Total other expense increased to $3.2 million in 1996 or 12% compared to an increase of 4.9% in 1995 and an increase of 3.6% in 1994. This represents a moderate increase when compared with the increase in the Corporation's noninterest income and the Bank's overall growth. These results reflect management's continued emphasis and commitment to the management of this area of the Bank's operations. Salaries and employee benefits, the largest component of other expenses increased by 13.3% in 1996, as a result of fully staffing the Bank's new branch on Kempsville Road, and the Bank's newly formed Trust Department. This expense increased 6.6% in 1995 and 8.3% in 1994. Net occupancy expense increased $24.3 thousand in 1996, following a $73.3 thousand increase in 1995, and a $37.1 thousand decrease in 1994. The increases in 1995 and 1996 reflected necessary modifications and improvements to the Bank's physical facilities, the opening of the Bank's sixth branch location, as well as the installation of new ATM equipment at all ATM locations during 1995. Other operating expenses, which include a grouping of numerous transactions relating to normal banking operations, increased $130 thousand or 16.2% following a decrease of $43.7 thousand or 5.1% in 1995 and an increase of $11.9 thousand or 1.4% in 1994. Again, when compared with the increase in the Corporation's noninterest income during the past three years, the increase in noninterest expense is considered nominal and reflects normal increases for outside services.
Liquidity and Interest Sensitivity
Bank liquidity is a measure of the ability to generate and maintain sufficient cash flows to fund operations and to meet financial obligations to depositors and borrowers promptly and in a cost-effective manner. Asset liquidity is provided primarily by maturing loans and investments, and by cash received from operations. Other sources of asset liquidity include readily marketable assets, especially short-term investments, and longer-term investment securities that can serve as collateral for borrowings. On the liability side, liquidity is affected by the timing of maturing liabilities and the ability to generate new deposits or borrowings as needed.
Commonwealth's Asset/Liability Management Committee (ALCO) is responsible for formulating liquidity strategies, monitoring performance based on established objectives and approving new liquidity initiatives. ALCO's overall objective is to optimize net interest income within the constraints of prudent capital adequacy, liquidity needs, the interest rate and economic outlook, market opportunities, and customer requirements. General strategies to accomplish this objective include maintaining a strong balance sheet, achieving solid core deposit growth, taking on manageable interest rate risk, adhering to conservative financial management on a daily basis, monitored regularly by ALCO and reviewed periodically with the Board of Directors.
The Bank's funding requirements are supplied from a wide range of traditional sources, including various types of demand deposits, money market accounts, certificates of deposit and short-term borrowings. Large certificates of deposit, over $100,000 accounted for 5.5%, 4.8%, and 4.19% of the Bank's total deposits at December 31, 1996, 1995, and 1994, respectively. As a percentage of average assets, core deposits have increased from 86.9% in 1994 to 87.8% in 1995, and 94.6% in 1996. Management seeks to ensure adequate liquidity to fund loans, deposit withdrawals, and the Bank's financial requirements and opportunities. To provide liquidity for current, ongoing and unanticipated needs, the Bank maintains a portfolio of marketable investment securities, structures and monitors the flow of funds from these securities and from maturing loans, and maintains access to short-term funding sources, including a Federal funds line of credit with its correspondent banks and the ability to borrow from the Federal Reserve System.
The Corporation's loan portfolio net of unearned income and allowance for loan losses increased by 8% to $64.9 million in 1996 compared with a 10.8% increase in 1995 to $60.1 million from the $54.3 million at year end 1994. Balances in a number of loan categories also increased. Total commercial loans increased 15.5% to $41.7 million in 1996 compared with an increase of 13.1% to $36.2 million in 1995, following an 14.1% increase in 1994 to $32.0 million. These increases reflect a continuing exodus of commercial customers from the area's regional institutions to Bank of the Commonwealth, the oldest community Bank in Southside Hampton Roads. Consumer loans decreased $1.1 million or 4.7% in 1996, reflecting the intense competition for consumer installment loans in Hampton Roads. This increase followed an increase of $1.7 million or 7.1% in 1995 and an increase of $2.3 million or 10.9% in 1994.
Sources of Funds
Purchased liabilities are composed of certificates of deposit of $100,000 and over (large CDs) and balances held in "sweep accounts" for customers. Purchased funds at December 31, 1996 equalled $8.8 million or a 33.3% increase in short-term borrowings during 1996 following a $1.9 million or 40% increase in short term borrowings during 1995, and a $1.6 million or 35.3% decrease in short term borrowings during 1994. At December 31, 1996, 1995 and 1994, approximately 100% of Commonwealth's purchased funds consisted of funds invested by local customers which, as such, are less volatile than other categories of purchased funds or brokered deposits. On both an average and year-end basis, the composition of purchased funds continued to shift in 1996, 1995 and 1994 from the balance sheet category of large CDs to short-term borrowings. This shift in mix coincided with liquidity needs and balance sheet management strategies in a low interest rate environment.
Uses of Funds
Total earning assets at December 31, 1996 increased 13.6% from year-end 1995 compared with 1995's increase of 17.2% and 1994's increase of 2.8%. The increase of $7 million in 1996 reflected investments in government securities and Federal funds sold. The increases in 1995 reflected higher levels of loans, while the increases in 1994 reflected higher loans outstanding and higher levels of investments in Federal funds sold.
The composition of long-term investment securities as of December 31, 1996 and 1995 is presented in Note 3 to the Consolidated Financial Statements.
At year-end 1996, 1995 and 1994, investment securities totaled $23.7 million, $17.3 million, and $14.9 million, respectively.
In managing the investment securities portfolio, management's philosophy has been to provide the maximum return over the long term on funds invested while giving consideration to risk and other Corporate objectives. During periods of increasing interest rates, the market value of the investment portfolio declines in relation to book value.
Decisions to acquire investments of a particular type are based upon an assessment of economic and financial conditions, including interest rate risk, liquidity, capital adequacy, the type of incremental funding available to support such assets and an evaluation of alternative loan or investment instruments.
Investment securities are purchased with the ability to hold until maturity and with the intent to hold for the foreseeable future. Management re-evaluates asset and liability strategies when economic and financial conditions fluctuate in a magnitude that might adversely impact the company's overall interest rate risk, liquidity or capital adequacy positions. Re-assessment may alter management's intent to hold certain securities for the foreseeable future and result in repositioning a portion of the investment portfolio. Often, security sales are required to implement a change in strategy.
On November 15, 1995, the Financial Accounting Standards Board released their Implementation Guide of Statement 115. As expected, the guide allowed financial institutions to make a one-time reclassification (between November 15th and December 31, 1995) of investments between the ""Available-for-Sale" (AFS) and "Held-to-Maturity" (HTM) portfolios. During this period (one day only), transfers between HTM and AFS could be made without the risk of tainting other securities within the portfolio. As a result of this action, an adjustment was made in the Bank's securities portfolio. Certain bonds were sold in anticipation of their "call" in order to prefund their reinvestment. This partial portfolio restructure enabled the Bank to smooth out cashflows within it's "Investment Ladder". See Note 3 to the Consolidated Financial Statements for a breakdown of the securities held in each of these accounts. During 1996 it was determined that further repositioning could enhance yields and smooth cashflows from the investment portfolio by shifting certain investment funds to different investment sectors and by moderately lengthening the portfolio's duration. The liquidation and reinvestment achieved two important management objectives:
o To increase the portfolio yield and thus the earnings contribution from the Bank's investment portfolio, and
o To add amortizing investments and thus increase the regularity of principal cashflows from the bond portfolio.
Management frequently assesses the performance of the investment portfolio to ensure its yield and cashflow performances are consistant with the broad strategic plan of the entire Bank. Flexibility is one of the hallmarks of the Bank's ability to meet the dynamic banking needs of its customers.
Year-end total loans net of unearned income increased $4.4 million or 7.4% in 1996 following increases of 10.6% or $5.9 million and 12.9% or $6.37 million at year end 1995 and 1994, respectively. The results were largely due to the efforts of the Bank's officers to develop new loan relationships with customers from the area's regional institutions combined with an improved economic environment.
Loans represented the largest category of earning assets and the Bank will continue with its efforts to develop creditable loan relationships in order to enhance its earnings opportunities while simultaneously strengthening its underwriting criteria. The policies, procedures and lending guidelines implemented during the past two years have been reported to shareholders in detail in previous quarterly and annual reports.
A number of measures have been taken by Commonwealth over the past several years to reduce overall exposure and earnings vulnerability in the real estate sectors of the Corporation's trade area, including strengthening real estate underwriting, management review policies and practices, and reducing higher risk concentrations within the real estate portfolio. Commonwealth's real estate portfolio is comprised of loans to customers located within the Corporation's established marketplace. Diversification of the loan portfolio continues.
During the past two years, a considerable volume of new loan relationships have been developed with "old line and well-established" local businesses, who have transferred their relationships to Commonwealth from other "regional financial institutions" that are experiencing further consolidation. This has been an excellent source of new business for the Bank. We intend to aggressively continue to target these relationships in future periods.
Further explanations regarding the changes in the volume of outstanding loans are included in Management's Discussion and Analysis of Financial Condition and Results of Operations under the section entitled "Liquidity and Interest Sensitivity".
Dividends and Dividend Policy
The Corporation's Board of Directors determines the amount of and whether or not to declare dividends. Such determinations by the Board take into account the Corporation's financial condition, results of operations, and other relevant factors. The Corporation's only source of funds for cash dividends are dividends paid to the Corporation by the Bank.
Based on the Corporation's earnings record for 1996 and 1995, the Corporation declared a 6% stock dividend in each year. It is anticipated that this policy will continue to be re-evaluated during 1997. Based on the Corporation's improved record of profitability, it is expected that the payment of cash dividends will be resumed in future periods.
Income Taxes
Corporations are required to pay the greater of the regular corporate income tax or the alternative minimum tax (AMT).
In 1996, income tax expense was $364.2 thousand, up from $282.1 thousand in 1995, and $278.3 thousand in 1994. These increases were attributable to improvements in earnings.
Inflation
The Corporation carefully reviews Federal Reserve monetary policy in order to insure an appropriate position between the cost and utilization of funds.
The effect of changing prices on financial institutions is typically different than on non-banking companies since virtually all of a bank's assets and liabilities are monetary in nature. In particular, interest rates are significantly affected by inflation, but neither the timing nor magnitude of the changes are directly related to price level indices. Therefore, the Corporation can best counter inflation over the long term by managing net interest income and controlling net increases in noninterest income and expenses.
Capital Resources and Adequacy
Average shareholders' equity increased at the rate of 15.1% in 1996 compared with 13.4% in 1995, and 9.4% in 1994. During these periods, the main source of capital to the Bank has been internally generated retained earnings.
The Federal Reserve Board, the Office of the Controller of the Currency, and the FDIC have issued risk-based capital guidelines for U. S. banking organizations. These guidelines provide a capital framework that is sensitive to differences in risk profiles among banking companies.
Risk-based capital ratios are another measure of capital adequacy. At December 31, 1996, The Bank's risk-adjusted capital ratios were 13.1% for Tier 1 and 14.4% for total capital, well above the required minimums of 4.0% and 8.0%, respectively, as compared with 13.1% and 14.4% respectively at December 31, 1995, and 10.0% and 11.3% at December 31, 1994. These ratios are calculated using regulatory capital (either Tier 1 or total capital) as the numerator and both on-and off-balance sheet risk-weighted assets as the denominator. Tier 1 capital consists primarily of common equity less goodwill and certain other intangible assets. Total capital adds certain qualifying debt instruments and a portion of the allowance for loan losses to Tier 1 capital. One of four risk weights, primarily based on credit risk, is applied to both on- and off-balance sheet assets to determine the asset denominator. Under Federal Deposit Insurance Corporation (FDIC) rules, Commonwealth was considered "well-capitalized," the highest category of capitalization defined by the regulators allowing for the lowest level of FDIC insurance premium rates, as of December 31, 1996, 1995 and 1994.
The Bank's capital is adequate to support the present level of assets and to provide for some future growth.
At December 31, 1996, shareholders' equity stood at $9.57 million as compared with $8.77 million at year-end 1995 and $7.79 million at year-end 1994. These increases were brought about by a net profit of $836.4 thousand in 1996, a net profit of $835.1 thousand in 1995, combined with a change in unrealized gains of $149.8 thousand on securities available for sale, and a net profit of $814.3 thousand in 1994.
In order to maintain a strong equity capital position, to protect against the risks of loss, in the investment and loan portfolios and on other assets, management will continue to monitor the Bank's capital position. Several measures have been or will be employed, to maintain the Bank's capital position, including but not limited to:
o Continuing its efforts to return all nonperforming assets to performing status,
o Monitoring the Bank's growth, and
o Continued utilization of its formal asset/liability policy.
Once again, it should be noted that the Bank's capital position has always exceeded and continues to exceed the minimum standards established by the regulatory authorities.
(1) Adjusted to reflect 1996, 1995 & 1994 Stock Dividends.
PART II
Item 7.
Item 7. Financial Statements.
Refer to the index to the Consolidated Financial Statements on Page for the required information.
Item 8.
Item 8. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure.
None.
PART III
Item 9.
Item 9. Directors, Executive Officers, Promoters and Control Persons; Complianc With Section 16(a) of the Exchange Act.
The following sets forth the names, ages and business experience of the Corporation's executive officers.
Edward J. Woodard, Jr., 54
Chairman of the Board, President and Chief Executive Officer of the Corporation and the Bank.
John H. Gayle, 58
Executive Vice President and Secretary of the Corporation and Executive Vice President and Cashier of the Bank, and Vice President and Secretary of BOC Title Hampton Roads.
Richard R. Early, 52
Senior Vice President and Senior Trust Officer of the Bank since September 1996. Prior to accepting the position with the Bank, Mr. Early was Senior Vice President and Senior Trust Officer at Bank of Lancaster from May 1990 through September 1996.
Simon Hounslow, 32
Vice President and Commercial Loan Officer of the Bank.
Richard W. Webb, 44
Vice President and Branch Administration Officer of the Bank. Prior to joining the Bank in August 1993, Mr. Webb was a banker with Home Savings Bank from 1975 through July 1993.
Item 10.
Item 10. Executive Compensation.
The information called for in this Item is incorporated by reference from the Corporation's definitive Proxy Statement for its 1997 Annual Meeting of Shareholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the end of the Corporation's fiscal year.
Item 11.
Item 11. Security Ownership of Certain Beneficial Owners and Mangement.
The information called for in this Item is incorporated by reference from the Corporation's definitive Proxy Statement for its 1997 Annual Meeting of Shareholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the end of the Corporation's fiscal year.
Item 12.
Item 12. Certain Relationships and Related Transactions.
The information called for in this item is incorporated by reference form the Corporation's definitive Proxy Statement for its 1997 Annual Meeting of Shareholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the end of the Corporationi's fiscal year.
Item 13.
Item 13. Exhibits and Reports on Form 8-K.
(a) (3) Exhibits
(b) Reports filed on Form 8-K for the quarter ended December 31, 1996.
None
ANNUAL REPORT ON FORM 10-K ITEM 8, LIST OF FINANCIAL STATEMENTS FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA YEAR ENDED DECEMBER 31, 1996 COMMONWEALTH BANKSHARES, INC.
FORM 10-KSB--ITEM 7
COMMONWEALTH BANKSHARES, INC.
LIST OF FINANCIAL STATEMENTS
The following consolidated financial statements of Commonwealth Bankshares, Inc. and subsidiary are included:
Consolidated balance sheets--December 31, 1996 and 1995.
Consolidated statements of operations--Years ended December 31, 1996, 1995, and 1994.
Consolidated statements of shareholders' equity--Years ended December 31, 1996, 1995, and 1994.
Consolidated statements of cash flows--Years ended December 31, 1996, 1995 and 1994.
Notes to consolidated financial statements--December 31, 1996.
Schedules to the consolidated financial statements required by Article 9 of Regulations S-X are not required under the related instructions or are inapplicable, and therefore have been omitted.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Commonwealth Bankshares, Inc. (Registrant)
Date: March 29, 1997 by: E. J. Woodard, Jr. -------------------------------- E. J. Woodard, Jr., CLBB Chairman of the Board, President & CEO
by: John H. Gayle -------------------------------- Executive Vice President & Cashier (Principal Financial Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated.
E. J. Woodard, Jr. Herbert L. Perlin - ------------------------------------- ---------------------------- E. J. Woodard, Jr., CLBB Director and Herbert L. Perlin, Director Chairman of the Board, President and Chief Executive Officer
George H. Burton, Jr. Richard J. Tavss - ------------------------------------- ---------------------------- George H. Burton, Jr.,Director Richard J. Tavss, Director
Morton Goldmeier Morton M. Zedd - ------------------------------------- ---------------------------- Morton Goldmeier, Director Morton M. Zedd, Director
William P. Kellam - ------------------------------------- William P. Kellam, Director
William D. Payne, MD - ------------------------------------- William D. Payne, MD, Director
INDEX
PAGE
Independent auditors' report
Financial statements Consolidated balance sheets Consolidated statements of income Consolidated statements of stockholders' equity Consolidated statements of cash flows Notes to consolidated financial statements
Board of Directors of Commonwealth Bankshares, Inc. Norfolk, Virginia
We have audited the accompanying consolidated balance sheets of Commonwealth Bankshares, Inc. and its subsidiary as of December 31, 1996 and 1995, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Commonwealth Bankshares, Inc. and its subsidiary at December 31, 1996 and 1995, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles.
PLOTT & WALTON, PC
Richmond, Virginia January 17, 1997
COMMONWEALTH BANKSHARES, INC.
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1996 AND 1995
ASSETS
1996 1995 ---- ----
Cash and cash equivalents: Cash and due from banks (Note 2) $ 5,655,944 $ 5,135,875 Federal funds sold 5,718,439 5,131,844 ------------ ----------- Total cash and cash equivalents 11,374,383 10,267,719
Investment securities: Securities available for sale (Note 3) 9,590,274 5,968,175 Securities to be held to maturity (Note 3) 14,072,217 11,290,140 ------------ ----------- Total investment securities 23,662,491 17,258,315
Loans (Notes 4 and 5): Commercial 11,078,914 8,889,880 Commercial construction 1,867,926 1,470,129 Commercial mortgage 28,796,673 25,795,631 Residential mortgage 17,206,173 18,668,317 Installment loans to individuals 4,600,931 3,970,015 Other 2,448,714 2,809,860 ------------ ----------- Gross loans 65,999,331 61,603,832 Unearned income (164,724) (231,186) Allowance for loan losses (932,000) (1,256,000) ------------ ----------- Loans, net 64,902,607 60,116,646
Premises and equipment, net (Notes 6 and 11) 2,442,691 2,340,746
Real estate acquired in settlement of loans 1,719,642 3,467,207
Accrued interest receivable 736,092 634,383
Other assets 1,332,320 952,341 ------------ -----------
$106,170,226 $95,037,357 ============ ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
1996 1995 ---- ----
Liabilities: Deposits: Non-interest bearing $ 10,686,956 $13,147,115 Interest bearing: Demand 17,807,271 15,482,900 Savings 4,237,750 4,195,594 Other time deposits 57,530,478 49,430,750 ------------ ----------- Total deposits 90,262,455 82,256,359
Securities sold under agreements to repurchase (Notes 3 and 10) 3,573,350 2,290,477
Long-term debt (Note 11) 609,280 684,019
Accrued interest payable 334,162 283,726
Income tax payable - 16,206
Other liabilities 1,822,509 736,184 ------------ ----------- Total liabilities 96,601,756 86,266,971
Stockholders' equity (Notes 8, 9, and 17): Common stock, par value $2.50 - 5,000,000 shares authorized; 947,501 and 894,103 shares issued and outstanding in 1996 and 1995, respectively 2,368,752 2,235,258 Additional paid-in capital 4,106,361 3,715,666 Retained earnings 3,121,362 2,811,562 Net unrealized gain (loss) on securities available for sale, net of income tax provision (benefit) of $(14,428) and $4,000 in 1996 and 1995, respectively (28,005) 7,900 ------------ ----------- Total stockholders' equity 9,568,470 8,770,386 ------------ ----------- $106,170,226 $95,037,357 ============ ===========
The accompanying notes are an integral part of these consolidated financial statements.
COMMONWEALTH BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995, AND 1994
(Continued)
COMMONWEALTH BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME (CONTINUED)
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995, AND 1994
The accompanying notes are an integral part of these consolidated financial statements.
COMMONWEALTH BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995, and 1994
(Continued)
COMMONWEALTH BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (CONTINUED)
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995, and 1994
The accompanying notes are an integral part of these consolidated financial statements.
COMMONWEALTH BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995, 1994
(Continued)
COMMONWEALTH BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995, 1994
The accompanying notes are an integral part of these consolidated financial statements.
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1996
1. Summary of significant accounting policies
The accounting and reporting policies of Commonwealth Bankshares, Inc. (the Parent) and its subsidiary, Bank of the Commonwealth (the Bank) and its subsidiary, BOC Title of Hampton Roads, Inc., are in accordance with generally accepted accounting principles and conform to general practices within the banking industry. The more significant of the principles used in preparing the financial statements are briefly described below.
Principles of consolidation - The accompanying consolidated financial statements include the accounts of the Parent and the Bank and its subsidiary, collectively referred to as "the Company." All significant intercompany balances and transactions have been eliminated in consolidation.
Nature of operations - The Bank operates under a state bank charter and provides full banking services. As a state bank, the Bank is subject to regulation of the Bureau of Financial Institutions and the Federal Reserve System. The Bank serves Norfolk and Virginia Beach, Virginia through its six banking offices.
Estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Investment securities - Management determines the appropriate classification of securities at the time of purchase. If management has the intent and the Company has the ability at the time of purchase to hold securities until maturity or on a long-term basis, they are classified as investments to be held to maturity and carried at amortized historical cost. Securities to be held for indefinite periods of time and not intended to be held to maturity or on a long-term basis are classified as available for sale and carried at fair value.
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
1. Summary of significant accounting policies (Continued)
Investment securities -(Continued) Securities held for indefinite periods of time include securities that management intends to use as part of its asset and liability management strategy and that may be sold in response to changes in interest rates, resultant prepayment risk and other factors related to interest rate and resultant prepayment risk changes.
Realized gains and losses on dispositions are based on the net proceeds and the adjusted book value of the securities sold, using the specific identification method. Unrealized gains and losses on investment securities available for sale are based on the difference between book value and fair value of each security. These gains and losses are credited or charged to stockholders' equity, whereas realized gains and losses flow through the Company's yearly operations.
Loans - Interest on loans is accrued and credited to income based upon the principal amount outstanding. Fees collected and costs incurred in connection with loan originations are deferred and recognized over the term of the loan.
It is management's practice to cease accruing interest on loans when payments are 120 days delinquent. However, management may elect to continue the accrual of interest when the estimated net realizable value of collateral is sufficient to cover the principal balance and accrued interest, and the loan is in the process of collection.
Impaired loans - Effective January 1, 1995, the Bank adopted Statement of Financial Accounting Standards (SFAS) No. 114, "Accounting by Creditors for Impairment of a Loan," as amended by SFAS No. 118. These pronouncements require that an impaired loan be measured based on the present value of expected future cash flows discounted at the effective interest rate of the loan, or at fair value of the loan's collateral for "collateral dependent" loans. The Bank considers a loan impaired when it is probable that the Bank will be unable to collect all interest and principal payments as scheduled in the loan agreement. A loan is not considered impaired during a period of delay in payment if the ultimate collectibility of all amounts due is expected.
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
1. Summary of significant accounting policies (Continued)
Impaired loans - (Continued) A valuation allowance is required to the extent that the measure of the impaired loan is less than the recorded investment. Consistent with the Bank's method for nonaccrual loans, interest receipts for impaired loans are recognized on the cash basis. The Bank had no impaired loans as of December 31, 1996 or 1995.
Allowance for loan losses - The allowance for loan losses is maintained at a level adequate to absorb probable losses. Management's determination of the adequacy of the allowance is based on an evaluation of past loan loss experience, an analysis of potential problem loans, current economic conditions, volume, growth and composition of the loan portfolio and other relevant factors. The allowance is increased by provisions for loan losses charged against operations.
Real estate acquired in settlement of loans - Real estate acquired in settlement of loans is stated at the lower of cost or estimated fair market value of the property, less estimated disposal costs, if any. Cost includes loan principal and accrued interest. Any excess of cost over the estimated fair market value at the time of acquisition is charged to the allowance for loan losses. The estimated fair market value is reviewed periodically by management and any write-downs are charged against current earnings.
Premises and equipment - Premises and equipment are stated at cost less accumulated depreciation. Ordinary maintenance and repairs are expensed as they are incurred. Deprecation is computed generally by the straight-line method. It is the Company's policy to capitalize additions and improvements and amortize the cost thereof over the estimated useful lives as follows:
Buildings and improvements 5 to 40 years Furniture and equipment 3 to 10 years
Income taxes - Deferred income taxes are provided for timing differences in the recognition of income and expenses for financial reporting purposes and for income tax purposes. Timing differences result principally from provisions for loan losses, depreciation and net loan fees.
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
1. Summary of significant accounting policies (Continued)
Per share data - Net income per share is based on the weighted average number of shares outstanding.
Off balance sheet financial instruments - In the ordinary course of business the Bank has entered into off balance sheet financial instruments consisting of commitments to extend credit, commitments under credit card arrangements and standby letters of credit. Such financial instruments are recorded in the financial statements when they become payable.
Cash and cash equivalents - For purposes of the consolidated statements of cash flows, cash and cash equivalents includes cash and due from banks and federal funds sold.
Long-lived assets - Effective January 1, 1996, the Bank adopted Statement of Financial Accounting Standards (SFAS) No. 121. "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of," which requires certain assets to be reduced in value whenever events or changes in circumstances indicate that the carrying value of those assets may not be recoverable. The adoption of SFAS No. 121 had no impact on the consolidated financial statements.
Reclassifications - Certain prior year amounts have been reclassified to conform to the 1996 presentation. These reclassifications have no effect on previously reported net income.
2. Cash and due from banks
The Bank is required to maintain average reserve balances in cash or on deposit with the Federal Reserve Bank. Required reserves were approximately $195,000 at December 31, 1996 and 1995.
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
3. Investment securities
Securities with a carrying value of $1,864,750 on November 15, 1995, were transferred from held to maturity to available for sale. This transfer was in accordance with the FASB's special report "A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities."
The aggregate carrying and market values of investment securities at December 31, 1996 and 1995, were as follows:
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
3. Investment securities (Continued)
Securities with a book value of $7,102,557 and $5,810,802 and market value of $6,883,544 and $5,617,676 at December 31, 1996 and 1995, respectively, were pledged as collateral to secure public deposits and for other purposes.
Proceeds from the sale of investment securities, gross realized gains, gross realized losses, and the related income taxes on net realized gains were as follows:
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
3. Investment securities (Continued)
Year ended December 31, 1996 1995 1994 -------------------------------
Securities available for sale: Gross realized gains $ 15,721 $ 31 359 $ - Gross realized losses 3,488 - 7,338 Applicable income tax on net realized gains (losses) 3,235 10,662 (2,495)
Securities to be held to maturity: Gross realized gains 884 447 107 Gross realized losses 9,547 3,376 1,956 Applicable income tax on net realized gains (losses) (2,945) (996) (629)
The amortized cost and fair values of investment securities available for sale and to be held to maturity at December 31, 1996, by expected maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
4. Loans
Nonaccrual loans were approximately $2,065,000 and $1,655,000 at December 31, 1996 and 1995, respectively. Interest which would have been recorded on these loans under the contractual terms is approximately $202,000 and $175,000 as of December 1996 and 1995, respectively. Interest income actually recorded on these loans was approximately $102,000 and $59,000 in 1996 and 1995, respectively.
5. Allowance for loan losses
Changes in the allowance for loan losses were as follows:
Year ended December 31, 1996 1995 1994 ------------------------------- Balance, beginning of year $1,256,000 $1,208,000 $1,129,000 Provision for loan losses 529 52,932 101,787 Loans charged off (338,106) (12,657) (54,442) Recoveries of previous charge-offs 13,577 7,725 31,655 ---------- ---------- ---------- Net loans charged off (324,529) (4,932) (22,787) ---------- ---------- ----------
Balance, end of year $ 932,000 $1,256,000 $1,208,000 ========== ========== ==========
6. Premises and equipment and leases
Premises and equipment:
Premises and equipment are summarized as follows:
December 31, 1996 1995 ---------------------- Land $ 185,918 $ 190,308 Buildings and improvements 1,241,438 1,264,664 Leasehold improvements 304,584 281,870 Furniture and equipment 2,504,645 2,116,689 Construction in progress 145,007 212,589 ---------- ---------- 4,381,592 4,066,120 Less accumulated depreciation 1,938,901 1,725,374
$2,442,691 $2,340,746 ========== ==========
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
6. Premises and equipment and leases (Continued)
Leases:
The principal offices of the Parent and the Bank are leased from Boush Bank Building Associates, a related party, under terms of a net operating lease which expires on November 18, 2008. The Bank has the option of renewing the lease for up to five additional five-year periods at the same rental terms and conditions. The Bank also has the option of purchasing undivided interests in the building and related land at any time at the lessor's original cost. In connection with the acquisition of the leased property, the lessor obtained primary financing of $1,600,000 through the issuance of a revenue bond by the Norfolk Redevelopment and Housing Authority and secondary financing of approximately $240,000 by the Bank. Rent expense under the lease, which is based on interest expense incurred by the lessor, was $74,641 in 1996, $74,895 in 1995 and $60,151 in 1994.
The Bank has a commitment to provide the lessor with such loans as are necessary for the lessor to make principal payments on the primary financing described above. The Bank is obligated to purchase in January of each year, if certain financial covenants are met as of the preceding year end, such undivided interest in the leased property as would not exceed 90% of what the Bank would be permitted to purchase under banking regulations of the Commonwealth of Virginia. Under this provision of the lease, the Bank purchased 34.7% of the leased property in 1988 for $637,410 and 19.7% in 1987 for $362,201. The Bank has not made any additional purchases since 1988.
The Bank also leases other buildings for four branch offices. Such leases contain renewal options and have remaining terms of 6 to 155 months as of December 31, 1996.
Rental expense and related sublease income are as follows: Year ended December 31, 1996 1995 1994 ----------------------------
Gross rental expense $134,072 $187,936 $181,049 Sublease rental income 63,378 65,368 81,773 -------- -------- --------
Net rental expense $ 70,694 $122,568 $ 99,276 ======== ======== ========
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
6. Premises and equipment and leases (Continued)
Future minimum lease payments, by year and in the aggregate, under noncancelable operating leases consist of the following at December 31, 1996:
Sublease Rental Rental Expense Income ------- ------
1997 $ 159,247 $ 57,566 1998 151,109 47,087 1999 145,370 35,640 2000 130,631 - 2001 129,547 - Thereafter 555,005 - ---------- --------
$1,270,909 $140,293 ========== ========
7. Deposits
The aggregate amount of short-term jumbo certificates of deposit, each with a minimum denomination of $100,000, was $5,295,686 and $4,405,574 at December 31, 1996 and 1995, respectively.
At December 31, 1996, the scheduled maturities of certificates of deposit, included in other time deposits, are as follows:
1997 $16,250,115 1998 7,619,317 1999 11,429,041 2000 9,501,653 2001 and thereafter 7,776,236 ----------- $52,576,362 ===========
8. Stockholders' equity
The Company's Articles of Incorporation authorize the issuance of 300,000 shares of Serial Preferred Stock, par value $25 per share, none of which has been issued at December 31, 1996. The Board of Directors is authorized to issue this stock in one or more series, to establish the number of shares to be included in each such series, and to fix the designation, relative rights, preference and limitations of each such series.
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
8. Stockholders' equity (Continued)
During 1996, the Company declared a 6% stock dividend to stockholders of record on March 31, 1996. Cash of $2,437 was paid for fractional shares. During 1995, the Company declared a 6% stock dividend to stockholders of record on March 31, 1995. Cash of $2,267 was paid for fractional shares. During 1994, the Company declared a 5% stock dividend to stockholders of record on April 1, 1994. Cash of $1,901 was paid for fractional shares. The Company's earnings per share data have been restated for prior years to reflect the changes in shares outstanding.
9. Stock option plans
During 1990, a stock option plan was adopted which granted options to certain employees to purchase shares of the Company's common stock at a price determined at the date the options were granted. Options to purchase 21,816 shares are outstanding as of December 31, 1996. The options expire February 20, 2000. No options have been exercised. Options to purchase shares were adjusted for the stock dividends declared in 1996, 1995 and 1994.
During 1995, a stock option plan was adopted which granted options to non-employee directors to purchase shares of the Company's common stock at a price determined at the date the options were granted. Options to purchase 38,213 shares are outstanding as of December 31, 1996. The options expire January 17, 2005. No options have been exercised. Options to purchase shares were adjusted for the stock dividend declared in 1996.
10. Short-term borrowings
Securities sold under agreements to repurchase generally mature within one to three days from the transaction date. The maximum amount outstanding at the end of a month during 1996 was $5,224,056 and the average daily balance during 1996 was $3,504,033. The securities underlying these agreements were under the Bank's control.
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
11. Long-term debt
Long-term debt is summarized as follows:
December 31, 1996 1995
Obligation under Norfolk Redevelopment and Housing Authority Revenue Bond $609,280 $635,392
Other - 48,627 -------- -------- $609,280 $684,019 ======== ========
The bond represents the unpaid balance of that portion of the primary financing of the Bank's principal offices related to the Bank's interest in the property. At December 31, 1996, premises with a carrying value of approximately $793,000 were pledged as collateral for the Bank's portion of the total unpaid obligation related to the bond. Principal payments of $26,112 are due each January 1 with a final payment of the remaining balance due January 1, 2010. Interest is payable monthly at 68.6% of the prime rate of a regional bank which totalled 5.66% at December 31, 1996.
Maturities of long-term debt by year and in the aggregate are summarized as follows:
1997 $ 26,112 1998 26,112 1999 26,112 2000 26,112 2001 26,112 Thereafter 478,720 ------- $609,280 ========
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
12. Retirement plan and other supplemental compensation agreements
In 1993 the Bank adopted a thrift and profit sharing plan (Plan) qualified under Section 401(k) of the Internal Revenue Code. Eligible employees, as defined by the Plan, can elect to defer up to 15% of compensation. The Bank may at its discretion make a matching contribution and the amount was $15,444, $10,722, and $8,160 for 1996, 1995, and 1994, respectively. In addition, a discretionary contribution of $4,556, $9,200, and $11,840, was made in 1996, 1995, and 1994, respectively, to the profit sharing section of the Plan.
The Bank has entered into a Deferred Supplemental Compensation Agreement (the Supplemental Agreement) with Mr. E. J. Woodard, Jr. The Supplemental Agreement, as amended on April 27, 1993, provides that if Mr. Woodard remains in the full-time employment of the Bank until age 65, then upon retirement Mr. Woodard or his designated beneficiary will be entitled to receive the sum of $250,000 payable in 120 equal monthly installments.
13. Income taxes
Net deferred tax asset, included in other assets, is $403,224 and $491,029 as of December 31, 1996 and 1995, respectively.
The net deferred tax asset includes the following components:
December 31, 1996 1995 --------------------- Deferred tax liability: Depreciation $(119,283) $(111,595) Net unrealized gain on securities available for sale - (4,000) Deferred gain on sale of fixed assets (20,756) - --------- --------- Total deferred tax liability (140,039) (115,595)
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
13. Income taxes (Continued)
December 31, 1996 1995 --------------------- Deferred tax asset: Provision for loan losses 230,658 325,278 Deferred compensation 168,813 156,591 Accrued vacation 89,254 76,583 Deferred net loan fees 40,110 48,172 Net unrealized loss on securities available for sale 14,428 - --------- --------- Total deferred tax asset 543,263 606,624 --------- ---------
Net deferred tax asset $ 403,224 $ 491,029 ========= =========
The components of applicable income tax expense (benefit) are as follows:
Year ended December 31, 1996 1995 1994 -----------------------------
Current $258,031 $382,500 $387,286 Deferred 106,233 (100,352) (109,035) -------- -------- -------- $364,264 $282,148 $278,251 ======== ======== ========
Timing differences in the recognition of revenues and expenses for income tax and financial reporting purposes result in deferred income taxes as follows:
Year ended December 31, 1996 1995 1994 ----------------------------
Provision for loan losses $ 94,620 $ (63,312) $ (84,562) Depreciation 7,688 79 6,389 Deferred gain on sale of fixed assets 20,756 - - Deferred compensation (12,222) (16,361) (18,953) Accrued vacation (12,671) (5,664) (10,329) Deferred net loan fees 8,062 (15,094) (1,580) -------- --------- ---------
$106,233 $(100,352) $(109,035) ======== ========= =========
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
13. Income taxes (Continued)
The difference between income tax expense and the amount computed by applying the statutory federal income tax rate of 34% are as follows:
Year ended December 31, 1996 1995 1994 ----------------------------
Income tax expense at statutory rates $408,234 $380,006 $371,396 Increase (decrease) due to: Tax exempt income (53,221) (50,583) (43,528) Other 9,251 (47,275) (49,617) -------- -------- --------
Applicable income tax expense $364,264 $282,148 $278,251 ======== ======== ========
14. Commitments, contingent liabilities and financial instruments
The Bank is a party to financial instruments with offbalance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit risk not recognized in the balance sheet.
The Bank's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. The Bank anticipates no losses as a result of these transactions.
Financial instruments whose contract amounts represent credit risk are as follows:
December 31, 1996 1995 ----------------------- Commitments to extend credit $7,634,244 $6,471,703 Standby letters of credit 626,400 592,133
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
14. Commitments, contingent liabilities and financial instruments (Continued)
Commitments to extend credit include unused lines of credit, credit card arrangements, and the unused portions of construction loans. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of customers to a third party. The Bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained if deemed necessary by the Bank upon extension of credit is based upon management's credit evaluation of the counter party. Collateral held varies, but may include cash, marketable securities, accounts receivable, inventory, property, plant and equipment and real estate.
SFAS No. 107, "Disclosures about Fair Values of Financial Instruments", requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet. In cases where quoted market prices are not available, fair values are based on estimates using discounted cash flow analyses or other valuation techniques. Those techniques involve subjective judgement and are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. As a result, the derived fair value estimates cannot be substantiated by comparison to independent markets, and in many cases, could not be realized in immediate settlement of the instrument.
The following methods and assumptions were used by the Bank in estimating the fair value of its financial instruments. All of the Bank's financial instruments were held or issued for purposes other than trading.
The principal components of calculated fair values are cash flows and the discount rate. Cash flows are affected by scheduled principal maturities, repricing characteristics, prepayment assumptions, and interest cash flows.
Interest cash flows are calculated by assuming that the yield/cost of the portfolio remains unchanged from the historical level until affected by maturity, prepayment or repricing.
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
14. Commitments, contingent liabilities and financial instruments (Continued)
The discount rates used to determine the fair value of the financial instruments are constructed using a build-up approach. This approach views the discount rate as consisting of four components: the risk-free rate, credit quality, operating expenses and prepayment option price.
The risk-free rate forms the foundation of the discount rate and is derived from the term structure of interest as reflected in the Treasury yield curve. The point on the Treasury yield curve which corresponds to the time into the future for the cash flow is selected as the risk-free rate.
The credit quality component is the annualized yield needed to cover the loss of value expected over the entire life of a portfolio. The higher the credit quality component, the higher the credit risk.
The operating expense component represents an annualized cost rate derived from operating expense allocations. This component is used to adjust the risk-free rate in order to compensate for operating expenses of the Bank.
The prepayment option price is the final component and represents a basis point adjustment to the risk-free rate to reflect the value of imbedded prepayment options.
The estimated fair values of the Bank's financial instruments as of December 31, 1996 and 1995, are as follows (in thousands):
December 31, December 31, 1996 1995 ------------ ------------
Carrying Fair Carrying Fair Amount Value Amount Value ------ ----- ------ ----- Financial assets: Cash and short term investments $11,281 $ 11,281 $10,266 $10,266 Investment securities 23,663 23,389 17,258 16,949
Loans 65,506 61,066 Allowance for loan loss (932) (1,256) ------- ------- Net loans 64,574 65,937 59,810 62,188 ------- -------- ------- -------
Total financial assets $99,518 $100,607 $87,334 $89,403 ======= ======== ======= =======
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
14. Commitments, contingent liabilities and financial instruments (Continued)
December 31, December 31, 1996 1995 ------------ -------------
Carrying Fair Carrying Fair Amount Value Amount Value ------ ----- ------ -----
Financial liabilities: Deposits $90,507 $90,959 $82,566 $83,266 Securities sold not owned 3,573 3,573 2,291 2,291 Long-term debt 609 575 684 703 ------- ------- ------- -------
Total financial liabilities $94,689 $95,107 $85,541 $86,260 ======= ======= ======= =======
SFAS No. 107 excludes certain financial instruments and all non financial instruments from its disclosure requirements. The disclosures also do not include certain intangible assets such as core deposit premiums, mortgageservicing rights and goodwill. Accordingly, the aggregate fair value amount presented should not be interpreted as representing the underlying value of the Bank.
15. Concentrations of credit
The Bank grants commercial, real estate and consumer loans to customers throughout its lending area, primarily the cities of Virginia Beach and Norfolk, Virginia. Although the Bank has a diversified loan portfolio, a significant portion of its debtors' abilities to honor their contracts is dependent upon the economic environment of its lending area. The concentrations of credit by type of loan are set forth in the balance sheet. The distribution of commitments to extend credit approximates the distribution of loans outstanding. Standby letters of credit were granted primarily to commercial borrowers.
At December 31, 1996, the Company's cash and due from banks included two commercial bank deposit accounts aggregating $129,575 in excess of the Federal Deposit Insurance Corporation limit of $100,000 per institution.
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
16. Related parties
The Bank has granted loans to directors and executive officers of the Company and to their associates. Related party loans are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons and do not involve more than normal risk of collectibility. The aggregate dollar amount of these loans was $2,601,252 and $2,447,136 at December 31, 1996 and 1995, respectively. During 1996, $768,406 of new loans were made, and repayments totaled $614,290.
The Bank has also sold participation in loans on a non-recourse basis to certain of the Company's directors. Such loans amounted to $764,832 and $386,745 as of December 31, 1996 and 1995, respectively.
17. Regulatory matters
The Company and its subsidiary are affiliates within the meaning of Section 23A of the Federal Reserve Act. Accordingly, they are subject to the limitations specified in such section on the making of loans or extension of credit to, or purchase of securities under repurchase agreement from, each other. Therefore, substantially all of the net assets of the Bank are restricted from use by the Company in the form of loans or advances. Dividends, however, may be paid to the Company by the Bank under formulas established by the appropriate regulatory authorities. These formulas contemplate that the current earnings and earnings retained for the two preceding years may be paid to the Company without regulatory approval. In 1997, the Bank can initiate dividend payments without said regulatory approvals of approximately $1,680,000 plus an additional amount equal to the Bank's net earnings for 1997 up to the date of any such dividend declaration. Substantially all of the retained earnings of the Company are represented by undistributed earnings of the Bank.
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
17. Regulatory matters (Continued)
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain offbalance sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to riskweighted assets (as defined) and of Tier I capital (as defined ) to average assets (as defined). Management believes, as of December 31, 1996, that the Bank meets all capital adequacy requirements to which it is subject.
As of December 31, 1996, the most recent notification from the Federal Reserve Bank categorized the Bank as adequately capitalized under the regulatory framework for prompt corrective action. To be categorized as adequately capitalized the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the institution's category.
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
17. Regulatory matters (Continued)
18. Parent company only financial information
COMMONWEALTH BANKSHARES, INC. (PARENT COMPANY ONLY)
BALANCE SHEETS
DECEMBER 31, 1996 AND 1995
ASSETS
1996 1995
Cash on deposit with subsidiary $ 243,470 $ 251,111 Investment in subsidiary 9,327,521 8,516,580 ---------- ----------
$9,570,991 $8,767,691
LIABILITIES AND STOCKHOLDERS' EQUITY
Due to subsidiary $ 2,521 $ 5,204
Total stockholders' equity 9,568,470 8,762,487 ---------- ----------
$9,570,991 $8,767,691
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
18. Parent company only financial information
COMMONWEALTH BANKSHARES, INC. (PARENT COMPANY ONLY)
STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995, AND 1994
1996 1995 1994 ---- ---- ----
Expenses: Legal expense $ 2,719 $ 6,560 $ 12,862 Other 1,100 1,325 950 -------- -------- -------- Total expenses 3,819 7,885 13,812 -------- -------- --------
Loss before income taxes and equity in undistributed net income of subsidiary (3,819) (7,885) (13,812)
Income tax benefits 1,298 2,681 4,700 -------- -------- --------
Loss before equity in undistributed net income of subsidiary (2,521) (5,204) (9,112)
Equity in undistributed net income of subsidiary 838,947 840,721 823,203 -------- -------- --------
Net income $836,426 $835,517 $814,091 ======== ======== ========
COMMONWEALTH BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996
18. Parent company only financial information (Continued)
COMMONWEALTH BANKSHARES, INC. (PARENT COMPANY ONLY)
STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995, AND 1994
1996 1995 1994 ---- ---- ----
Operating activities: Net income $836,426 $835,517 $814,091 Adjustments to reconcile net income to net cash from (used in)operating activities: Equity in undistributed net income of subsidiary (838,946) (840,721) (823,203) Decrease in amount due from subsidiary - - 2,187 Increase (decrease) in amount due to subsidiary (2,684) (3,908) 9,112 -------- -------- -------- Net cash from (used in) operating activities (5,204) (9,112) 2,187
Financing activity: Dividends paid (2,437) (2,267) (1,901) -------- -------- --------
Net increase (decrease) in cash on deposit with subsidiary (7,641) (11,379) 286
Cash on deposit with subsidiary, beginning of year 251,111 262,490 262,204 -------- -------- --------
Cash on deposit with subsidiary, end of year $243,470 $251,111 $262,490 ======== ======== ========