ITEM 1. BUSINESS
Provident Bancorp, Inc.
Provident Bancorp, Inc. ("Bancorp") is a Cincinnati-based commercial banking and financial services company which operates primarily in Ohio and northern Kentucky. Bancorp recently expanded its operations to provide financial services on a national scale further reducing its dependence upon a single geographic region. At December 31, 1996, Bancorp had total assets of $6.8 billion, total deposits of $4.6 billion and total shareholders' equity of $517 million.
Bancorp was incorporated in 1980 for the purpose of acquiring the Common Stock of The Provident Bank ("Provident") owned by American Financial Group ("AFG"). At December 31, 1996, Carl H. Lindner, certain members of his family and certain entities controlled by and/or established for the benefit of such family members beneficially owned approximately 43% of AFG's and 58% of Bancorp's outstanding voting Common Stock. Bancorp's executive offices are located at One East Fourth Street, Cincinnati, Ohio 45202 and its telephone number is (513) 579-2000.
Bancorp conducts its banking operations through Provident and The Provident Bank of Kentucky.
Commercial Banking. Central to Bancorp's long-term strategy is the concept of relationship banking with commercial customers that emphasizes attracting new small and middle market customers and cross- selling additional services to established customers. These services include cash management, loan, lease, letter of credit, trade financing and corporate trust activities. Bancorp implements this strategy by attracting and retaining experienced banking officers and rewarding them for originating loans and cross-selling additional services. In addition, Bancorp originates regional and national corporate loan and lease transactions that are consistent with the overall relationship lending strategy of Bancorp. At December 31, 1996, Bancorp's total commercial lending portfolio was $3.4 billion.
Consumer Banking. Bancorp offers deposit accounts providing pricing incentives and various levels of services and benefits depending on the needs of and balances maintained by the customer. Through these accounts, Bancorp believes it can more effectively offer additional banking services such as credit cards, consumer and mortgage loans, home equity loans, auto loans and leases, retirement accounts and investment accounts. Bancorp's total consumer lending portfolio was $1.9 billion as of December 31, 1996.
Retail Distribution. Bancorp's banking subsidiaries have 72 branch offices: 57 in the greater Cincinnati area (including 9 in northern Kentucky), 12 in the greater Dayton area, 1 in Columbus, Ohio and 2 in Cleveland, Ohio. Of the 72 branch offices, 20 are located within food supermarkets. In addition to the banking centers, Bancorp operates 161 ATMs for customers to perform their banking transactions. Bancorp also provides a seven day a week, 24 hour a day telephone customer service center able to respond to customers' questions or instructions.
Other Operations. Bancorp also provides trust, custodial, asset management and securities brokerage to its customers.
New Financial Services. In recent years, Bancorp has expanded its business in both the financial products it offers and the geographical area it services. The following is a summary of these expansions:
In September 1995, Provident Consumer Financial Services ("PCFS"), a division of Provident, began originating, on a national basis, nonconforming consumer closed end home equity loans. Since its inception through year-end 1996, PCFS has originated $390 million of these type of loans. During 1996, PCFS securitized and sold $310 million of these mortgages to the secondary market for a pre-tax gain of $24 million. Bancorp also plans to use PCFS's network of offices and brokers throughout the United States to expand its business by originating conforming mortgage loans.
During mid-1996, Bancorp introduced its MeritValu program which is an on-line, multiple-merchant frequent shopper rewards program which supports cash, credit card and all other methods of payment by the consumer. The program allows consumers to earn rebates and spend them like cash on goods and services at participating merchants, while the merchants benefit from increased sales and customer data information. As of year-end 1996, the MeritValu program had 68,000 active cardholders, supported by 65 retailers in the Cincinnati area. In February 1997, Bancorp announced an agreement to launch a private label version of MeritValu through the Chambers of Commerce of Greater Ft. Lauderdale, Greater Miami and Greater Boca Raton. The three chambers of commerce represent more than 8,000 businesses in South Florida and a corresponding employee base of about 350,000.
In December 1996, Bancorp acquired Information Leasing Corporation ("ILC"), and its affiliated lease servicing company. ILC is a full service, small ticket equipment leasing company which focuses on establishing strategic relationships with high volume, quality equipment vendors and customers. ILC, which operates throughout the United States, generates its business through contractual vendor programs, master lease agreements, and from small ticket vendor programs. ILC had over $110 million in assets at the time of acquisition.
In February 1997, Bancorp purchased South Hillsborough Community Bank ("SHCB"), a $40 million Florida state chartered bank. SHCB has three offices located in Southeast Hillsborough County, approximately 20 miles south of Tampa. This acquisition will allow Bancorp to expand its presence in the Florida market.
Miscellaneous
The financial services business is highly competitive. The subsidiaries of Bancorp compete actively with national and state banks, savings and loan associations, securities dealers, mortgage bankers, finance companies and other financial service entities.
Bancorp and its subsidiaries employed approximately 2,100 employees equating to approximately 1,900 full-time-equivalent employees.
Supervision and Regulation
Bancorp is registered as a bank holding company, and is subject to the regulations of the Board of Governors of the Federal Reserve under the Bank Holding Company Act of 1956, as amended ("BHCA"). Bank holding companies are required to file periodic reports with and are subject to examinations by the Federal Reserve. Bancorp is prohibited by the BHCA from acquiring direct or indirect control of more than 5% of the outstanding shares of any class of voting stock, or substantially all of the assets of any bank or merging or consolidating with another bank holding company, without prior approval of the Federal Reserve. The BHCA, as amended, authorizes interstate bank acquisitions anywhere in the country and effective June 1, 1997 will allow interstate branching by acquisition and consolidation in those states that have not opted out by that date. As of December 31, 1996, Ohio, Kentucky and Florida have not opted out of interstate branching.
Additionally, Bancorp is prohibited by the BHCA from engaging in nonbanking activities, unless such activities are determined by the Federal Reserve to be closely related to banking. The BHCA does not place territorial restrictions on the activities of such nonbanking- related activities.
There are various legal and regulatory limits on the extent to which Bancorp's subsidiary banks may pay dividends or otherwise supply funds to Bancorp. In addition, federal and state regulatory agencies also have the authority to prevent a bank or bank holding company from paying a dividend or engaging in any other activity that, in the opinion of the agency, would constitute an unsafe or unsound practice. See ITEM 7 "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Liquidity" and Note P included in "Notes to Consolidated Financial Statements".
Various requirements and restrictions under federal and state laws regulate the operations of Bancorp's banking affiliates, requiring the maintenance of reserves against deposits, limiting the nature of loans and interest that may be charged thereon, restricting investments and other activities, and subjecting the banking affiliates to regulation and examination by the Federal Reserve or state banking authorities and the FDIC.
The Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") provides that a holding company's controlled insured depository institutions can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC in connection with the default of an affiliated insured bank or savings association.
The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") covers a wide range of banking regulatory issues including: (i) the recapitalization of the Bank Insurance Fund; (ii) deposit insurance reform, including requiring the FDIC to establish a risk- based premium assessment system; (iii) substantial new examination, audit and reporting requirements on insured depository institutions and (iv) a number of other regulatory and supervisory matters. FDICIA requires federal bank regulatory authorities to take "prompt corrective action" with respect to bank organizations that do not meet minimum capital requirements.
Bancorp's subsidiary banks are "well capitalized" and are not prohibited by FDICIA from accepting brokered deposits or offering interest rates on deposits higher than the prevailing rate in their markets. As of December 31, 1996, Bancorp's subsidiary banks had brokered deposits (as defined) of $765.5 million.
The monetary policies of regulatory authorities, including the Federal Reserve, have a significant effect on the operating results of banks and bank holding companies. The nature of future monetary policies and the effect of such policies on the future business and earnings of Bancorp and its subsidiaries cannot be predicted.
Provident Securities and Investment Company, a Provident subsidiary, is licensed as a retail securities broker and is subject to regulation by the Securities and Exchange Commission ("SEC"), state securities authorities and the National Association of Securities Dealers, Inc. Provident Investment Advisors, Inc., a Bancorp subsidiary, is a registered investment advisor, subject to regulation by the SEC and state securities authorities.
ITEM 2.
ITEM 2. PROPERTIES
Bancorp and certain of its subsidiaries lease their executive offices at One East Fourth Street, Cincinnati, Ohio and additional space at Three East Fourth Street, Cincinnati, Ohio under leases expiring in 2010 from a trust for the benefit of a subsidiary of AFG. Provident also leases approximately 5,000 square feet of office space from Great American Insurance Company, a subsidiary of AFG. Provident leases approximately 123,000 square feet of additional office space in downtown Cincinnati. Provident owns five buildings in the Queensgate area of Cincinnati that contain approximately 196,000 square feet, of which three buildings are used for offices, data processing and warehouse facilities and two buildings are leased to other parties. Provident owns twenty-five of its branch locations and leases thirty- eight. Bancorp owns a 3,000 square foot building in which Provident Kentucky's main office is located in Alexandria, Kentucky. Bancorp also owns the 12,000 square foot building in Cold Spring, Kentucky in which one of Provident Kentucky's branches is located. In addition to the two branches leased from Bancorp, Provident Kentucky owns two of its branch locations and leases five. SHCB owns one of it branch locations and leases two. For information concerning rental obligations see Note F included in "Notes to Consolidated Financial Statements" that are included in this report in Part II, Item 8.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Bancorp and its subsidiaries are not parties to any pending legal proceedings other than routine litigation incidental to their business, the results of which will not be material to Bancorp or its financial condition.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None in the fourth quarter.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Common Stock is traded on the NASDAQ National Market under the symbol "PRBK". The following table sets forth, for the periods indicated, the high and low daily closing sales prices as reported on NASDAQ and the quarterly dividends paid by Bancorp. Disclosures relating to Bancorp's Common Stock and per common share information have been adjusted for 3-for-2 common stock splits effective May 24, 1996 and December 19, 1996.
At February 28, 1997, there were approximately 4,300 holders of record of Bancorp's Common Stock.
In 1996 and 1995 Bancorp paid dividends on its Common Stock of $21.4 million and $16.4 million and on its Preferred Stock of $.5 million and $2.4 million, respectively. Bancorp increased its quarterly dividend rate per share from $.14 to $.16 in February 1997. Bancorp has indicated its intention to pay annual dividends of approximately 30% of recurring net earnings. Recurring net earnings is defined as net earnings excluding the net after-tax effect of certain amounts related to acquisitions, security gains or losses and changes in accounting principles. It is expected that in the next several years, Bancorp's revenues will consist principally of dividends paid to it by its subsidiaries and interest generated from lending and investing activities. A discussion of limitations and restrictions on the payment of dividends by subsidiaries to Bancorp is contained under ITEM 7 "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Liquidity" and Note P included in "Notes to Consolidated Financial Statements".
On November 27, 1996, Provident Capital Trust I, a business trust established by Bancorp, issued $100 million of 8.60% Capital Securities ("Capital Securities") and invested the proceeds thereof in 8.60% Junior Subordinated Debentures ("Debentures") issued by Bancorp. Along with the Debentures, Bancorp issued guarantees on the Capital Securities. These issuances were exempt from registration under the Securities Act of 1933 pursuant to Section 4(2) of that Act. A further discussion of these transactions is provided in Note H included in "Notes to Consolidated Financial Statements".
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following is a summary of selected financial data for Bancorp and subsidiaries for the five years ended December 31, 1996. The summary should be read in conjunction with the Financial Statements and Notes to Consolidated Financial Statements included under Item 8 "FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA".
Additional financial data and a discussion of major variances in financial operations between the current reporting period and the previous two periods is included in Item 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This discussion should be read in conjunction with the audited consolidated financial statements. Average balances reported are based on daily calculations.
From time to time, Bancorp may publish forward-looking statements relating to such matters as anticipated financial performance, business prospects, new banking and financial service products and similar matters. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. In order to comply with the terms of the safe harbor, Bancorp notes that a variety of factors could cause its actual results and experiences to differ materially from the anticipated results or other expectations expressed in its forward-looking statements. These risks and uncertainties include, without limitation, changes in interest rates, developments in the economies served by Bancorp, changes in anticipated credit quality trends and changes in accounting, tax or regulatory practices or requirements.
GENERAL
Bancorp reported net earnings for 1996 of $81.2 million, which represented an increase of $9.3 million (13%) over 1995 net earnings. Net interest income increased $37.4 million (18%) while the provision for loan and lease losses increased $33.0 million. The significant increase in the provision for loan and lease losses was the result of the high level of net charge-offs and the growth in total loans and leases experienced during 1996. Noninterest income increased $42.0 million (74%) primarily due to increases in gain on sales of loans and leases and other service charges and fees. Noninterest expense increased $29.5 million (21%) because of increases in compensation, professional services, deposit insurance and other expense.
Average net loans and leases increased by $555.6 million (13%) in 1996 over the prior year. The majority of the increase was within commercial and financial loans and consumer lease financing which increased $254.3 million (13%) and $208.3 million (84%), respectively. Asset quality ratios improved in 1996, with nonperforming assets decreasing to .42% of total assets compared to .77% in 1995. Both collections and charge-offs of loans were responsible for the decrease. The ratio of net charge-offs to average loans was .85% for 1996 compared to .13% for 1995. A recovery of $5.8 million relating to one borrower which had been charged off in 1991 contributed to the lower ratio experienced in 1995. While management expects some improvement in the net charge-offs to average loans ratio in 1997, management does not think it will approach the ratio realized for 1995.
As noted above, gain on sales of loans and leases made a significant contribution to Bancorp's net income during 1996. Of the $31.0 million gain recorded during the year, $24.3 million was realized from the sale of $312.4 million of residential closed end non-conforming home equity loans originated by PCFS. PCFS's goals include the origination of $800 million of this product within the next year and the sale of at least $100 million each quarter. However, management notes that this is a forward-looking statement and there is no assurance that originations or sales of this magnitude can be made or that they will generate a net profit at the same rate as realized in 1996.
Bancorp reported net earnings for 1995 of $71.9 million, an increase of $14.2 million (25%) over 1994 net earnings. Net interest income increased $20.7 million (11%) while the provision for loan and lease losses increased $2.0 million (17%). Noninterest income increased $20.5 million (56%) primarily due to increases in gains from the sales of loans and leases, mortgage loan servicing rights and Heritage Savings Bank's ("Heritage") deposits and branches. Noninterest expense increased $19.5 million (16%) because of increases in compensation and other expense.
Average net loans and leases increased by $723.5 million (20%) in 1995 compared to 1994. This increase consisted principally of growth in commercial and financial loans of $379.9 million (23%), consumer lease financing of $191.5 million (331%) and instalment loans of $83.1 million (10%). Asset quality was not as strong during 1995 as during 1994. The ratio of nonperforming assets to total assets was .77% and .20% as of December 31, 1995 and 1994, respectively. This compares to .76% for the average of the past five years. Net charge-offs as a percentage of average net loans and leases was .13% in 1995 in contrast to .02% for 1994. For the past five years, the average has been .36%. The lower ratios experienced in 1995 and 1994 resulted primarily from the recovery of $11.7 million, which was recognized equally during 1995 and 1994, relating to one borrower.
NET INTEREST INCOME
Net interest income equals the difference between interest earned on loans, leases and investments and interest incurred on deposits and other borrowed funds. Net interest income is affected by changes in both interest rates and the amounts of interest earning assets and interest bearing liabilities outstanding.
Net interest income represents the principal source of income for Bancorp. In 1996, 1995 and 1994, net interest income on a taxable equivalent basis was $240.6 million, $203.1 million and $182.3 million, respectively, which represented approximately 71%, 78% and 83%, respectively, of the net revenues (net interest income plus noninterest income) of Bancorp.
Net interest margin represents net interest income as a percentage of total interest earning assets. For 1996, the net interest margin, on a fully taxable equivalent basis, was 3.96%, compared to 3.82% in 1995 and 4.10% in 1994. The improvement in net interest margin from 1995 to 1996 reflects the average rate paid on interest bearing liabilities, which decreased 29 basis points, more than offsetting the decrease on interest earning assets, which decreased 13 basis points. The decrease in the overall cost of interest bearing liabilities was primarily due to the decline in the rate paid on time deposits, which more than offset an increase in higher cost liabilities. The decrease in the average rate earned on interest earning assets was principally due to a lower average rate earned on commercial and financial loans which was partially offset by an increase in higher yield assets. Bancorp enters into interest rate swap transactions to manage the impact of interest rate moves and interest rate risk. During 1996, interest rate swaps increased the net interest margin by 23 basis points.
The decline in the net interest margin from 1994 to 1995 reflects the average rate paid on interest bearing liabilities, which increased 132 basis points, more than offsetting the increase on interest earning assets, which increased 92 basis points. The increase in the overall cost of interest bearing liabilities was primarily due to an increase in the average balance of time deposits along with higher interest rates paid on time deposits. The increase in interest earning assets was principally due to an increase in the average balance of commercial and financial loans along with higher rates received on commercial and financial loans and instalment loans. During 1995, interest rate swaps decreased the net interest margin by 10 basis points.
Table 1 provides an analysis of net interest income and illustrates the interest income earned and interest expense charged for each major component of interest earning assets and interest bearing liabilities. The net interest spread is the difference between the average yield earned on assets and the average rate incurred on liabilities. For comparative purposes, the table has been adjusted to reflect tax- exempt income on a fully taxable equivalent basis assuming an income tax rate of 35%.
TABLE 1: Net Interest Income, Average Balances and Rates
Interest free funds (interest earning assets less interest bearing liabilities) increased $103.1 million (17%) in 1996 and increased $71.8 million (13%) in 1995. Such funds, consisting primarily of demand deposits and shareholders' equity, supported 12% of total interest earning assets in each of the last three years. In preparing the net interest margin table, nonaccrual loan balances are included in the average balances for loans and leases. Loan fees are included in loan and lease income as follows: 1996 - $17.4 million, 1995 - $18.2 million and 1994 - $15.4 million.
Table 2 shows the changes in net interest income on a tax equivalent basis resulting from changes in volume and changes in rates. Changes not solely due to volume or rate have been allocated proportionately.
TABLE 2: Net Interest Income Changes Due to Volume and Rates
PROVISION FOR LOAN AND LEASE LOSSES
The provision for loan and lease losses was $47.0 million, $14.0 million and $12.0 million in 1996, 1995 and 1994, respectively. The increase of $33 million in 1996 over 1995 is due to the increase in net charge-offs from 1995 to 1996 of $36.2 million and the growth in total loans and leases of $415.4 million (8%) during 1996. The provision for loan and lease losses increased $2.0 million (17%) from 1994 to 1995 due to increases in total loans and leases of $691.5 million (16%) and nonperforming loans of $35.0 million. The ratio of the loan loss reserve as a percentage of total loans and leases has remained consistent over the last three years. The ratio was 1.26% at year-end 1996 compared to 1.23% at year-end 1995 and 1.24% at year-end 1994.
NONINTEREST INCOME
Table 3 details the components of noninterest income and their change since 1994:
TABLE 3: Noninterest Income
Noninterest income increased $42.0 million (74%) in 1996 compared to 1995. Service charges on deposit accounts increased primarily due to increased fee rates on corporate and consumer deposit accounts, nonsufficient funds and ATM usage. The increase in other service charges and fees resulted from the recognition of gains and fees related to commercial lending. Gain on sales of loans and leases increased as a result of the sale of residential closed end non- conforming home equity loans by PCFS. Other income increased primarily as a result of the receipt of additional consideration related to a loan that had been restructured as further discussed under "Credit Risk Management".
Noninterest income increased $20.5 million (56%) in 1995 compared to 1994. Service charges on deposit accounts increased due to higher rates on corporate deposit accounts, nonsufficient funds, and ATM fees. Other service charges and fees increased primarily due to a gain on the sale of mortgage loan servicing rights. The sale of equipment leases was the principal reason for the increase in gain on sale of loans and leases. Other income increased chiefly due to a gain from the sale of Heritage's deposits and branches.
NONINTEREST EXPENSE
Table 4 details the components of noninterest expense and their change since 1994:
TABLE 4: Noninterest Expense
Noninterest expense increased $29.5 million (21.3%) for 1996 compared to 1995. Salaries and employee benefits, primarily in the areas of commercial and consumer lending, securities brokerage, and information delivery, increased as a result of merit and promotion increases, increases in incentives and increased personnel. Professional services increased primarily due to increases in management consulting, residential loan subservicing and legal expenses. The increase in deposit insurance expense was due to the one time assessment of $8.2 million for the capitalization of the Savings Association Insurance Fund. Equipment expense increased primarily due to the depreciation of expanded telebanking and computer equipment. Increases in loan origination expense and credit card processing were the primary reasons for the increase in charges and fees. Franchise taxes increased primarily due to the increase in net worth of Bancorp and adjustments made to estimates during 1995 and 1996. Marketing expense, primarily for the MeritValu Frequent Shopper Program, was the primary reason for the increase in other expense.
Noninterest expense increased $19.5 million (16%) for 1995 compared to 1994. Salaries and employee benefits increased as a result of merit and promotion increases, expenses related to the sale of Heritage's branches, and increased personnel in lending, telebanking and electronic delivery systems. Occupancy expense increased primarily due to increased rent expense from additional supermarket branches, ATMs and space for telebanking. Increased professional fees resulted from the Heritage transaction. The increase in equipment expense was primarily due to increased depreciation expense relating to Bancorp's data processing operations. Charges and fees increased due to costs associated with obtaining credit card applications. Increases in marketing, recruiting and insurance expense were the primary reasons for the increase in other expense.
INCOME TAXES
The effective tax rates for 1996, 1995 and 1994 were 34.5%, 32.9% and 34.1%, respectively. The decrease in the effective rate for 1995 reflects the reversal of tax-exempt negative goodwill associated with the sale of Heritage's deposits and branches and the increase in the level of tax-exempt interest income.
INVESTMENT SECURITIES
Investment securities represented approximately 17% of average earning assets in 1996, compared to 16% in 1995 and 15% in 1994. The amortized cost and market value of investment securities at the dates indicated are summarized in Table 5:
TABLE 5: Investment Securities
Table 6 shows the December 31, 1996, maturities and weighted average yields for investment securities. Yields on equity securities which comprise the fixed rate, due after 10 years classification of other securities have been omitted from the table. A 35% tax rate was used in computing the tax equivalent yield adjustment. The yields shown are calculated based on original cost and effective yields weighted for the scheduled maturity of each security. Mortgage-backed and asset- backed securities are assigned to maturity categories based on their estimated average lives.
TABLE 6: Investment Securities Yields and Maturities
Bancorp executes interest rate swaps to convert floating rate investment securities to a fixed rate. At December 31, 1996, Bancorp had $500 million in fixed receive swaps of which $200 million are callable by the counterparty. The weighted average pay rate and receive rate on the $500 million interest rate swaps were 5.67% and 6.35%, respectively, as of year-end.
LOANS AND LEASES
Average net loans and leases were approximately 81% and 83% of total average earning assets in 1996 and 1995, respectively. Average net loans and leases increased $555.6 million (13%) in 1996 over 1995. Increases in commercial and financial loans of $254.3 million (13%) and consumer lease financing of $208.3 million (84%) were the primary reasons for the increase in loans and leases. Additionally, significant loan origination activity is not fully reflected in the average or ending loan balances due to the sale and securitization of residential loans during 1996. Bancorp does not have a material exposure to foreign loans, energy loans or agricultural loans. Table 7 shows loans and leases outstanding at period end by type of loan:
TABLE 7: Loan and Lease Portfolio Composition
Table 8 shows the composition of the commercial and financial loan category by industry type at December 31, 1996:
TABLE 8: Commercial and Financial Loans
Amount on Type Amount % Nonaccrual (Dollars in Millions) Construction $81.4 3 $1.2 Manufacturing 527.3 22 3.7 Transportation / Utilities 173.5 7 3.5 Wholesale Trade 190.0 8 2.2 Retail Trade 235.3 10 .6 Finance & Insurance 106.4 4 .5 Real Estate Operators / Investment 300.4 12 .6 Service Industries 379.5 16 .3 Automobile Dealers 110.3 5 - Other (1) 300.8 13 1.6 $2,404.9 100 $14.2
(1) Includes various kinds of loans, such as small business loans and loans with balances under $100,000.
Table 9 shows the composition of commercial mortgage and construction loans by loan and property type at December 31, 1996:
TABLE 9: Commercial Mortgage and Construction Loans
At December 31, 1996 and 1995, the amount of first mortgage residential loans that were considered available for sale was immaterial.
Loans outstanding at December 31, 1996, are presented in Table 10 by maturity, based on remaining scheduled repayments of principal:
TABLE 10: Loan Maturities
CREDIT RISK MANAGEMENT
Bancorp maintains a reserve for loan and lease losses to absorb potential losses in its portfolio. Management's determination of the adequacy of the reserve is based on reviews of specific loans and leases, credit loss experience, general economic conditions and other pertinent factors. If, as a result of charge-offs or increases in the risk characteristics of the lending portfolio, the reserve is below the level considered by management to be adequate to absorb future loan and lease losses, the provision for loan and lease losses is increased. Loans and leases deemed uncollectible are charged off and deducted from the reserve and recoveries on loans and leases previously charged off are added to the reserve.
Table 11 shows selected information relating to Bancorp's loans, leases and reserves for loan and lease losses:
TABLE 11: Reserve For Loan and Lease Losses
Loans and leases are charged off against the reserve when they are determined to be uncollectible. Instalment and commercial and financial loans account for most of the increase in net charge-offs during 1996. Instalment charge-offs increased primarily in indirect auto loans, where inadequate risk adjusted yields are resulting in a declining portfolio, and in the credit card portfolio. Six commercial and financial loans, primarily in the retail segment, totaled $15.1 million in charge-offs. The increase in net charge-offs in 1995 is primarily due to increases in charge-offs of $2.7 million and $2.1 million in instalment and commercial and financial loans, respectively. The high level of recoveries in 1995 and 1994 resulted from recoveries of $5.8 million and $5.9 million, respectively, of a commercial loan that was charged off in 1991.
In 1993, Provident and a commercial customer entered into an agreement in which Provident granted certain concessions on its loans and agreed not to exercise certain rights available to it under the loan documents. In return, the customer issued to Provident 346,718 shares of its common stock, representing 5% of its issued and outstanding common stock, and 74,659 shares of Series B non-voting convertible preferred stock that is convertible into 746,590 shares of its common stock. Although these shares were not registered under the Securities Act of 1933, Provident could require the registration by the customer. In 1995, Provident and the commercial customer amended the agreement whereby certain loan maturity dates were extended and additional funds were made available for future borrowing. In consideration, the customer removed certain restrictions from the selling of these shares and issued a stock warrant for the purchase of an additional 200,000 shares of common stock at the quoted market price as of the date the warrant was issued. Provident sold 375,000 shares and 225,000 shares of common stock during 1996 and 1995, respectively. The proceeds received from the sales resulted in $6.6 million being recorded as other noninterest income during 1996 and $3.1 million and $0.4 million being recorded as loan loss recoveries and interest income, respectively, during 1995. As of December 31, 1996, Bancorp owns 493,308 shares of common stock and common stock equivalents, along with the stock warrant. The stock and stock warrant are recorded at a nominal amount on Bancorp's balance sheet.
Table 12 shows the dollar amount of the reserve for loan and lease losses using management's estimate by principal loan and lease category:
TABLE 12: Allocation of Reserve For Loan and Lease Losses
Management considers the present allowance to be appropriate and adequate to cover losses inherent in the loan and lease portfolio based on the current economic environment. However, future economic changes cannot be predicted. Deterioration in economic conditions could result in an increase in the risk characteristics of the loan and lease portfolio and an increase in the provision for loan and lease losses.
Table 13 presents a summary of various indicators of credit quality:
TABLE 13: Credit Quality
Nonperforming assets decreased $19.4 million during 1996. Nonaccrual loans decreased $16.4 million during 1996. Significant activity within nonaccrual loans included the addition of three loans totaling $9.6 million, the charge-off of five loans totaling $11.1 million, the transfer of two loans to other real estate and equipment totaling $6.6 million and two loans being brought current and removed from nonaccrual status for $8.2 million. Renegotiated loans decreased $4.0 million primarily due to the sale of one loan.
Nonperforming assets increased $37.3 million during 1995. Nonaccrual loans increased $31.2 million during 1995, primarily due to four loans being placed on nonaccrual status. Renegotiated loans increased principally due to one loan being restructured. Other real estate and equipment owned increased primarily due to property on an operating lease being reclassified due to the bankruptcy of the lessee.
When a loan is placed on nonaccrual status or is renegotiated, the recognition of interest income differs from what would have been recognized had the loan retained its original terms. The gross amount of interest income recognized during 1996 with respect to these loans was $499,000 compared to $2,323,000 that would have been recognized had the loans remained current in accordance with their original terms.
Of the $21.1 million in nonaccrual loans at December 31, 1996, management estimates approximately $3.9 million of potential loss. The loss estimate is based, in part, upon information from Provident's credit watch and impaired loan lists ("lists"), and loss exposure reports. The lists are prepared quarterly following detailed discussions between lending officers, the credit and loan review departments and senior management. The lists include nonperforming loans along with loans and leases that were classified by bank examiners. The lists also include loans and leases where potential borrower problems may raise concern about the ability of the borrower to comply with the present loan repayment terms. These loans and leases, while not nonperforming or necessarily expected to result in losses, are considered in need of closer monitoring. The loss exposure report is prepared monthly and updates loan and lease balance information and loss estimates from the previous lists. The loss exposure report also includes other real estate owned balances and any loss exposure involving other real estate.
The year-end 1996 lists and loss exposure reports included approximately $37.6 million of loans and leases that were current, but which due to the possible credit problems of such borrowers that were known by management or other factors, were considered to be in need of closer monitoring. Through an ongoing monitoring process, the value of the collateral securing these loans and leases is analyzed each quarter to determine loss potential. A review of pertinent loan and lease information, including borrower financial statements and collateral appraisals, determined that loans and leases with an aggregate principal amount of approximately $14.2 million had some loss potential. The loss potential was estimated to be approximately $7.0 million. In determining this estimate, collateral values are carefully examined on an ongoing basis. Management considers the present reserve for loan and lease losses of $66.7 million to be appropriate and adequate to cover the estimated losses in the lending portfolio.
DEPOSITS
Average total interest bearing deposits increased 6% during 1996 to $3.8 billion after increasing 18% during 1995 to $3.6 billion. Increases in brokered deposits and public fund time deposits were the primary reasons for the increase in interest bearing deposits. For 1996 and 1995, average total interest bearing deposits represented 71% and 77%, respectively, of average interest bearing liabilities. Bancorp does not have a material amount of foreign deposits. Table 14 presents a summary of period end deposit balances:
TABLE 14: Deposits
At December 31, 1996, the maturities of deposits of $100,000 or more are as follows (In Millions):
3 months or less $327 Over 3 through 6 months 325 Over 6 through 12 months 119 Over 12 months 647 Total $1,418
Included in Certificates of Deposit ("CD's") of $100,000 or more at December 31, 1996, 1995 and 1994 are brokered deposits of $765 million, $752 million and $694 million, respectively.
In 1995, Bancorp began issuing brokered CD's with embedded call options combined with interest rate swaps with matching call dates as part of its CD program. Bancorp has the right to redeem the CD's on specific dates prior to their stated maturity while the interest rate swaps are callable at the option of the swap counterparty. The terms and conditions of the call options embedded in the interest rate swaps match those of the CD's, offsetting any option risk exposure to Bancorp. At December 31, 1996, Bancorp had $356 million of callable CD's.
BORROWED FUNDS
Borrowed funds are an important source of funds to support earning assets. In 1996, average short-term debt increased $122.4 million (19%), while average long-term debt increased $317.5 million (69%). The increase in the average balance for federal funds purchased and repurchase agreements was the primary reason for the increase in average short-term debt in 1996. The issuance of $300 million in medium-term bank notes in December 1995 was the primary reason for the increase in average long-term debt in 1996.
In November 1996, Provident Capital Trust I (the "Trust") was formed for the purpose of issuing $100 million of preferred capital securities ("Capital Securities"). The Capital Securities, which qualify as Tier 1 capital for bank regulatory purposes, have a stated rate of 8.6% and mature on December 1, 2026. The proceeds from the Capital Securities became part of Bancorp's general funds for use in its business. For financial reporting purposes, the accounts of the Trust are included in the consolidated financial statements of Bancorp, with the Capital Securities being classified as long-term debt and its related distributions classified as interest on long-term debt.
In 1995, average short-term debt increased $186.0 million (42%), while average long-term debt increased $58.1 million (15%). The increased use of federal funds purchased and repurchase agreements was the primary reason for the increase in average short-term debt in 1995. The increase in long-term debt is attributable to borrowings on Medium- Term Bank Notes of $312.5 million and advances from the Federal Home Loan Bank ("FHLB") of $150 million. The medium-term borrowings have stated fixed rates, however, they have been converted to variable one- month London Interbank Offered Rate ("LIBOR") funds through the use of interest rate swaps. The FHLB advances have a variable rate based on the one-month LIBOR rate. The proceeds from the additional debt became part of Provident's general funds for use in its business.
CAPITAL RESOURCES
Total stockholders' equity at December 31, 1996 and 1995 was $516.8 million and $432.5 million, respectively. The increase in the stockholders' equity during 1996 was primarily the result of net income exceeding dividends paid for the year.
The following table reflects various measures of capital and its performance for the past three years:
TABLE 15: Return on Equity and Assets
1996 1995 1994
Net Earnings to Average Assets 1.28% 1.29% 1.24% Net Earnings to Average Total Equity 17.67 18.37 16.64 Average Total Equity to Average Assets 7.23 7.02 7.43 Common Dividend Payout to Net Earnings 26.40 22.78 25.47 Preferred Dividend Payout to Net Earnings .66 3.39 5.15
Cash dividend payout is continually reviewed by management. Bancorp has indicated its intention to pay annual dividends of approximately 30% of recurring net earnings. Recurring net earnings is defined as net earnings excluding the net after-tax effect of certain amounts related to acquisitions, security gains or losses and changes in accounting principles. Bancorp declared two common dividend rate increases during 1996. In April 1996, the quarterly dividend rate was increased from $.122 to $.140 per share beginning with second quarter dividend payments. In December 1996, Bancorp announced the quarterly dividend rate will be raised to $.160 per share beginning with dividend payments made in 1997. Bancorp also increased the common dividend rate during 1994 and 1995 by $.013 and $.011, respectively.
Over the past two years, the preferred dividend payout to net earnings ratio has decreased significantly due to two events. First, Bancorp elected in the fourth quarter of 1994 to change the preferred dividend rate to a rate equivalent to that paid on its Common Stock, as permitted by the terms of the preferred stock. Second, fewer shares of the preferred stock are outstanding as 301,146 shares were converted into 4,234,865 shares of Common Stock in December 1995. As of December 31, 1996, 70,272 shares of D Preferred remain outstanding which is convertible into 988,200 shares of Common Stock.
Bancorp's capital expenditure program in recent years has included expansion and improvement in the branch, ATM, and telebanking networks, and improvements to data processing capabilities of Bancorp. Capital expenditures for 1997 are estimated to be approximately $9 million and include the purchase or construction of system applications, data processing equipment, ATMs and branches. Management believes that currently available funds and funds provided by normal operations will be sufficient to meet capital requirements.
LIQUIDITY
Adequate liquidity is necessary to meet the borrowing needs and deposit withdrawal requirements of customers as well as to satisfy liabilities, fund operations and support asset growth. Bancorp has a number of sources to provide for liquidity needs. First, liquidity needs can be met by the liquid assets on its balance sheet such as cash and deposits with other banks. Additional sources of liquidity include the sale of investment securities classified as available for sale and the sale of commercial and consumer loans and leases. Provident sold $469.3 million of residential mortgage loans during 1996. Another source for providing liquidity is the generation of new deposits. Total deposits increased by 10% during 1996 to $4.6 billion. Bancorp may borrow both short-term and long-term funds. Bancorp obtained $228.4 million in long-term borrowings during 1996 and has an additional $688.1 million available for borrowing under a medium-term bank note program. Approximately $67.1 million of long-term debt is due to be repaid during 1997.
Although no significant capital expenditures are expected for Bancorp on a parent-only basis (the "Parent") during 1997, the Parent still has liquidity needs. The Parent's primary liquidity needs will be the payment of dividends to its preferred and common shareholders, funds for activity within commercial paper and interest payments on long- term debt. The major source of liquidity for the Parent is dividends paid to it by its subsidiaries. The Parent received dividends of $25 million in 1996, $23 million in 1995 and $26 million in 1994 from its subsidiaries. The maximum amount available for dividends that may be paid in 1997 to the Parent by Provident without approval is approximately $96.1 million, plus 1997 net earnings. Dividends of approximately $3.8 million plus 1997 net earnings may be paid in 1997 by Provident Kentucky. Management believes that amounts available from the banking subsidiaries will be sufficient to meet the Parent's liquidity requirements in 1997. Under the Federal Deposit Insurance Corp. Improvement Act of 1991 ("FDICIA"), an insured depository institution, such as Bancorp's banking subsidiaries, would be prohibited from making capital distributions, including the payment of dividends, if, after making such distribution, the institution would
become "undercapitalized" (as such term is defined in the statute). A discussion of restrictions on transfer of funds from subsidiaries to Bancorp is presented in Note P, included in "Notes to Consolidated Financial Statements".
Additional sources of liquidity to the Parent include loan payments and sales of investment securities. At December 31, 1996, the Parent had $175 million and $40 million in lines of credit with unaffiliated banks to support commercial paper borrowings of $139.7 million and other general obligations, respectively. As of February 28, 1997, these lines had not been used.
OFF-BALANCE SHEET FINANCIAL AGREEMENTS
Bancorp employs derivatives, such as interest rate swaps, interest rate caps, financial futures and forward contracts primarily to manage the interest rate risk inherent in Bancorp's core businesses.
Bancorp uses interest rate swaps as its primary off-balance sheet financial instrument. At December 31, 1996, approximately $2.1 billion in interest rate swaps held by Bancorp essentially convert a fixed rate of interest into a shorter repricing frequency. Approximately $1.6 billion are pay variable receive fixed swaps used to convert the interest rate sensitivity of long-term fixed rate deposit and debt liabilities to a floating interest rate based on LIBOR. Bancorp also employs $500 million of this type of swap in association with floating rate collateralized mortgage obligations ("CMO's") and asset backed securities to create a synthetic fixed rate investment portfolio with a reduced prepayment risk profile.
Interest rate swaps in which Bancorp pays a fixed rate of interest in exchange for receiving a floating interest rate of LIBOR or prime rate are used to manage the interest rate risk associated with long-term fixed rate commercial and residential real estate mortgage loans. Bancorp had $32 million of pay fixed receive variable rate swaps at December 31, 1996.
Bancorp manages the credit risk in these transactions through its counterparty credit policy, which limits transacting business only with counterparties classified as investment grade by the rating agencies of Moody's and Standard & Poor's. Generally, Bancorp requires bilateral collateral agreements as a technique to reduce credit risk. These bilateral collateral agreements have threshold credit limits above which investment securities must be pledged as collateral for the mark-to-market. At December 31, 1996, Bancorp pledged investment securities with a carrying value of $4.4 million as collateral to two of its counterparties to cover the mark-to-market. As a second credit risk measure, Bancorp utilizes bilateral netting of interest payments. The frequency and timing of the interest payments are matched between counterparties, thereby reducing the credit exposure.
At December 31, 1996, there were no past due amounts on any interest rate swap. Bancorp has never experienced a credit loss related to an off-balance sheet position, and does not reserve for credit losses on these transactions.
The following table shows the composition of interest rate swap agreements as of December 31, 1996:
TABLE 16: Interest Rate Swap Agreement Maturities
The changes in interest rate swap agreements for the years ended December 31 were as follows: 1996 1995 (In Millions) Beginning Notional Amount $1,802 $1,556 New Contracts 729 1,004 Matured / Terminated Contracts (397) (758) Ending Notional Amount $2,134 $1,802
Bancorp uses financial futures contracts and forward contracts to manage interest rate risk in a manner similar to interest rate swap agreements. At December 31, 1996, Bancorp had no outstanding positions in financial futures contracts or forward contracts.
Bancorp maintains a portfolio of interest rate caps sold to corporate customers at their request to manage the interest rate risk associated with their borrowings. Bancorp offsets the interest rate risk of customer cap transactions by purchasing an offsetting position in interest rate caps of matching terms. Bancorp executes these transactions as a customer convenience and does not consider itself to be a dealer in these financial instruments. At December 31, 1996, Bancorp's positions in matched customer interest rate caps were $146.8 million in notional principal amount.
Interest rate swaps increased the net interest margin by 23 basis points in 1996, decreased the net interest margin by 10 basis points in 1995, and increased the net interest margin by 13 basis points in 1994.
INTEREST RATE SENSITIVITY
Recognizing that interest rate risk is inherent in its core business activities and understanding that fluctuating interest rates may cause volatility in its net interest income, Bancorp actively engages in the interest rate risk management process. At December 31, 1996, Bancorp's interest rate sensitivity position was within established guidelines.
Bancorp develops forecasts and assumptions as to deposit growth and mix, loan growth and mix, deposit and loan pricing spreads, early repayment of assets and early redemption of liabilities. The resulting impact on net interest income is then evaluated, given potential changes in interest rate risk.
Bancorp actively manages and makes modifications to its balance sheet through product structuring, product pricing, and promotional offerings to achieve its targeted interest rate risk management objectives. If management believes additional modifications to Bancorp's sensitivities are warranted, off-balance sheet financial agreements such as interest rate swaps, interest rate caps and futures contracts are employed. At December 31, 1996, Bancorp had positions in interest rate swaps and interest rate caps and had no positions in futures contracts. A summary of the interest rate swap positions may be found in Note M of the "Notes to Consolidated Financial Statements".
Bancorp employs several analytical techniques in the assessment of interest rate risk, including gap analysis, simulation analysis, duration analysis, and market value of portfolio equity analysis. Bancorp relies most heavily on simulation analysis as it's primary analytical technique.
Bancorp simulates net interest income over a variety of interest rate scenarios including "shock" analysis of +/- 100 basis points and +/- 200 basis points. These shock scenarios assume an instantaneous and permanent change in the pricing of all interest rate sensitive assets and liabilities and do not give consideration to any management of the shock by Bancorp. As a result, these shock scenarios are considered worst case scenarios through which Bancorp can quantify its maximum exposures. Bancorp also simulates net interest income through a market driven forecast using forward yield curves implied by the financial futures markets. Bancorp develops most of its strategies and tactics using the forward yield curve as the base interest rate scenario.
Table 17 provides a summary of Bancorp's gap analysis, which measures the difference between interest sensitive assets and liabilities repricing in the same time period. For this analysis, cash flow of assets and liabilities are segregated by their stated or forecasted repricing intervals. The forecasted repricing includes assumptions of early loan repayments, specifically in the areas of instalment and residential mortgage loan receivables. These prepayment assumptions are based on industry average prepayment rates for these loan products. Similarly, assumptions are made to the anticipated repricing and maturity characteristics of liability products with managed interest rates such as NOW and money market accounts. Adjustments are then made for the impact of off-balance sheet derivatives. Bancorp manages its gap through a targeted 12 month cumulative time horizon. At December 31, 1996, management assessed its gap position as a liability sensitivity of approximately 12% through the 12 month cumulative period. A liability sensitivity implies potential margin compression in a rising rate environment, and potential margin expansion in a falling rate environment.
TABLE 17: Interest Rate Sensitivity
IMPACT OF INFLATION AND CHANGING PRICES
The majority of assets and liabilities of a financial institution are monetary in nature and therefore differ greatly from capital intensive companies that have a significant investment in fixed assets or inventories. However, inflation does have an important impact in the banking industry. During periods of inflation, monetary assets lose value, while monetary liabilities gain value. This results in the need to increase equity capital at higher than normal rates in order to maintain an appropriate equity to assets ratio. Inflation can also have a significant effect on noninterest expenses, which tend to rise during periods of general inflation. Inflation has not had a material effect on Bancorp in the recent past.
Bancorp's ability to react to changes in interest rates has a significant impact on financial results. As discussed previously, management attempts to increase or decrease interest rate sensitivity in order to protect against wide interest rate fluctuations.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Report of Ernst & Young LLP, Independent Auditors 29
Financial Statements:
Provident Bancorp, Inc. and Subsidiaries Consolidated Balance Sheets 30 Consolidated Statements of Earnings 31 Consolidated Statements of Changes in Shareholders' Equity 32 Consolidated Statements of Cash Flows 33 Notes to Consolidated Financial Statements 34
Supplementary Data:
Quarterly Consolidated Results of Operations (unaudited) 59
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
Board of Directors Provident Bancorp, Inc.
We have audited the accompanying consolidated balance sheets of Provident Bancorp, Inc. and subsidiaries as of December 31, 1996 and 1995, and the related consolidated statements of earnings, changes in shareholders' 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 management of Provident Bancorp, Inc. 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 consolidated financial position of Provident Bancorp, Inc. and subsidiaries at December 31, 1996 and 1995, and the consolidated 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.
ERNST & YOUNG LLP
Cincinnati, Ohio January 13, 1997
See notes to consolidated financial statements.
See notes to consolidated financial statements.
See notes to consolidated financial statements.
See notes to consolidated financial statements.
PROVIDENT BANCORP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A. ORGANIZATION AND ACQUISITIONS Provident Bancorp, Inc ("Bancorp") was incorporated in February, 1980 for the purpose of acquiring and holding the Common Stock of The Provident Bank ("Provident") owned by American Financial Group ("AFG"). The acquisition of Provident in October, 1980 was accounted for as a pooling-of-interests.
Bancorp is Cincinnati-based and operates primarily throughout Ohio and northern Kentucky. It owns two banking subsidiaries that provide financial services to its customers on a national basis.
All data relating to Bancorp's Common Stock and per common share information has been adjusted for 3-for-2 common stock splits effective May 24, 1996 and December 19, 1996.
In December 1996, Bancorp acquired Information Leasing Corporation ("ILC"), an equipment leasing company, and Procurement Alternatives Corporation ("PAC"), ILC's affiliated lease servicing company. Combined, ILC and PAC had over $110 million in assets at the time of acquisition. As consideration for the purchase, Bancorp issued 776,786 shares of its Common Stock at the date of purchase plus an additional 258,929 shares of Common Stock and $2,000,000 if certain financial objectives are met over the next four fiscal years. Using the purchase method to account for the acquisition, $16.2 million of goodwill was recorded. In September 1995, Bancorp purchased Mathematical Investment Management, Inc. ("MIM"), a mutual fund advisor, for 103,622 shares of Bancorp Common Stock. The $60 million in mutual fund assets advised by MIM were merged into Riverfront Funds, Inc. ("Riverfront"), a proprietary family of mutual funds. The purchase method was used to account for the MIM acquisition resulting in $1.9 million of goodwill being recorded. Pro-forma results of operations as though ILC, PAC and MIM had occurred at the beginning of the period are not provided due to the immaterial effects it would have on Bancorp's financial statements taken as a whole.
B. ACCOUNTING POLICIES The following is a summary of significant accounting policies:
BASIS OF PRESENTATION The consolidated financial statements include the accounts of Bancorp and its subsidiaries, all of which are wholly owned. Bancorp's investments in partnerships (included in "Other Assets") are carried at the lower of cost or net realizable value and are adjusted for changes in equity. Certain estimates are required to be made by management in the preparation of the consolidated financial statements. All significant intercompany balances and transactions have been eliminated. Certain reclassifications have been made to conform to the current year presentation.
STATEMENT OF CASH FLOWS For cash flow purposes, cash equivalents include amounts due from banks and federal funds sold and reverse repurchase agreements. Generally, federal funds sold and reverse repurchase agreements are purchased and sold for one-day periods.
INVESTMENT SECURITIES Bancorp adopted Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities", effective January 1, 1994. Securities classified as held to maturity are those securities that Bancorp has the intent and ability to hold to maturity, subject to continued credit worthiness of the issuer. Accordingly, these securities are stated at amortized cost.
Securities classified as available for sale are intended to be held for indefinite periods of time and include those securities that Bancorp may employ as part of asset/liability management strategy or that may be sold in response to changes in interest rates, prepayments, regulatory capital requirements or similar factors. Certain interest rate swaps have been entered into that relate to securities classified as available for sale. These securities and interest rate swaps are stated at fair value with unrealized gains and losses excluded from earnings and reported as a separate component of shareholders' equity, net of taxes.
Securities purchased with the intention of recognizing short-term profits are placed in the trading account and are carried at market value. The specific identification method is the method used for determining gains and losses from securities transactions.
LOANS Interest on loans is computed on the outstanding principal balance. The portion of loan fees which exceeds the direct costs to originate the loan is deferred and recognized as interest income over the actual lives of the related loans using the interest method. Any premium or discount applicable to specific loans purchased is amortized over the remaining lives of such loans using the interest method. Loans are generally placed on nonaccrual status when the payment of principal and/or interest is past due 90 days or more. However, instalment loans are not placed on nonaccrual status because they are charged off when 120 days to 150 days past due. In addition, loans that are well secured and in the process of collection are not placed on nonaccrual status. When a loan is placed on nonaccrual status, any interest income previously recognized that has not been received is reversed. Future interest income is recorded only when a payment is received. Bancorp generally recognizes income on impaired loans on a cash basis.
LEASE OPERATIONS Unearned income on direct financing leases is amortized over the terms of the leases resulting in an approximate level rate of return on the net investment in the leases. Income from leveraged lease transactions is recognized using a method which yields a level rate of return in relation to Bancorp's net investment in the lease. The investment includes the sum of the aggregate rentals receivable and the estimated residual value of leased equipment less unearned income and third party debt on leveraged leases. Commercial leases are generally placed on nonaccrual status when payments are past due 90 days or more while consumer leases are generally charged off when 120 days to 150 days past due.
LOAN AND LEASE LOSS RESERVE The reserve for loan and lease losses is maintained to absorb potential losses in the lending portfolio. Management's determination of the adequacy of the reserve is based on reviews of specific loans and leases, credit loss experience, general economic conditions and other pertinent factors. The reserve is increased by charges to earnings, as provisions for loan and lease losses. Loans and leases deemed uncollectible are charged off and deducted from the reserve and recoveries on loans and leases previously charged off are added to the reserve.
Bancorp adopted SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," as amended by SFAS No. 118, "Accounting by Creditors for Impairment of a Loan -- Income Recognition and Disclosures", effective January 1, 1995. Bancorp considers a nonperforming loan, except consumer loans, to be an impaired loan where it is probable that all amounts due will not be collected according to the contractual terms of the loan agreement. Bancorp measures the value of an impaired loan based on the present value of expected future cash flows discounted at the loan's effective interest rate or, if more practical, at the loan's observable market price, or the fair value of the collateral if the loan is collateral dependent. The adoption of this SFAS had no material impact on Bancorp's consolidated financial condition or results of operations.
LOAN SALES Bancorp classifies loans that are intended to be sold within a short period of time as available for sale. Such loans are carried at the lower of aggregate cost or market value. In 1996 Bancorp began selling non-conforming residential loans. These sales have been primarily through securitized public offerings. Under these types of sales, gains or losses are determined based on the calculated present value of future cash flows of the underlying loans, net of interest payments to security holders, loan loss assumptions and normal servicing revenue. These net cash flows, which are represented by residual interest securities, are included in "Investment Securities Available for Sale".
In 1995, Bancorp sold its rights to service conforming residential loans for others. Prior to 1995, Bancorp generally retained the right to service residential loans that it sold. Gains and losses on loan sales are included in "Noninterest Income". Such gains and losses are determined by the difference between the sale proceeds and the carrying value of loans sold. These gains and losses are adjusted, where appropriate, by the present value of the difference between estimated future net servicing revenues and normal servicing revenues and by any other item as provided for in the sales agreement. The resulting excess servicing fees are deferred and amortized as an adjustment to service fee income over the estimated life of the related loans using the interest method.
SFAS No. 122, "Accounting for Mortgage Servicing Rights" was adopted by Bancorp on January 1, 1996. Under this SFAS, when mortgage loans are originated or purchased by an institution and subsequently sold or securitized with servicing retained, the cost of the loan shall be allocated between the loan (without servicing) and the fair value of the servicing. Prior to this SFAS, no costs of the loan were allocated
to the servicing. The adoption of this SFAS had no material impact on Bancorp's consolidated financial position or results of operations.
PREMISES AND EQUIPMENT Premises and equipment are stated at cost less depreciation and amortization that are computed principally on the straight-line method over the estimated useful lives of the assets.
Bancorp adopted SFAS No. 121, "Accounting for the Impairment of Long- Lived Assets and for Long-Lived Assets to Be Disposed Of" on January 1, 1996. This SFAS requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever circumstances indicate that the carrying value may not be recoverable. An impairment loss is recorded when the sum of the expected future cash flows is less than the carrying amount of the assets. The adoption of SFAS 121 had no material impact on Bancorp's consolidated financial position or results of operations.
OTHER REAL ESTATE OWNED Real estate owned is recorded at the lower of cost or fair value and is included in "Other Assets". Bancorp's policy is to include in the cost of real estate owned the unpaid balance of applicable loans, costs of foreclosure, unpaid taxes and subsequent major repairs. However, in no case is the carrying value of real estate owned greater than net realizable value. Real estate taxes are capitalized on real estate held for development. Other costs are expensed as incurred.
INTANGIBLES The excess of the purchase price over net identifiable tangible and intangible assets acquired in a purchase business combination (goodwill) is included in other assets. Goodwill related to bank acquisitions is amortized over varying periods not exceeding 25 years. Goodwill related to nonbank acquisitions is amortized over varying periods not exceeding 40 years.
RESERVE FOR RETIREMENT OF CAPITAL SECURITIES The Capital Notes of Provident included in "Long-Term Debt" are designated as "Capital Securities" under Ohio law. In accordance with the terms of the Notes, Provident has classified a portion of its retained earnings as "Reserve for Retirement of Capital Securities" in amounts designed to replace the Notes with capital at the time those Notes are repaid.
BENEFIT PLANS SFAS No. 123, "Accounting for Stock-Based Compensation" was issued in October, 1995. The SFAS encourages, but does not require, adoption of a fair value-based accounting method for stock- based employee compensation plans. Bancorp elected to continue its accounting in accordance with APB Opinion No. 25, "Accounting for Stock Issued to Employees", whereby no compensation expense is recognized for the granting of stock options. Pro forma disclosures of what net earnings and earnings per share would have been had the new fair value method been used is presented in Note J of the Notes to Consolidated Financial Statements.
INCOME TAXES Bancorp files a consolidated federal income tax return that includes all of its subsidiaries. Subsidiaries provide for income taxes on a separate-return basis and remit to Bancorp amounts determined to be currently payable.
OFF-BALANCE SHEET FINANCIAL AGREEMENTS Bancorp employs derivatives such as interest rate swaps, interest rate caps, financial futures and forward contracts to manage the interest sensitivity of certain on- balance sheet assets and liabilities. The net interest income or expense on interest rate swaps is accrued and recognized as an adjustment to the interest income or expense of the associated on- balance sheet asset or liability. Realized gains and losses on interest rate swap transactions used to manage interest rate risk that are terminated prior to maturity are deferred and amortized as a yield adjustment over the remaining original life of the agreement. Deferred gains and losses are recorded in "Other Assets" and "Other Liabilities", as applicable. At December 31, 1996, these unamortized amounts were immaterial. Futures and forwards are also used to manage exposure to changes in interest rates. Realized gains and losses on futures and forward contracts used for risk management are deferred. These deferred items are either amortized to interest income or expensed over the life of the assets and liabilities they are associated with, or are recognized as a component of income in the period of disposition of the assets and liabilities.
EARNINGS PER COMMON SHARE Primary earnings per common share are computed by dividing net earnings, less the dividend requirement on preferred stock, by the weighted average number of common stock equivalents outstanding during the year. Fully diluted net earnings per common share are computed by dividing net earnings by the weighted average number of common stock equivalents, including the additional common stock outstanding as a result of the assumed conversion of the Series D Preferred Stock as of the first day of the year for which earnings per share data is shown.
NEW ACCOUNTING STANDARD SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" becomes effective January 1, 1997. This SFAS provides accounting and reporting standards for transfers and servicing of financial assets and extinguishment of liabilities occurring after December 31, 1996 and does not permit earlier or retroactive application. These standards are based on a financial-components approach that focuses on control. Under this approach, after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished. Also, this SFAS provides standards for distinguishing transfers of financial assets that are sales from transfers that are secured borrowings. The adoption of SFAS No. 125 is not expected to have a material impact on Bancorp's financial position or results of operations.
C. INVESTMENT SECURITIES The amortized cost and estimated market values of securities available for sale at December 31 were as follows:
Investment securities with a carrying value of approximately $476.1 million and $562.9 million at December 31, 1996, and 1995, respectively, were pledged as collateral to secure public and trust deposits, repurchase agreements, Federal Home Loan Bank ("FHLB") advances, interest rate swap agreements and for other purposes.
In 1996, 1995 and 1994 gross gains of $96,000, $18,000 and $- and gross losses of $-, $104,000 and $-, respectively, were realized on the sale of securities Available for Sale. In 1995, FHLB stock, classified as Held to Maturity, was sold. Bancorp was no longer required to hold the stock due to the sale of deposits of Heritage Savings Bank. The stock was sold at its cost basis of $416,000 resulting in no gain or loss. No other sales of securities classified as Held to Maturity occurred in 1996, 1995 or 1994.
During December, 1995, Bancorp reallocated securities that had been identified as Held to Maturity to the classification Available for Sale. The Financial Accounting Standards Board, in its special report, A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities, which was issued on November 15, 1995, permitted this one time reallocation. On the date of transfer, these securities had an amortized cost of $247.4 million and an unrealized gain of $375,000. The transfer was made to allow for greater flexibility in the future use of these securities. No other transfers were made among the security categories of Held to Maturity, Available for Sale and Trading categories during 1996, 1995 and 1994.
Mortgage-backed and asset-backed securities are shown below based on their estimated average lives at December 31, 1996. All other securities are shown by contractual maturity. 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.
Available for Sale Amortized Estimated Cost Market Value (In Thousands) Due in one year or less $74,129 $73,623 Due after 1 through 5 years 805,276 810,460 Due after 5 through 10 years 52,565 52,580 Due after 10 years 94,814 96,244 Total $1,026,784 $1,032,907
D. LEASE FINANCING Bancorp's leasing operations consists of commercial lease financing and consumer lease financing. During 1996, commercial lease financing increased significantly due to the acquisition of ILC. At the acquisition date, ILC had approximately $95 million of net investments in finance leases. Commercial lease financing includes the leasing of transportation equipment, manufacturing equipment, data processing and office equipment. The majority of the leases are classified as direct financing leases, with expiration dates over the next 1 to 9 years. Rentals receivable at December 31, 1996 and 1995 include $12.5 million and $12.6 million, respectively, for leveraged leases which is net of principal and interest on the nonrecourse debt. The residual values on the leveraged leases that were entered into are estimated to be approximately $47.4 million and $37.8 million in total at December 31, 1996 and 1995, respectively.
Consumer lease financing is the leasing of automobiles. The leases are classified as direct financing leases, with expiration dates over the next 1 to 5 years. This type of credit was initiated in 1994 and is principally directed toward individuals.
The components of the net investment in lease financing at December 31 were as follows:
The following is a schedule by year of future minimum lease payments to be received for the next five years as of December 31, 1996:
Commercial Consumer (In Thousands) 1997 $72,611 $114,758 1998 57,923 105,384 1999 33,252 87,021 2000 20,569 57,407 2001 14,010 22,497 Thereafter 12,985 - Total $211,350 $387,067
E. RESERVE FOR LOAN AND LEASE LOSSES The changes in the loan and lease loss reserve for the years ended December 31 were as follows:
1996 1995 1994 (In Thousands) Balance at Beginning of Period $60,235 $51,979 $40,542 Provision for Loan and Lease Losses Charged to Earnings 47,000 14,000 12,000 Acquired Reserves 1,373 - - Recoveries Credited to the Reserve 4,894 8,452 9,009 113,502 74,431 61,551 Losses Charged to the Reserve (46,809) (14,196) (9,572) Balance at End of Period $66,693 $60,235 $51,979
The following table shows Bancorp's investment in impaired loans as calculated under SFAS No. 114 as amended by SFAS No. 118:
1996 1995 (In Thousands) Impaired Loans Requiring a Valuation Allowance of $2.2 Million in 1996 and $12.8 Million in 1995 $5,159 $33,129 Impaired Loans Not Requiring a Valuation Allowance 5,484 3,697 Total Impaired Loans $10,643 $36,826
Average Balance of Impaired Loans for the Year $16,428 $7,813
The valuation allowance recorded on impaired loans is included in the reserve for loan losses.
Loans and leases on nonaccrual status at December 31, 1996, 1995 and 1994 were $21.1 million, $37.5 million and $6.3 million, respectively. Loans renegotiated to provide a reduction or deferral of interest or principal were $786,000, $4,753,000 and $961,000 at December 31, 1996, 1995 and 1994, respectively.
F. PREMISES AND EQUIPMENT The following is a summary of premises and equipment at December 31:
1996 1995 (In Thousands) Land $7,381 $7,342 Buildings 21,266 21,068 Leasehold Improvements 6,650 6,136 Furniture and Fixtures 70,887 58,474 Revenue Equipment 112,418 51,885 218,602 144,905 Less Depreciation and Amortization (72,961) (53,929) Total $145,641 $90,976
The future gross minimum rentals under noncancelable leases for the rental of premises and equipment for 1997 and subsequent years are as follows:
Premises Equipment (In Thousands) 1997 $5,382 $263 1998 5,257 241 1999 5,080 170 2000 4,684 37 2001 4,360 - Thereafter 19,018 - Total $43,781 $711
Rent expense for all bank premises and equipment leases was $6,596,000, $5,692,000 and $4,329,000 in 1996, 1995 and 1994, respectively.
G. SHORT-TERM DEBT Short-term debt was as follows at December 31:
At December 31, 1996, Bancorp had $175 million in lines of credit with unaffiliated banks to support commercial paper borrowings. As of January 13, 1997, these lines had not been used.
H. LONG-TERM DEBT Long-term debt consisted of the following at December 31:
In November 1996, Bancorp established Provident Capital Trust I (the "Trust"). The Trust exists for the sole purpose of selling $100 million of 8.60% Capital Securities ("Capital Securities") to outside investors and investing the proceeds thereof in 8.60% Junior Subordinated Debentures (the "Debentures") issued by Bancorp. Proceeds from the sale of the Debentures were used for general corporate purposes. The Capital Securities qualify as Tier 1 capital for bank regulatory purposes.
Both the Capital Securities and Debentures call for semi-annual dividend/interest payments commencing June 1, 1997. Bancorp has the right to defer payment of interest on the Debentures at any time for a period not exceeding ten consecutive semi-annual periods. If interest payments on the Debentures are deferred, distributions on the Capital Securities will also be deferred. The Capital Securities are mandatorily redeemable upon the maturity of the Debentures on December 1, 2026 or upon earlier redemption as provided by the Indenture. Bancorp has the right to redeem the Debentures, in whole or in part, on or after December 1, 2006 at a premium, declining ratably to par on December 1, 2016. Bancorp has guaranteed the payment of distributions and payments on liquidation of the Trust or redemption of the Capital Securities, but only to the extent of funds held by the Trust.
Under Provident's amended $1 Billion Bank Notes program, notes can be issued with either fixed or floating rates. The notes are not secured nor insured by the FDIC. Subordinated notes qualify as Tier 2 capital while senior notes do not. Provident repaid $50 million in maturing senior debt during 1996. At December 31, 1996, $687.5 million was available under this program.
Of the $312.5 million issued under the $1 Billion Bank Notes program, Bancorp issued $12.5 million with a callable debt structure. The notes have a final maturity of 2005, but have a call option exercisable by Bancorp in 2000. These notes are hedged with an interest rate swap with a call option, exercisable by the swap counterparty, which matches that of the notes, which was executed to reduce Bancorp's overall funding cost and to modify the interest rate sensitivity of the notes. Under the terms of this transaction, if the swap counterparty exercises the call option on the interest rate swap in 2000, Bancorp may, at its discretion, exercise its call option to redeem the notes at the same time, or if the market offers a similarly attractive funding cost, Bancorp may execute another interest rate swap to hedge the notes for the remaining five years to maturity. Because the terms of the call options are matching, any options risk to Bancorp has been neutralized.
The notes payable to the FHLB are collateralized under a blanket agreement by investment securities and residential loans receivable with a book value of $260.4 million. They are subordinated to the claims of depositors and other creditors of Provident and are not insured by the FDIC.
The 6.38% Subordinated Notes, which qualify as Tier 2 capital, were issued through an underwritten offering in January, 1994 by Provident. They are subordinated to the claims of depositors and other creditors of Provident and are not insured by the FDIC. The 7.13% Subordinated Notes, which also qualify as Tier 2 capital, were issued in March 1993 by Provident. The 9% Fixed Rate Capital Notes are designated as "Capital Securities" under Ohio law and, in accordance with the terms of the Notes, Provident classifies a portion of its undivided profits as "Reserve for Retirement of Capital Securities".
Bancorp borrowed $130.0 million through a sale-leaseback transaction with various investors during 1996. The borrowings are secured by auto leases within the consumer lease financing portfolio. The debt calls for principal payments throughout the life of the borrowing with final principal payments due in the year 2004.
As discussed in Note A, Bancorp purchased ILC, an equipment leasing company during 1996. ILC financed their leases by borrowing funds from various institutions of which $56.2 million was outstanding at December 31, 1996. Payment requirements on the debt matches the rentals receivable on the equipment lease payments. The weighted average interest rate on all of ILC borrowings were 7.79% with an average maturity date of 1999.
As of December 31, 1996, scheduled principal payments on long-term debt for the following five years were as follows:
1997 1998 1999 2000 2001 (In Thousands) Provident Bancorp, Inc. $724 $601 $588 $270 $206 Subsidiaries 40,436 33,411 18,755 315,383 16,391
I. INCOME TAXES The composition of income tax expense follows:
1996 1995 1994 (In Thousands) Current: State $37 $74 $51 U.S. 23,888 6,463 24,392 23,925 6,537 24,443 Deferred 18,918 28,769 5,428 Total $42,843 $35,306 $29,871
The effective tax rate differs from the statutory rate applicable to corporations as a result of permanent differences between accounting and taxable income. None of these differences were material.
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of Bancorp's deferred tax liabilities and assets as of December 31 are as follows:
J. BENEFIT PLANS Bancorp has a Retirement Plan for the benefit of its employees. Included under this plan is an Employee Stock Ownership Plan ("ESOP") and a Personal Investment Election Plan ("PIE Plan"). Bancorp also maintains a Life and Health Plan for Retired Employees ("LH Plan"), an Employee Stock Purchase Plan ("ESPP"), a Deferred Compensation Plan ("DCP") and stock option plans.
The ESOP covers all employees who are qualified as to age and length of service. It is a trusteed plan with the entire cost borne by Bancorp. All fund assets are allocated to the participants. Bancorp's contributions are discretionary by the directors of Bancorp. The contributions made by Bancorp are charged against earnings in the year for which they are declared. In 1996, 1995 and 1994 Bancorp contributed $3,472,000, $3,274,000 and $2,825,000, respectively, to the ESOP.
The PIE Plan, a tax deferred retirement plan, covers all employees who are qualified as to age and length of service. Employees who wish to participate in the PIE Plan may contribute from 1% to 8% of their pre- tax salaries (to a maximum prescribed by the Internal Revenue Service) to the plan as voluntary contributions. Bancorp will make a matching contribution equal to 25% of the pre-tax voluntary contributions made by the employees during the plan year. The contribution made by Bancorp is charged against earnings as the employees' contributions are made. Bancorp incurred expense of $505,000, $456,000 and $396,000 for this retirement plan for 1996, 1995 and 1994, respectively.
Bancorp's LH Plan provides medical coverage as well as life insurance benefits to eligible retirees. The LH Plan is contributory until the retiree reaches age 62 after which time Bancorp pays the entire cost, however, Bancorp's responsibility for the payment of premiums is limited to a maximum of two times the monthly premium costs as of the effective date of the LH Plan. Monthly premiums exceeding the maximum amount payable by Bancorp shall be the responsibility of the retiree. Bancorp may amend or terminate the LH Plan at any time, without the consent of the retirees.
The ESPP provides eligible employees with an opportunity to purchase Bancorp's Common Stock through payroll deduction in an amount up to 10% of their compensation, at a price equal to eighty-five percent of the fair market price on either the first or the last business day of each calendar month, whichever is lower. Bancorp incurred expense of $168,000, $132,000 and $91,000 for the ESPP for 1996, 1995 and 1994, respectively.
The DCP permits participants, selected by the Compensation Committee of the Board of Directors, to defer compensation in a manner that aligns their interests with those of Bancorp shareholders through the investment of deferred compensation in Bancorp Common Stock. The DCP allows participants to postpone the receipt of 5% to 50% of compensation until retirement. Amounts deferred are invested in a Provident Stock Account or a Self-Directed Account. Bancorp will credit the Provident Stock Account with an amount dependent upon Bancorp's pre-tax earnings per share, for each share of Bancorp Common Stock in the account. The calculated credit is charged against earnings by Bancorp annually. Under the DCP, Bancorp expensed approximately $1,925,000, $995,000 and $400,000 in 1996, 1995 and 1994, respectively.
Bancorp has two Employee Stock Option Plans, an Advisory Director's Stock Option Plan and an Outside Directors' Stock Option Plan. The 1988 and 1996 Employee Stock Option Plans made 3,909,375 and 450,000 options available for grant, respectively. These plans authorize the issuance of options to purchase Common Stock for officers and key employees. The options are to be granted, with exercise prices from 95% to 110% of market value, at date of grant. Options become exercisable beginning one year from date of grant generally at the rate of 20% per year. During 1992, the Advisory Directors' Stock Option Plan and Outside Directors' Stock Option Plan were approved. These plans authorized the issuance of 371,250 and 168,750 options, respectively. The terms of these options are comparable to the terms of the Employee Stock Option Plans.
The following table summarizes option activity for the three years ended December 31, 1996:
Weighted Average Number of Options Exercise Options Available Price Outstanding for Grant
At January 1, 1994 $8.78 2,737,064 558,263 Authorized - - 1,125,000 Granted 13.78 204,750 (204,750) Exercised 8.29 (70,763) - Canceled 11.48 (9,000) 9,000 At December 31, 1994 9.14 2,862,051 1,487,513 Authorized - - - Granted 15.18 585,000 (585,000) Exercised 8.38 (148,552) - Canceled 10.39 (41,963) 41,963 At December 31, 1995 10.25 3,256,536 944,476 Authorized - - 450,000 Granted 24.81 1,175,967 (1,175,967) Exercised 9.53 (174,357) - Canceled 15.84 (36,982) 36,982 At December 31, 1996 14.28 4,221,164 255,491
At December 31, 1996, 1995 and 1994, there were 2,138,571, 1,845,346 and 1,580,839, options exercisable respectively, having a weighted average option price per share of $9.15, $8.71 and $8.28, respectively. The following table summarizes information about stock options outstanding at December 31, 1996:
For purposes of providing the pro forma disclosures required under SFAS No. 123, the fair value of stock options granted in 1995 and 1996 was estimated at the date of grant using a Black-Scholes option pricing model. The Black-Scholes option pricing model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because Bancorp's stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, management believes that the Black-Scholes model may not necessarily provide a reliable single measure of the fair value of its stock options.
The following weighted-average assumptions were used in the option pricing model for 1996 and 1995 respectively: risk-free interest rates of 6.55% and 6.55%; dividend yields of 3.75% and 5.00%; volatility factors of the expected market price of Bancorp's Common Stock of .228 and .234 and an expected life of the option of 9 years. Based on these assumptions, the weighted-average exercise price and weighted-average fair value of options granted in 1996 and 1995 are as follows:
No compensation cost has been recognized for stock option grants. Had compensation cost been determined for stock option awards based on the fair values at grant dates as discussed above, Bancorp's net income and earnings per share would not have been materially different from amounts reported.
K. PREFERRED STOCK In 1991, Bancorp issued 371,418 shares of series B Non-Voting Convertible Preferred Stock ("B Preferred") to AFG as partial consideration for the acquisition of Hunter Savings Association. Pursuant to the terms of the B Preferred, Bancorp, during the fourth quarter of 1994, elected to change the dividend rate from $8.00 per share to a rate equivalent to that paid on its Common Stock.
In 1995, Bancorp exchanged the B Preferred for an identical number of Series C Preferred Stock ("C Preferred") and later exchanged the C Preferred for the same number of Series D Preferred Stock ("D Preferred"). The terms of the D Preferred are substantially identical to the B Preferred except that the terms of the D Preferred permit AFG, its subsidiaries or affiliates to convert the D Preferred into Bancorp Common Stock regardless of their percentage of ownership of Bancorp's voting equity securities. In December 1995, 301,146 shares of the D Preferred were converted into 4,234,865 shares of Common Stock. As of December 31, 1996, 70,272 shares of D Preferred remain outstanding. These shares have a stated value and liquidation value of
$100 per share and a conversion ratio of 14.0625 shares of Bancorp's Common Stock for each share of convertible preferred stock.
L. REGULATORY CAPITAL REQUIREMENTS Bancorp and its banking subsidiaries are 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 Bancorp's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, Bancorp and its banking subsidiaries must meet specific capital guidelines that involve quantitative measures of its assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. 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 Bancorp and its banking subsidiaries to maintain minimum ratios of 4.00% for Tier 1 capital to average assets, 4.00% for Tier 1 capital to risk-weighted assets, and 8.00% for total risk- based capital to risk-weighted assets. As of December 31, 1996, Bancorp and its banking subsidiaries meet all capital requirements to which it is subject.
As of December 31, 1996, Bancorp and its banking subsidiaries' capital ratios were categorized as well capitalized for regulatory purposes. To be categorized as well capitalized, Bancorp and its banking subsidiaries must maintain minimum ratios of 5.00% for Tier 1 capital to average assets, 6.00% for Tier 1 capital to risk-weighted assets, and 10.00% for total risk-based capital to risk-weighted assets. There have been no subsequent conditions or events which management believes have changed the institutions' status.
M. OFF-BALANCE SHEET FINANCIAL AGREEMENTS Bancorp uses financial instruments with off-balance sheet risk to manage its interest rate risk and to meet the financing needs of its customers. These financial instruments include derivatives such as interest rate swaps and caps along with commitments to extend credit and standby letters of credit. These instruments may involve credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet.
Interest rate swap agreements involve the exchange of interest payment obligations without the exchange of the underlying principal amounts. Such interest rate swap transactions, which are a part of Bancorp's asset/liability management program, are structured to modify interest rate risk of specified assets and/or liabilities resulting from interest rate fluctuations. Interest rate swap agreements have a credit risk component based on the ability of a counterparty to meet the obligations to Bancorp under the terms of the interest rate swap agreement. Notional principal amounts express the volume of the transactions, but Bancorp's potential exposure to credit risk is limited only to the flow of interest payments. Bancorp manages its credit risk in these transactions through counterparty credit policies. At December 31, 1996, Bancorp had bilateral collateral agreements in place with its counterparties, against which Bancorp has pledged investment securities with a carrying value of $4.4 million as collateral.
Summary information with respect to the interest rate swap portfolio used to manage Bancorp's interest rate sensitivity follows:
The expected notional maturities of Bancorp's interest rate swap portfolio at December 31, 1996 are as follows:
After 1 After 3 1 Year Through 3 Through 5 After 5 or Less Years Years Years (In Millions) Pay Variable Receive Fixed $622 $461 $496 $523 Pay Fixed Receive Variable 12 1 8 11
Since many of the commitments to extend credit are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Bancorp evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained if deemed necessary by Bancorp upon extension of credit is based on management's credit evaluation of the counter- party. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment, and income-producing commercial properties.
Standby letters of credit are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral is obtained based on management's credit assessment of the customer.
Bancorp's commitments to extend credit which are not reflected in the balance sheet at December 31 are as follows:
1996 1995 (In Millions) Commitments to Extend Credit $1,699 $1,641 Standby Letters of Credit 116 94
N. TRANSACTIONS WITH AFFILIATES At December 31, 1996, Carl H. Lindner, certain members of his family and certain entities controlled by and/or established for the benefit of such family members beneficially owned approximately 43% of AFG's and 58% of Bancorp's outstanding voting common stock. Bancorp leases its home office space and other office space from a trust, for the benefit of a subsidiary of AFG. During 1995, the lease agreements were rewritten and extended to the year 2010, with Bancorp receiving $1.2 million which represented the net present value of the difference between payments of the old and current lease agreements. Bancorp is amortizing the amount received against rent expense until September 1997, which was the expiration of the old lease agreements. Bancorp also leased one of its branch locations and seventy-three ATM locations from principal shareholders and their affiliates. Rentals charged by AFG and affiliates for the years ended December 31, 1996, 1995 and 1994 amounted to $2,296,000, $1,397,000 and $1,233,000, respectively. Rentals of $218,000 were charged by principal shareholders and their affiliates during 1996 for branch and ATM locations.
Bancorp offers shares of The Riverfront Funds, Inc. ("Riverfront"), a proprietary family of mutual funds, to customers. Riverfront is a registered investment company with six portfolios, each having a different investment objective. Provident manages the portfolios and performs other related services, such as shareholder services and acting as fund accountant and custodian. Riverfront is offered to customers of Provident, including personal trust, employee benefit, agency and custodial clients, as well as individual investors. At December 31, 1996, Riverfront had total assets of $361.4 million. Approximately $34.1 million of the amount was held by Bancorp and $144.5 million was held by Provident's trust department. During 1996, 1995 and 1994, Bancorp recorded approximately $1,150,000, $950,000 and $390,000 of income net of related expenses, respectively, from management fees of Riverfront.
Bancorp has had certain transactions with various executive officers, directors and principal holders of equity securities of Bancorp and its subsidiaries and entities in which these individuals are principal owners. Various loans and auto leases have been made as well as the sale of commercial paper and repurchase agreements to these persons. Such loans to these persons aggregated approximately $38.9 million and $28.8 million at December 31, 1996, and 1995, respectively. None of these loans were held by the parent company. During 1996, new loans aggregating $21.8 million were made to such parties and loans aggregating $11.7 million were repaid. All of the loans were made at market interest rates and, in the opinion of management, all amounts are fully collectible. At December 31, 1996, and 1995, Bancorp's commercial paper amounting to $4.0 million and $6.0 million, respectively, was held by these persons. Additionally, repurchase agreements in the amount of $16.8 million and $6.5 million had been sold to these persons at December 31, 1996, and 1995, respectively. All of these transactions were at market interest rates.
O. FAIR VALUE OF FINANCIAL INSTRUMENTS Carrying values and estimated fair values for certain financial instruments as of December 31 are shown in the following table. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Because no secondary market exists for many of Bancorp's assets and liabilities, the derived fair values are calculated estimates, and the fair values provided herein do not necessarily represent the actual values which may be realized in the disposition of these instruments. The aggregate fair value amounts presented do not represent the underlying value of Bancorp. What is presented below is a point-in-time valuation which is affected, in part, by unrealized gains and losses resulting from management's implementation of its program to manage overall interest rate risk. It is not management's intention to immediately dispose of a significant portion of its financial instruments. As a result, the following fair value information should not be interpreted as a forecast of future earnings and cash flows.
The following methods and assumptions were used by Bancorp in estimating its fair value disclosures for financial instruments:
Cash and cash equivalents: The carrying amounts reported in the balance sheet for cash and short-term instruments approximate those assets' fair values.
Investment securities (including mortgage-backed securities): Fair values for investment securities, which also are the amounts carried in the balance sheet, are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments.
Trading account assets: Fair values for Bancorp's trading account assets, which also are the amounts recognized in the balance sheet, are based on quoted market prices where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments.
Loans receivable: For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values for certain residential mortgage loans and other consumer loans are based on quoted market prices of similar loans sold in conjunction with securitization transactions, adjusted for differences in loan characteristics. The fair values for other loans (e.g., commercial real estate, commercial and financial loans, construction loans, and other business loans) are estimated using discounted cash flow analyses, using interest rates currently being offered for loans, with similar terms to borrowers of similar credit quality.
Off-balance sheet financial instruments: The amounts shown under carrying value represent fees receivable arising from the related unrecognized financial instruments. Fair values for Bancorp's lending commitments and standby letters of credit are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties' credit standing. Fair value for interest rate swaps is based upon current market quotes.
Deposit liabilities: The fair values disclosed for demand deposits (e.g., interest and noninterest checking, passbook savings, and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). The carrying amounts for variable-rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.
Short-term debt: The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings approximate their fair values.
Long-term debt: The fair values of Bancorp's long-term borrowings that are traded in the markets are calculated using their market prices. The fair values of Bancorp's other long-term borrowings (other than deposits) are estimated using discounted cash flow analyses, based on Bancorp's current incremental borrowing rates for similar types of borrowing arrangements.
P. ADDITIONAL INFORMATION
RESTRICTIONS ON CASH AND NONINTEREST BEARING DEPOSITS Federal Reserve Board regulations require that Provident and Provident Bank of Kentucky ("Provident Kentucky") maintain certain minimum reserve balances. The average amount of those reserve balances for the year ended December 31, 1996, was approximately $41.1 million.
INVESTMENT IN PARTNERSHIPS Bancorp's share of partnerships was carried at approximately $15.4 million and $12.6 million at December 31, 1996, and 1995, respectively, which includes equity in net earnings (losses) of $536,000, $601,000 and $(344,000) in the years 1996, 1995 and 1994, respectively.
OTHER REAL ESTATE OWNED At December 31, 1996, and 1995, the carrying value of other real estate and equipment owned was $6.6 million and $5.6 million, respectively.
PARENT COMPANY FINANCIAL INFORMATION Parent Company only condensed financial information for Provident Bancorp, Inc. is as follows:
RESTRICTIONS ON TRANSFER OF FUNDS FROM SUBSIDIARIES TO PARENT The transfer of funds by the banking subsidiaries to the parent as dividends, loans or advances is subject to various laws and regulations that limit the amount of such transfers that can be made without regulatory approval. The maximum amount available for dividend distribution that may be paid in 1997 by Provident to its parent without approval is approximately $96.1 million, plus 1997 net earnings. Dividends of approximately $3.8 million plus 1997 net earnings may be paid in 1997 by Provident Kentucky to its parent. Pursuant to Federal Reserve and State regulations, the maximum amount available to be loaned to affiliates (as defined), including their Parent, by the banking subsidiaries, was approximately $68.7 million to any single affiliate, and $137.3 million to all affiliates combined of which $59.3 million was loaned at December 31, 1996.
SUPPLEMENTARY DATA
Quarterly Consolidated Results of Operations - (Unaudited)
The following are quarterly consolidated results of operations for the two years ended December 31, 1996.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None
PART III
The following items are incorporated by reference to Bancorp's definitive proxy statement to be filed with the Commission pursuant to Regulation 14A within 120 days after the close of Bancorp's fiscal year ending December 31, 1996:
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORT ON FORM 8-K
(a) 1. See Index to Financial Statements on page 28 for a list of all financial statements filed as a part of this report.
2. Schedules to the consolidated financial statements required by Article 9 of Regulation S-X have been omitted as they are not required, not applicable or the information required thereby is set forth in the related financial statements.
3. Exhibits:
Number Exhibit Description Filing Status
3.1 Articles of Incorporation Filed herewith.
3.2 Amended Code of Regulations Incorporated by reference to Annex I to Provident Bancorp, Inc.'s Proxy Statement for the 1994 Annual Meeting of Shareholders.
4.1 Instruments defining the Bancorp has no outstanding rights of security holders issue of indebtedness exceeding 10% of the assets of Bancorp and Consolidated Subsidiaries. A copy of the instruments defining the rights of security holders will be furnished to the Commission upon request.
Number Exhibit Description Filing Status
4.2 Plan of Reorganization Incorporated by reference to relating to Series D, Form 10-K for 1995. Non-Voting Convertible Preferred Stock
10.1 Restated Agreement and Plan Incorporated by reference to of Reorganization, as Form S-2 (File No. 33-44641). amended through May 8, 1992, between Provident Bancorp, Inc. and Merit Savings Association
10.2 Restated Agreement and Plan Incorporated by reference to of Reorganization, as Form S-2 (File No. 33-44641). amended through May 11, 1992, between Provident Bancorp, Inc. and Peoples Federal Savings Association of Bellevue
10.3 Third Restated Agreement Incorporated by reference to and Plan of Reorganization, Form S-2 (File No. 33-44641). as amended through April 30, 1992, between Provident Bancorp, Inc. and Suburban Federal Savings and Loan Association of Covington
10.4 Agreement and Plan of Incorporated by reference to Reorganization between Form S-3 (File No. 33-69666). Provident Bancorp, Inc. and Heritage Savings Bank
10.5 Second Restated Agreement Incorporated by reference to and Plan of Reorganization, Form S-2 (File No. 33-44641). as amended through May 6, 1992, between Provident Bancorp, Inc. and Thrift Savings and Loan Company
10.6 Junior Subordinated Incorporated by reference to Indenture, dated as of Exhibit 4.1 on Form 8-K dated November 27, 1996, between November 27, 1996. Bancorp and the Bank of New York, as Indenture Trustee.
10.7 Amended and Restated Incorporated by reference to Declaration of Trust of Exhibit 4.3 on Form 8-K dated Provident Capital Trust I, November 27, 1996. dated as of November 27, 1996.
Number Exhibit Description Filing Status
10.8 Form of Guarantee Agreement Incorporated by reference to to be entered into by registration statement number Bancorp and The Bank of New 333-20769. York, as Guarantee Trustee.
Management Compensatory Agreements
10.9 Provident Bancorp, Inc. Incorporated by reference to 1990 Employee Stock Post-Effective Amendment No. Purchase Plan 1 to Form S-8 (File No. 33-34904).
10.10 Provident Bancorp, Inc. Incorporated by reference to Retirement Plan (As amended) Form S-8 (File No. 33-90792).
10.11 Provident Bancorp, Inc. Incorporated by reference to 1988 Stock Option Plan (As Form S-8 (File No. 33-34906), amended) Form S-8 (File No. 33-43102) and Form S-8 (File No. 33-84094).
10.12 Provident Bancorp, Inc. Incorporated by reference to 1992 Advisory Directors' Form 8-K filed October 22, Stock Option Plan (As 1992, and Form S-8 (File No. amended) 33-62707).
10.13 Provident Bancorp, Inc. Incorporated by reference to 1992 Outside Directors' Form S-8 (File No. 33-51230). Stock Option Plan
10.14 Provident Bancorp, Inc. Incorporated by reference to Restricted Stock Plan Form S-2 (File No. 33-44641).
10.15 Provident Bancorp, Inc. Incorporated by reference to Deferred Compensation Plan Form S-8 (File No. 33-61576) and Form 8-K filed March 28, 1995.
21 Subsidiaries of Provident Filed herewith. Bancorp, Inc.
23 Consent of Independent Filed herewith. Auditors
27 Financial Data Schedule Filed herewith.
(b) Reports on Form 8-K:
Date of Report Item 5. Other Events
October 3, 1996 Revised its estimate of net income for the third quarter of 1996 to $17 million as a result of a one-time special assessment on Savings Association Insurance Fund deposits.
November 27, 1996 Provident Capital Trust I, a Delaware statutory business issued $100 million of its 8.60% capital securities. Bancorp owns all of the beneficial ownership interests represented by the common securities of the Trust. The sole purpose of the Trust is to issue the capital and common securities of the Trust and invest the proceeds in 8.60% junior subordinated debentures issued by Bancorp. The capital securities mature in 2026 and are callable in ten years at a premium of 104.30 that declines ratably over the next ten years. The capital securities qualify as Tier I Regulatory Capital.
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, Provident Bancorp, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Provident Bancorp, Inc.
/s/Allen L. Davis
Allen L. Davis President March 20, 1997
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Provident Bancorp, Inc. and in the capacities and on the dates indicated.
Signature Capacity Date
/s/Allen L. Davis Director and President March 20, 1997 Allen L. Davis (Principal Executive Officer)
/s/Philip R. Myers Director March 20, 1997 Philip R. Myers
/s/Sidney A. Peerless Director March 20, 1997 Sidney A. Peerless
/s/Joseph A. Pedoto Director March 20, 1997 Joseph A. Pedoto
/s/John R. Farrenkopf Vice President and March 20, 1997 John R. Farrenkopf Chief Financial and Accounting Officer (Principal Financial Officer and Principal Accounting Officer)