ITEM 1. BUSINESS GENERAL
IBT Bancorp, Inc. (the Corporation) is a registered bank holding company incorporated under Michigan law in September 1988. The Corporation has two subsidiaries: Isabella Bank and Trust and IBT Financial Services. Isabella Bank and Trust has one wholly owned subsidiary, IBT Agency. Its principal subsidiary, Isabella Bank and Trust has twelve banking offices located throughout Isabella County, northeastern Montcalm County, and southern Clare County, all of which are located in central Michigan. IBT Financial Services is a full service retail brokerage offering stocks, bonds and mutual funds to individuals. IBT agency is authorized to sell life insurance, casualty insurance, and fixed and variable annuities. The principal city in which the Corporation operates is Mount Pleasant, which has a population of approximately 24,000. Central Michigan University, with enrollment of 16,000 students, is the area's largest employer and provides a stable source of employment and income. Mount Pleasant, as a result of having a large state supported university within its boundaries and being centrally located between 4 cities of similar size, has a sizable retail shopping industry. Mt. Pleasant is also the base for the state's oil and gas production; Michigan is the 12th largest producer of oil and gas in the United States. Other economic activity in Isabella County includes farming, light industrial manufacturing and gaming at the Saginaw Chippewa Indian Tribe Reservation. The area's unemployment rate is approximately 3.0% and the average household income is $34,500.
COMPETITION
The Corporation competes with other commercial banks, many of which are subsidiaries of other bank holding companies, savings and loan associations, finance companies, credit unions, and retail brokerage firms. The Bank is a community bank and focuses on providing high-quality, personalized service at a fair price. Based on deposits maintained by all financial institutions, the Bank's market share exceeded 50% of the total for Isabella County in both 1997 and 1996. The Bank offers a broad array of banking services to businesses, institutions, and individuals. Deposit services offered include checking accounts, savings accounts, certificates of deposit, and direct deposits. Lending activity includes loans made pursuant to lines of credit, real estate loans, consumer loans, student loans, and charge card loans. Other financial related products include trust services, stocks, investment securities, bond, mutual fund sales, 24 hour banking service locally and nationally through shared automatic teller machines, and safe deposit box rentals.
LENDING
The Bank limits lending activity to its local market and has not purchased any loans from the secondary market. The Bank does not make loans to fund leveraged buyouts, has
no foreign corporate or government loans, and no corporate debt securities. The general lending philosophy of the Bank is to avoid concentrations to individuals and business segments. The following table sets forth the composition of the Bank's loan portfolio, as of December 31, 1997.
First and second residential mortgages are the single largest category of loans (41.4% of total loans). The Bank offers 3 and 5 year fixed rate balloon mortgages with a maximum 30 year amortization, and 15 and 30 year amortized fixed rate loans. Fixed rate loans with an amortization greater than 15 years are sold upon origination to the Federal Home Loan Mortgage Association. Fixed rate residential mortgage loans with an amortization of 15 years or less may be held for future sale or sold upon origination. Factors used in determining when to sell these mortgages include management's judgement about the direction of interest rates, the Corporation's need for fixed rate assets in the management of its interest rate sensitivity, and overall loan demand. The Corporation has a policy that these loans may not exceed 5% of its total assets.
The Bank's lending policies generally limit the maximum loan-to-value ratio on residential mortgages to 95% of the lower of appraised value of the property or the purchase price, with the condition that private mortgage insurance is required on loans with loan-to-value ratios in excess of 80%. The majority of the Bank's loans have a loan-to-value ratio of less than 80%. When underwriting residential real estate loans, the Bank evaluates the
borrower's ability to make monthly payments and the value of the property securing the loan. The Bank requires that the payment of principal, interest, taxes, and hazard insurance does not exceed 28% of a borrower's gross income and that all debt servicing does not exceed 36% of income. In addition to the above requirements, the Bank reviews credit reports and verifies employment, income, and financial information. Appraisals are performed by independent appraisers. The Bank requires an escrow account for taxes and insurance on all loans with loan-to-value in excess of 80%. All mortgage loan requests are reviewed by a mortgage loan committee; loans in excess of $200,000 require the approval of either the Bank's Board of Directors or its loan committee.
Construction and land development loans consisted solely of 1 to 4 family residential properties. These loans have a 6 to 9 month maturity and are made using the same underwriting criteria as residential mortgages. Loan proceeds are disbursed in increments as construction progresses and as inspections warrant. Construction loans are either converted to permanent loans at the completion of construction or are paid off from financing through another financial institution.
Commercial lending, which includes loans for farmland and agricultural production, state and political subdivisions, commercial real estate, and commercial loans equaled 17.0% of the Bank's loan portfolio at December 31, 1997. Repayment of commercial loans is often dependent upon the successful operation and management of a business; thus, these loans generally involve greater risk than other types of lending. The Bank minimizes its risk by limiting the amount of loans to any one borrower to $2.5 million. Borrowers with credit needs of more than $2.5 million are serviced through the use of loan participations with other commercial banks. All commercial real estate loans require loan-to-value limits of less than 80%. Depending upon the type of loan, past credit history, and current operating results, the Bank may require the borrower to pledge accounts receivable, inventory, and fixed assets. Personal guarantees are generally required from the owners of closely held corporations, partnerships, and proprietorships. In addition, the Bank requires annual financial statements, prepares cash flow analysis, and reviews credit reports. All commercial loan requests require the approval of two senior loan officers if the amount exceeds $200,000. Loan requests in excess of $200,000 require the approval of either the Bank's Board of Directors or its loan committee.
Consumer loans granted by the Bank include automobile loans, second mortgages, secured and unsecured personal loans, credit cards, student loans, and overdraft protection. The Bank does not offer revolving home equity loans nor does it purchase dealer paper. Loan amortization is generally for a period of up to 5 years; except home improvement loans, which are amortized for up to 10 years. The Bank places underwriting emphasis on a borrower's ability to pay rather than collateral value. Except for student loans, no installment loans are sold in the secondary market. All student loans are sold on the secondary market upon reaching a payout status.
SUPERVISION AND REGULATION
The Corporation is subject to supervision and regulation by the Federal Reserve Board under the Bank Holding Company Act of 1956, as amended. A bank holding company and its subsidiaries are able to conduct only the business of commercial banking and activities closely related or incidental to it. (See Regulation below.)
The Bank is chartered by the State of Michigan and is supervised and regulated by the Financial Institutions Bureau of the State of Michigan. The Bank is a member of the Federal Reserve System, its deposits are insured by the Federal Deposit Insurance Corporation to the extent provided by law, and is a member of the Federal Home Loan Bank of Indianapolis. (See Regulation below)
The Corporation's non-banking subsidiary, IBT Financial Services, Inc., is a broker-dealer, registered and subject to regulation by the Securities and Exchange Commission under federal securities laws. This subsidiary is also subject to regulation under state securities laws.
The Bank's non-banking subsidiary, IBT Agency, is a licensed insurance agency and is subject to regulation by the Michigan Insurance Bureau.
PERSONNEL
As of December 31, 1997, the Corporation had one full-time employee, the Bank had 150 full-time equivalent employees, IBT Financial Services had three full-time employees, and IBT Agency has a dual employee arrangement with IBT Financial Services. The Corporation and the Bank provide group life, health, accident, disability and other insurance programs for employees and a number of other employee benefit programs. The Corporation believes its relationship with its employees to be good.
LEGAL PROCEEDINGS
There are various claims and law suits in which the Bank is periodically involved, such as claims to enforce liens, condemnation proceedings on making and servicing of real property loans and other issues incident to the Bank's business. However, neither the Corporation nor the Bank is involved in any material pending litigation.
REGULATION
The earnings and growth of the banking industry and therefore the earnings of the Corporation and the earnings of the Bank are affected by the credit policies of monetary authorities, including the Federal Reserve System. An important function of the Federal Reserve System is to regulate the national supply of bank credit in order to combat recession and curb inflationary pressures. Among the instruments of monetary policy
used by the Federal Reserve to implement these objectives are open market operations in U.S. Treasury securities, changes in the discount rate on member bank borrowing, and changes in reserve requirements against member bank deposits. These methods are used in varying combinations to influence overall growth of bank loans, investments and deposits and may also affect interest rates charged on loans or paid for deposits. The monetary policies of the Federal Reserve System have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. The effect of such policies upon the future business and earnings of the Corporation and the Bank cannot be predicted.
THE CORPORATION
The Corporation, as a bank holding company, is regulated under the Bank Holding Company Act of 1956, as amended ("BHC Act"), and is subject to the supervision of the Board of Governors of the Federal Reserve System ("Federal Reserve Board"). The Corporation is registered as a bank holding company with the Federal Reserve Board and is required to file with the Federal Reserve Board an annual report and such additional information as the Federal Reserve Board requires. The Federal Reserve Board may also make inspections and examinations of the Corporation and its subsidiaries.
Under the BHC Act, bank holding companies such as the Corporation are prohibited, with certain limited exceptions, from engaging in activities other than those of banking or of managing or controlling banks and from acquiring or retaining direct or indirect ownership or control of voting shares or assets of any company which is not a bank or bank holding company, other than subsidiary companies furnishing services to or performing services for its subsidiaries, and other subsidiaries engaged in activities which the Federal Reserve Board determines to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. Under the BHC Act, bank holding companies may not (subject to certain limited exceptions) directly or indirectly acquire the ownership or control of more than 5% of any class of voting shares or substantially all of the assets of any company, including a bank or bank holding company, without the prior written approval of the Federal Reserve Board.
The BHC Act prohibits the Federal Reserve Board (subject to certain limited exceptions) from approving the acquisition, by a bank holding company, such as the Corporation, the principal banking operations of which are conducted in one state, of control of a bank or bank holding company conducting its principal banking operations in another state, unless the statutory laws of the state in which are conducted the principal banking operations of the bank holding company or bank to be acquired, explicitly authorize such an acquisition. Under existing Michigan law and with the approval of the Commissioner of the Michigan Financial Institutions Bureau, a Michigan-based bank and bank holding company (such as the Corporation) may now be acquired by a bank holding company located in any state, if the laws of such state would grant Michigan-based banks or bank
holding companies the right to acquire one or more banks or bank holding companies located in such state under conditions which are not unduly restrictive. Under the Michigan statute, the Commissioner of the Michigan Financial Institutions Bureau must not approve any such transaction without first determining among other things that the other state's law satisfies the reciprocity requirement imposed by the Michigan statute. Most states have adopted legislation that permits out-of-state bank holding companies to acquire local banks and bank holding companies subject, in most cases, to reciprocity requirements.
Under Federal Reserve Board policy, the Corporation is expected to act as a source of financing strength to its subsidiary bank and to commit resources to support its subsidiary. This support may be required at times when, in the absence of such Federal Reserve Board policy, the Corporation would not otherwise be required to provide it.
Under Michigan law, if the capital of a Michigan state chartered bank (such as the Corporation's bank subsidiary) has become impaired by losses or otherwise, the Commissioner of the Michigan Financial Institutions Bureau may require that the deficiency in capital be met by assessment upon the Bank's stockholders pro rata on the amount of capital stock held by each, and if any such assessment is not paid by any stockholder within 30 days of the date of mailing of notice thereof to such stockholder, cause the sale of the stock of such stockholder to pay such assessment and the costs of sale of such stock.
Any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary bank. In the event of a bank holding company's bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment. This priority would apparently apply to guarantees of capital plans under the Federal Deposit Insurance Corporation Improvement Act of 1991.
Certain additional information concerning regulatory guidelines for capital adequacy and other regulatory matters is presented herein under the caption "Capital" on page 22 and "Note I - Commitments and Other Matters" and "Note J - Regulatory Capital Matters" on pages 43 and 44, respectively.
ISABELLA BANK & TRUST
The Bank is subject to regulation and examination primarily by the Michigan Financial Institutions Bureau. As an insured state bank, which is a member of the Federal Reserve Bank of Chicago, the subsidiary is also subject to regulation and examination by the FDIC and the Federal Reserve.
The agencies and federal and state law extensively regulate various aspects of the banking business including, among other things, permissible types and amounts of loans, investments and other activities, capital adequacy, branching, interest rates on loans and on deposits and the safety and soundness of banking practices.
Banking laws and regulations also restrict transactions by insured banks owned by a bank holding company, including loans to and certain purchases from the parent holding company, non-bank and bank subsidiaries of the parent holding company, principal shareholders, officers, directors and their affiliates, and investments by the subsidiary banks in the shares or securities of the parent holding company (or any of the other non-bank or bank affiliates), acceptance of such share or securities as collateral security for loans to any borrower.
The Bank is also subject to legal limitations on the frequency and amount of dividends that can be paid to the Corporation. For example, a Michigan state bank may not declare a cash dividend or a dividend in kind except out of net profits then on hand after deducting all losses and bad debts, and then only if it will have a surplus amounting to not less than 20% of its capital after the payment of the dividend. Moreover, a Michigan state bank may not declare or pay any cash dividend or dividend in kind until the cumulative dividends on its preferred stock, if any, have been paid in full. Further, if the surplus of a Michigan state bank is at any time less than the amount of its capital, before the declaration of a cash dividend or dividend in kind, it must transfer to surplus not less than 10% of its net profits for the preceding half-year (in the case of quarterly or semi-annual dividends) or the preceding two consecutive half-year periods (in the case of annual dividends).
The payment of dividends by the Corporation and the Bank is also affected by various regulatory requirements and policies, such as the requirement to maintain adequate capital above regulatory guidelines. Recently enacted legislation will impose further restrictions on the payment of dividends by insured banks which fail to meet specified capital levels. The FDIC may prevent an insured bank from paying dividends if the bank is in default of payment of any assessment due to the FDIC. In addition, payment of dividends by a bank may be prevented by the applicable federal regulatory authority if such payment is determined, by reason of the financial condition of such bank, to be an unsafe and unsound banking practice. The Federal Reserve Board and the FDIC have issued policy statements providing that bank holding companies and insured banks should generally only pay dividends out of current operating earnings.
These regulations and restrictions may limit the Corporation's ability to obtain funds from the Bank for its cash needs, including payment of dividends and operating expenses.
The activities and operations of the Bank are also subject to other federal and state laws and regulations, including usury and consumer credit laws, the Federal Trust-in-Lending Act, Truth-in-Saving and Regulation Z of the Federal Reserve Board and the Federal Bank Merger Act.
ITEM 2.
ITEM 2. PROPERTIES The Corporation's offices are located in the main office building of the Bank. The Bank owns and operates all of its 12 facilities, which are located in Isabella, Montcalm and Clare counties in the State of Michigan. The Corporation's facilities current, planned, and best use is for transacting commercial and retail banking with the exception of approximately 8% of the main office, and 45% of the Clare office, which is leased to tenants. In management's opinion, each facility has excess capacity and is in good condition. The following table sets forth the location of the Corporation's offices, as well as certain additional information relating to those offices as of December 31, 1997.
(1) includes land and buildings (2) substantially remodeled in 1986 (3) substantially remodeled in 1990 (4) partially remodeled in 1986 and 1988 (5) substantially remodeled in 1976 and partially remodeled in 1986 (6) substantially remodeled in 1992 and 1996
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS The Corporation and the Bank are not involved in any material pending legal proceed ings. The Bank, because of the nature of its business, is at times subject to numerous pending and threatened legal actions which arises out of the normal course of their business.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted during the fourth quarter of 1997 to a vote of security holders through the solicitation of proxies or otherwise.
EXECUTIVE OFFICERS OF REGISTRANT
Pursuant to instruction G(3), the following information is included as an unnumbered item under Part I of this report in lieu of being included in the Proxy Statement for the Annual Shareholders Meeting to be held on May 5, 1998.
The names, ages, corporate positions, and years of service of the executive officers of the Corporation are as follows:
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDERS' MATTERS There is no established market for the Corporation's common stock or public information with respect to its market price. There are occasional sales by shareholders of which the management of the Corporation is aware. From January 1, 1996 through December 31, 1997 there were, so far as management knows, 51 sales of the Corporation's common stock. These sales involved 20,303 shares, as adjusted for a 10 percent stock dividend declared in December 1997 to be paid in March of 1998. The prices were reported to management in only some of the transactions, and management cannot confirm the prices which were reported during this period. The highest known price paid for the Bank's stock was $59.09 per share in both the third and fourth quarters of 1997, and the lowest price was $40.91 per share in the first three quarters of 1996. The following is a summary of all known transfers since January 1, 1996. All of the information has been adjusted to reflect the stock dividend referred to above.
The following table sets forth the cash dividends paid for the following quarters, adjusted for the 10 percent stock dividend.
IBT Bancorp's authorized stock consists of 4,000,000 shares, of which 792,455 shares are issued (871,800 after the stock dividend payable March 2, 1998) with a par value of $6 per share. As of year end 1997, there were 875 shareholders of record.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
SUMMARY OF SELECTED FINANCIAL DATA (DOLLARS IN THOUSANDS EXCEPT PER SHARE DATA)
(1) Retroactively restated in 1997 for the 10% stock dividend declared on December 15, 1997, payable March 2, 1998
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following schedules present the daily average amount outstanding for each major category (at historical cost) of interest earning assets, nonearning assets, interest bearing liabilities, and noninterest bearing liabilities. This schedule also presents an analysis of interest income and interest expense for the periods indicated. All interest income is reported on a fully taxable equivalent (FTE) basis using a 34% tax rate. Nonaccruing loans, for the purpose of the following computations, are included in the average loan amounts outstanding.
TABLE 1. DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY: INTEREST RATE AND INTEREST DIFFERENTIAL
RESULTS OF OPERATIONS
The Corporation achieved record net income for the eleventh consecutive year in 1997 with earnings of $3,609,000, an 8.1% increase over 1996. Earnings per share were $4.17, an increase of $0.27 over 1996 and $0.67 over 1995.
Two key measures of earnings performance commonly used in the banking industry are return on average assets and return on average shareholders' equity. Return on average assets measures the ability of a bank to profitably and efficiently employ its resources. The Corporation's return on average assets equaled 1.19% in 1997, 1.15% in 1996, and 1.11% in 1995. Return on average equity indicates how effectively a bank is able to generate earnings on capital invested by its shareholders. The Corporation's return on average shareholders' equity equaled 12.20% in 1997, 12.39% in 1996, and 12.17% in 1995.
NET INTEREST INCOME
The Corporation derives the majority of its income from interest earned on loans and investments, while its most significant expense is the interest cost incurred for funds used. Net interest income is the amount by which interest income on earning assets exceeds the interest cost of deposits. Net interest income is influenced by changes in the balance and mix of assets and liabilities, and market interest rates. Management exerts some control over these factors; however, Federal Reserve monetary policy and competition have a significant impact. In accordance with Statement of Financial Accounting Standards (SFAS) No. 91, interest income includes loan fees of $599,000 in 1997; $754,000 in 1996; and $601,000 in 1995. For analytical purposes, net interest income is adjusted to a "taxable equivalent" basis by adding the income tax savings from interest on tax-exempt loans and securities, thus making year-to-year comparisons more meaningful.
TABLE 2. VOLUME AND RATE VARIANCE ANALYSIS (Dollars in Thousands)
The following table details the dollar amount of changes in FTE net interest income for each major category of interest earning assets and interest bearing liabilities, and the amount of change attributable to changes in average balances (volume) or average rates. The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.
NET INTEREST INCOME (CONTINUED)
Changes in net interest income from period to period result from changes in the average balances (volume) of interest earning assets and interest bearing liabilities and the average rate earned and paid on such assets and liabilities. As shown in Tables 1 and 2, when comparing 1997 to 1996 fully taxable equivalent (FTE) net interest income increased $371,000 or 3.0%. A 5.4% increase in interest earning assets provided $1,329,000 of FTE interest income. The majority of this growth was funded by a 4.1% increase in interest bearing deposits, resulting in $516,000 of additional interest expense. Overall, changes in volume resulted in $813,000 of additional FTE interest income. The average FTE interest rate earned on assets decreased by 0.08%, decreasing FTE interest income by $381,000 and the average rate paid on deposits increased by 0.7%, increasing interest expense by $61,000. The net change related to interest rates earned and paid was a $442,000 reduction in FTE net interest income.
The Corporation's FTE net interest yield as a percentage of average earning assets equaled 4.44% in 1997 versus 4.54% in 1996. The 0.10% decrease in the net interest yield was primarily a result of the Corporation's increasing reliance on higher cost deposits such as certificates of deposit and money market accounts to fund asset growth. The percentage of assets funded with these deposits increased from 49.6% in 1996 to 51.6%. Management expects the Corporation's reliance on higher cost deposits to fund asset growth to continue. An additional factor in the decline of interest rate margins is the intense interest rate competition for new commercial and consumer loans. Rates charged for loans in relation to deposit costs has continually declined over the past several years.
In January 1998, Isabella Bank and Trust entered into an agreement to purchase these deposits of three Old Kent Bank branches. The details of the purchase can be found in Note K - Subsequent Events. The impact of this purchase on net interest margin yield will be significant. Management calculates that the yield will decline approximately 40 basis points in 1998. The primary factor for the decline is that the Bank will invest the majority of the proceeds from the purchase in investment securities, which have significantly lower yields than loans. Management does not expect the majority of these deposits to be invested in loans for three to five years. The purchase will also have an adverse impact on the Corporation's net income, return on equity, and per share income over the next two to three years. Long term, the management of the Corporation expects the impact on operating results to be positive.
In addition to the impacts of changes in asset and liability mix and the purchase of the branches will have on the Corporation's interest income, changes in interest rates also exert considerable influence. Management expects interest rates to remain steady during 1998. Based on this expectation and the Corporation's asset and liability repricing characteristics, management calculates that the Corporation's FTE net interest margin as a percentage of average assets will be further decreased by lower rates. Due to the many factors that can affect net interest income, interest income earned cannot be predicted with any certainty.
Net interest income increased $912,000 to $12.2 million in 1996 from $11.3 million in 1995. As shown in Tables 1 and 2, in 1996 (FTE) interest income increased $1,948,000, from a 9.2% increase in the volume of average earning assets. The growth of interest earning assets was funded primarily by an 8.2% increase in interest bearing deposits that resulted in additional interest expense of $918,000. Overall, the Corporation earned an additional $1,030,000 in FTE interest income as a result of volume. The average rate earned in 1996 decreased by .01%, decreasing FTE interest income by $76,000 and the average rate paid on deposits increased by 10 basis points, increasing interest expense by $42,000. The net result of increased interest rates earned and paid reduced FTE net interest income by $118,000.
PROVISION FOR LOAN LOSSES
The viability of any financial institution is ultimately determined by its management of credit risk. Total loans outstanding represent 76.3% of the Corporation's total year end deposits, and is the Corporation's single largest concentration of risk. Inevitably, poor operating performance may result from the failure to control credit risk. Given the importance of maintaining sound underwriting practices, both the Board of Directors and senior management spend a large portion of their time and effort in loan review. The provision for loan losses is the amount added to the allowance for loan losses on a monthly basis. The allowance for loan losses is management's estimation of potential future losses inherent in the
PROVISION FOR LOAN LOSSES (CONTINUED)
loan portfolio, and is maintained at a level considered by management to be adequate to absorb potential future losses. Evaluation of the allowance for loan losses and the provision for loan losses is based on a continuous review of the changes in the type and volume of the loan portfolio, reviews of specific loans to evaluate their collectibility, recent loan loss history, financial condition of borrowers, the amount of impaired loans, overall economic conditions, and other factors. This evaluation is inherently subjective as it requires material estimates, including the amounts and timing of future cash flows expected to be received on impaired loans that may be subject to significant change.
As shown in Table 3, total loans outstanding increased 0.8% in 1997 and 15.8% in 1996. The allowance for loan losses as a percentage of total outstanding loans at year end 1997 was 1.23% compared to 1.22% at December 31, 1996. The Corporation's net charged off loans as a percentage of average loans was 0.15% in 1997 and 0.06% in 1996.
TABLE 3. SUMMARY OF LOAN LOSS EXPERIENCE (Dollars in Thousands)
The following is a summary of loan balances at the end of each period and their daily average balances, changes in the allowance for possible loan losses arising from loans charged off and recoveries on loans previously charged off, and additions to the allowance which have been expensed.
As shown in Table 4, the percentage of loans classified as nonperforming by the Corporation as of December 31, 1997 and 1996 equaled 0.24% and 0.25% of total loans, respectively. The Bank's policy, including a loan considered impaired under SFAS No. 118, is to transfer a loan to nonaccrual status whenever it is determined that interest should be recorded on the cash basis instead of the accrual basis because of a deterioration in the financial position of the borrower, it is determined that payment in full of interest or principal cannot be expected, or the loan has been in default for a period of 90 days or more, unless it is both well secured and in the process of collection. Restructured loans are loans whose terms have been renegotiated to provide a reduction or deferral of interest or principal because of a deterioration in the financial position of the borrower.
TABLE 4. NONPERFORMING LOANS (Dollars in Thousands)
The following loans are all the credits which require classification for state or federal regulatory purposes.
As of December 31, 1997, there were no other interest bearing assets which required classification. Management is not aware of any recommendations by regulatory agencies which, if implemented, would have a material impact on the Corporation's liquidity, capital, or operations.
In management's opinion, the allowance for loan losses is adequate as of December 31, 1997. Management has allocated, as shown in Table 5, the allowance for loan losses to the following categories: 40.8% to commercial and agricultural loans; 21.8% to real estate loans; 29.2% to installment loans; and 8.2% unallocated. The above allocation is not intended to imply limitations on usage of the allowance. The entire allowance is available for any future loans without regard to loan type.
TABLE 5. ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES (Dollars in Thousands)
The allowance for loan losses has been allocated according to the amount deemed to be reasonably necessary to provide for the possibility of losses being incurred within the following categories:
NONINTEREST INCOME
Noninterest income consists of trust fees, deposit service charges, and fees for other financial services. Noninterest income decreased $90,000 or 4.1% in 1997 when compared to 1996. The most significant change was a $295,000 decrease in automatic teller machine fees. In December 1996, a major contract for providing ATM services was not renewed. During 1996, services provided under this contract generated $300,000 in revenue. The decline in revenue was partially offset by decreases in ATM operating costs, depreciation expense, and additional interest income due to a substantial decrease in vault cash. Other changes in noninterest income included a $37,000 increase in brokerage commissions, a $41,000 increase in trust fees, a $42,000 increase in overdraft fees, a $52,000 gain on the sale of ATM equipment, and a $34,000 increase in gains on the sale of residential real estate mortgages.
Included in other operating income is a $154,000 gain from the sale of $15.8 million in mortgages during 1997 versus a $120,000 gain on the sale of $18.8 million for 1996. The Corporation has established a policy that all 30-year fixed rate mortgage loans will be sold. During 1997, all 15 and 30 year fixed rate mortgage loans granted were sold on the secondary market. These loans were sold without recourse, with servicing retained. The gain on sale in 1997 and 1996 was calculated under the provisions of SFAS No. 125.
Total noninterest income increased $219,000 or 11.1% in 1996 when compared to 1995. The most significant changes were a $65,000 increase in automatic teller machine fees, a $48,000 gain on sale of student loans, a $44,000 increase in brokerage fees, and a $27,000 decrease in trust fees.
NONINTEREST EXPENSES
Controlling noninterest expenses is important to maintain adequate and satisfactory profitability. Noninterest expenses increased $15,000 or 0.2% in 1997 when compared with 1996. Noninterest expense declined from 3.04% of average assets in 1996 to 2.91% in 1997. The largest component of noninterest expense is salaries and employee benefits, which increased $241,000 or 5.2%. The majority of this increase was related to normal merit and promotional salary increases and additional staff. Salaries and benefits equaled 1.60% of average assets during 1997, and 1.59% during 1996 and 1995.
Occupancy and furniture and equipment expenses decreased $243,000 or 13.6% in 1997. The majority of this decrease was associated with a $72,000 decrease in automatic teller machine operating costs, a $61,000 decrease in computer operations expenses, and a $77,000 decline in building and equipment depreciation.
Other noninterest expenses increased $17,000, or 0.7%. The most significant increases were $31,000 in FDIC insurance premiums and $86,000 in other real estate expenses. These increases were offset by a $73,000 decrease in donations and a $20,000 decrease in printing and office supplies.
Noninterest expense increased $468,000 or 5.6% in 1996 when compared with 1995. Salaries and employee benefits increased $373,000 or 8.8%. The majority of this increase was related to normal merit and promotional salary increases and additional staff. Occupancy and furniture and equipment expenses increased $217,000 or 13.7% in 1996. The majority of this increase was associated with automatic teller machine operating costs, computer operations, furniture and equipment depreciation, and building repairs. Other noninterest expenses decreased $121,000, a 4.8% decrease. The most significant increases were in donations, printing and supplies, State of Michigan single business tax, and marketing. These increases were offset by decreases in FDIC premiums and other real estate expenses.
FEDERAL INCOME TAXES
Federal income tax expense for 1997 was $1,490,000 or 29.2% of pre-tax income compared to $1,295,000 or 27.9% of pre-tax income in 1996 and $1,065,000 or 26.5% in 1995. The continuing increase in income tax expense as a percentage of income is attributable to a decrease in non taxable municipal income as a percentage of the Corporation's pretax net income. A reconcilement of federal income tax expense and the amount computed at the federal statutory rate of 34% is found in Note E, Federal Income Taxes, in the accompanying consolidated financial statements.
ANALYSIS OF CHANGES IN THE STATEMENT OF CONDITION
Total assets were $318.7 million at December 31, 1997, an increase of $20.0 million or 6.7% over year end 1996. Asset growth was primarily funded by a $16.9 million increase in deposits and a $3.0 million increase in shareholders' equity. A discussion of changes in balance sheet amounts by major categories follows.
INVESTMENT SECURITIES
The primary objective of the Corporation's investing activities is to provide for safety of the principal invested. Secondary considerations include the need for earnings, liquidity, and the Corporation's overall exposure to changes in interest rates. During 1997, the Corporation's net holding of investment securities increased $4.6 million. Table 6 shows the carrying value of investment securities available for sale and held to maturity. Securities held to maturity, which are stated at amortized cost, consist mostly of local municipal bond issues, long term U.S. government and agency notes, and mortgage backed securities. The mortgage backed securities are issues of the Federal Home Loan Mortgage Corporation and pay regular monthly amortized principal and interest. These investments have less than 10 years to final maturity. Securities not classified by management as held to maturity are classified as available for sale and are stated at fair value.
TABLE 6. INVESTMENT PORTFOLIO (Dollars in Thousands)
The following is a schedule of the carrying value of investment securities available for sale and held to maturity:
Excluding those holdings of the investment portfolio in U.S. Treasury and U.S. government agency securities, there were no investments in securities of any one issuer which exceeded 10% of shareholders' equity. Other securities consist solely of Federal Reserve Bank and Federal Home Loan Bank stock, which are restricted investments and have no contractual maturity. The Corporation has a policy prohibiting investments in securities that it deems are unsuitable due to their inherent credit or market risks. Prohibited investments include stripped mortgage backed securities, collateralized mortgage obligations, zero coupon bonds, nongovernment agency asset backed securities, corporate bonds, and structured notes.
The following is a schedule of maturities of each category of investment securities (at carrying value) and their weighted average yield as of December 31, 1997. The weighted average interest rates have been computed on a fully taxable equivalent basis, based on amortized cost. The rates shown on securities issued by states and political subdivisions are stated on a taxable equivalent basis using a 34% tax rate.
TABLE 7. SCHEDULE OF MATURITIES OF INVESTMENT SECURITIES AND WEIGHTED AVERAGE YIELDS (Dollars in Thousands)
LOANS
The largest component of earning assets is loans. The proper management of credit and market risk inherent in loans is critical to the financial well-being of the Corporation. To control these risks, the Corporation has adopted strict underwriting standards. The standards include prohibitions against lending outside the Corporation's defined market area, lending limits to a single borrower, and strict loan to collateral value limits. The Corporation also monitors and limits loan concentrations extended to volatile industries. The Corporation has no foreign loans and there were no concentrations greater than 10% of total loans that are not disclosed as a separate category in Table 8.
TABLE 8. LOAN PORTFOLIO (Dollars in Thousands)
Total loans increased $1.8 million in 1997. The increase was primarily in residential real estate mortgages. During 1997, a total of 4,782 new loans were granted for a total of $101.1 million.
DEPOSITS
Total deposits were $284.6 million at year end 1997, a 6.3% increase over 1996. Average deposits increased 4.3% in 1997 and 8.6% in 1996. During 1997, average noninterest bearing deposits increased 5.4%, interest bearing demand deposits decreased 2.5%, savings deposits increased 2.7%, and time deposits increased 7.2%. Time deposits over $100,000 as a percentage of total deposits equaled 7.4% and 5.2% as of December 31, 1997 and 1996, respectively.
TABLE 9. AVERAGE DEPOSITS (Dollars in Thousands)
TABLE 10. MATURITIES OF TIME CERTIFICATES OF DEPOSIT OVER $100,000 (Dollars in Thousands)
Within the banking industry there is agreement that competition from mutual funds and annuities has had a significant impact on deposit growth. In response, the Corporation's subsidiaries now offer mutual funds and annuities to its customers. The Bank's trust department also offers a variety of financial products in addition to traditional estate services. Competition from other financial institutions in Isabella County, the Bank's primary market, has an impact on both the amount of and the cost of deposits. Isabella County has a population of less than 60,000 people and is serviced by eight financial institutions with 24 locations. This competition results in a higher cost of funds than would otherwise exist. Generally, deposit rates in Isabella County are higher than in the major metropolitan areas in the state. Currently, the Bank's market share of deposits in Isabella County is slightly in excess of 50%.
CAPITAL
The capital of the Corporation consists solely of common stock, capital surplus, retained earnings, and unrealized net gains on securities available for sale. Total capital increased approximately $3.0 million in 1997. The Corporation offers a dividend reinvestment and employee stock purchase plan. Under the provisions of the Plan, the Corporation issued 8,998 shares of common stock generating $479,000 of capital during 1997, and 9,966 shares of common stock generating $433,000 of capital in 1996.
The Federal Reserve Board's current recommended minimum primary capital to assets requirement is 6.0%. The Corporation's primary capital to assets, which consists of shareholders' equity plus the allowance for loan losses, was 10.5% at year end 1997. The purchase of the three branches from Old Kent Bank is a significant capital expenditure. The addition of approximately $52 million in assets and the subtraction from regulatory capital of the $5.2 million in deposit premiums will result in a 2.7% reduction in primary capital.
The Federal Reserve Board has established a minimum risk based capital standard. Under this standard, a framework has been established that assigns risk weights to each category of on and off balance sheet items to arrive at risk adjusted total assets. Regulatory capital is divided by the risk adjusted assets with the resulting ratio compared to the minimum standard to determine whether a corporation has adequate capital. The minimum standard is 8%, of which at least 4% must consist of equity capital net of goodwill. The following table sets forth the percentages required under the Risk Based Capital guidelines and the Corporation's values at December 31, 1997:
Percentage of Capital to Risk Adjusted Assets:
IBT Bancorp's secondary capital includes only the allowance for loan losses. The percentage for the secondary capital under the required column is the maximum amount allowed from all sources.
The Federal Reserve also prescribes minimum capital requirements for the Corporation's subsidiary bank, Isabella Bank and Trust. At December 31, 1997, Isabella Bank and Trust exceeded these minimums. For further information regarding Isabella Bank and Trust's capital requirements, refer to Note J, Regulatory Capital Matters.
LIQUIDITY
Liquidity management is designed to have adequate resources available to meet depositor and borrower discretionary demands for funds. Liquidity is also required to fund expanding operations, investment opportunities, and payment of cash dividends. The primary sources of the Corporation's liquidity are cash and cash equivalents and available for sale investment securities.
As of December 31, 1997 and 1996, cash and cash equivalents equaled 8.9% and 5.1% of total assets, respectively. Net cash provided from operations was $4.8 million in 1997 and $5.7 million in 1996. Net cash provided by financing activities equaled $16.1 million in 1997 and $13.9 million in 1996. The Corporation's investing activities used $7.5 million in 1997 and $26.1 million in 1996. The accumulated effect of the Corporation's operating, investing, and financing activities on cash and cash equivalents was a $13.4 million increase in 1997 and a $6.6 million decrease in 1996.
LIQUIDITY (CONTINUED)
In addition to cash and cash equivalents, investment securities available for sale are another source of liquidity. Securities available for sale equaled $57.4 million as of December 31, 1997 and $50.5 million as of December 31, 1996. In addition to these primary sources of liquidity, the Corporation has the ability to borrow in the federal funds market and at both the Federal Reserve Bank and the Federal Home Loan Bank. The Corporation did not borrow from any of these secondary sources during 1997 or 1996. The Corporation's liquidity is considered adequate by the management of the Corporation.
INTEREST RATE SENSITIVITY
Interest rate sensitivity management aims at achieving reasonable stability in the net interest margin through periods of changing interest rates. Interest rate sensitivity is determined by the amount of earning assets and interest bearing liabilities repricing within a specific time period, and their relative sensitivity to a change in interest rates. One tool used by management to measure interest rate sensitivity is gap analysis. As shown in Table 11, the gap analysis depicts the Corporation's position for specific time periods and the cumulative gap as a percentage of total assets.
Investment securities and other investments are scheduled according to their contractual maturity. Nonvariable rate loans are included in the appropriate time frame based on their scheduled amortization. Variable rate loans are included in the time frame of their earliest repricing. Of the $217.2 million in total loans, $15.7 million are variable rate loans. Time deposit liabilities are scheduled based on their contractual maturity except for variable rate time deposits in the amount of $1.0 million which are included in the 0 to 3 month time frame. Money market accounts reprice monthly and are included in the 0 to 3 month time frame.
Passbook savings, statement savings, and NOW accounts have no contractual maturity date and are believed to be predominantly noninterest rate sensitive by management. These accounts have been classified in the gap table according to their estimated withdrawal rates based upon management's analysis of deposit runoff over the past five years. Management believes this runoff experience is consistent with its expectation for the future. As of December 31, 1997, the Corporation had $22.1 million more in liabilities than assets maturing within one year. A negative gap position results when more liabilities, within a specified time frame, mature or reprice than assets.
In addition to the gap analysis, the Corporation utilizes a computer simulation to project interest margins into the future. These projections are based on the repricing characteristics and cash flows of the Corporation's interest earning assets and interest bearing deposits. By using different prepayment assumptions and interest rate and balance sheet scenarios, the Corporation can measure the effect of changes in interest rates on its net interest margin and adjust its position to minimize any change. The gap and interest rate risk reports are reviewed regularly by the Corporation's Asset and Liability Management Committee. The Corporation does not use interest rate swaps or derivatives in the management of interest rate risk.
TABLE 11. INTEREST RATE SENSITIVITY (Dollars in Thousands)
The following table shows the time periods and the amount of assets and liabilities available for interest rate repricing as of December 31, 1997. For purposes of this analysis, nonaccrual loans and the allowance for loan losses are excluded.
TABLE 12. LOAN MATURITY AND INTEREST SENSITIVITY (Dollars in Thousands)
The following table shows the maturity of commercial and agricultural loans outstanding at December 31, 1997. Also provided are the amounts due after one year, classified according to the sensitivity to changes in interest rates.
THE YEAR 2000
The year 2000 poses a significant risk to financial institutions because of their reliance on automation to manage information. If an automated computer application failed to work properly, it would be difficult, if not impossible, to conduct business. There are three basic risk areas: (1) application software and hardware, (2) spillover business risk, and (3) systemic.
APPLICATION SOFTWARE AND HARDWARE
Isabella Bank and Trust relies solely on outside vendors to provide its main operating system. The main operating system processes customer information and internal accounting information. The failure of any one of its components to be year 2000 compliant could result in financial loss and/or the loss of customer and investor confidence. Primary components of the system include an IBM AS400, an NCR sorter and reader, bank application software from the Peerless Group, and trust services software from Sunguard. Secondary components of the system include an ATM (automatic teller machine) controller and ATMs, automatic clearing house interface system (direct deposit), and loan and deposit documentation software.
The AS400 was updated in 1997 and is year 2000 compliant. Other primary and secondary components of the system are at various stages of compliance. The Bank's management is closely monitoring the progress of all its vendors in becoming compliant. The Bank has on file the progress, plans, and timetable for each vendor to complete their year 2000 upgrades. Based on this information, the Bank expects all vendors to be substantially compliant by December 1998. These systems not only need to be made compliant, but must also be thoroughly tested. The Bank's internal audit department, with the assistance of its independent outside auditors, will perform testing. Testing is scheduled to begin in the summer of 1998 with a target completion date of March 1999.
In addition to the above systems, the Bank utilizes stand alone personal computers and programs in its day to day activities. The Bank is currently in the process of testing the software and hardware of each personal computer for year 2000 compliance. Any computer or software that fails to be compliant will be replaced in 1998.
SPILLOVER BUSINESS RISK
Many of the Bank's loan customers utilize computers in their day to day operations. Failure of customers to make the necessary adjustments could lead to a loss of business and loss of asset value and could create credit risk for the Bank. Management is reviewing all commercial extensions of credit over $50,000 to identify customers, based on the products or services that are most likely to have year 2000 compliance issues. These customers will be individually contacted to assess their current state of readiness. Customers that are found to have year 2000 compliance issues will be asked to provide the Bank with periodic updates on their progress in becoming compliant.
Additionally, a survey has been developed to assist other commercial borrowers in identifying their year 2000 risks. The Bank is currently developing plans to make resources available to businesses that request our assistance in assessing their risks.
SYSTEMIC
Banks have extensive institutional linkages. Critical linkages include the correspondent relationships for Federal funds sales and purchases, investment security book safekeeping, the Federal Reserve wire transfer and automatic clearing house systems, and check processing systems. Each one of these is an important component of the payment system. The failure of any one of these systems could create an inability for the Bank to conduct business as usual. The Bank exerts no control over these systems and/or the organizations that provide these linkages. A problem in one part of the payment or settlement systems would quickly affect the entire system. Other less critical linkages include ATM networks, credit reporting systems, mortgage loans sold delivery systems, and credit card processing networks. The Bank is requesting that providers of the above services furnish periodic updates of progress in updating their systems for the year 2000 and is reviewing its options if any one of the above systems fail.
Based on the information currently available, the cost of becoming year 2000 compliant will not have a material impact on the Corporation's financial position or results of operation. However, if the Corporation's vendors or customers are unable to resolve this issue in a timely manner, it could result in a material financial risk. Accordingly, the Corporation plans to devote all necessary resources to becoming year 2000 compliant in a timely manner.
SUPERVISION AND REGULATION
IBT Bancorp is subject to supervision and regulation by the Federal Reserve Board, under the Bank Holding Company Act of 1956, as amended. A bank holding company and its subsidiaries are able to conduct only the business of commercial banking and activities closely related or incidental to it.
Isabella Bank and Trust is chartered by the State of Michigan and is supervised and regulated by the Financial Institutions Bureau of the State of Michigan. The Bank is a member of the Federal Reserve System and its deposits are insured by the Federal Deposit Insurance Corporation to the extent provided by law.
IMPACT OF INFLATION
The majority of assets and liabilities of financial institutions are monetary in nature. Generally, changes in interest rates have a more significant impact on earnings of the Corporation than inflation. Although influenced by inflation, changes in rates do not necessarily move in either the same magnitude or direction as changes in the price of goods and services. Inflation does impact the growth of total assets, creating a need to increase equity capital at a higher rate to maintain an adequate equity to assets ratio, which in turn reduces the amount of earnings available for cash dividends.
ITEM 7(A) QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Corporation's primary market risks are interest rate risk and, to a lesser extent, liquidity risk. The Corporation has no foreign exchange risk, holds limited loans outstanding to agricultural and oil and gas concerns, and holds no trading account assets. Any changes in foreign exchange rates or commodity prices would have an insignificant impact, if any, on the Corporation's interest income and cash flows.
Interest rate risk ("IRR") is the exposure to the Corporation's net interest income, its primary source of income, to changes in interest rates. IRR results from the difference in the maturity or repricing frequency of a financial institution's interest earning assets and its interest bearing liabilities. Interest rate risk is the fundamental method in which financial institutions earn income and create shareholder value. Excessive exposure to interest rate risk could pose a significant risk to the Corporation's earnings and capital.
The Federal Reserve, the Corporation's primary Federal regulator, has adopted a policy requiring the Board of Directors and senior management to effectively manage the various risks that can have a material impact on the safety and soundness of the Corporation. The risks include credit, interest rate, liquidity, operational, and reputational. The Corporation has policies, procedures and internal controls for measuring and managing these risks. Specifically, the IRR policy and procedures include defining acceptable types and terms of investments and funding sources, liquidity requirements, limits on investments in long term assets, limiting the mismatch in repricing opportunity of assets and liabilities, and the frequency of measuring and reporting to the Board of Directors.
The Corporation uses several techniques to manage interest rate risk. The first method is gap analysis. Gap analysis measures the cash flows and/or the earliest repricing of the Corporation's interest bearing assets and liabilities. This analysis is useful for measuring trends in the repricing characteristics of the balance sheet. Significant assumptions are required in this process because of the imbedded repricing options contained in assets and liabilities. A substantial portion of the Corporation's assets are invested in loans and mortgage backed securities. These assets have imbedded options that allow the borrower to repay the balance prior to maturity without penalty. The amount of prepayments is dependent upon many factors, including the interest rate of a given loan in comparison to the current interest rates, for residential mortgages the level of sales of used homes, and the overall availability of credit in the market place. Generally, a decrease in interest rates will result in an increase in the Corporation's cash flows from these assets. Investment securities, other than those that are callable, do not have any significant imbedded options. Saving and checking deposits may generally be withdrawn on request without prior notice. The timing of cash flow from these deposits are estimated based on historical experience. Time deposits have penalties which discourage early withdrawals.
The second technique used in the management of interest rate risk is to combine the projected cash flows and repricing characteristics generated by the gap analysis and the interest rates associated with those cash flows and projected future interest income. By changing the amount and timing of the cash flows and the repricing interest rates of those cash flows, the Corporation can project the effect of changing interest rates on its interest income. Based on the projections prepared
for the year ended December 31, 1997 the Corporation's interest income would decline during a period of decreasing interest rates.
The following table provides information about the Corporation's assets and liabilities that are sensitive to changes in interest rates as of December 31, 1997. The Corporation has no interest rate swaps, futures contracts, or other derivative financial options. The principal amounts of assets and time deposits maturing were calculated based on the contractual maturity dates. Savings and NOW accounts are based on management's estimate of their future cash flows.
Quantitative Disclosures of Market Risk
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following consolidated financial statements of the registrant and reports of independent auditors are set forth on pages 29 through 45 of this report:
Reports of Independent Auditors Consolidated Balance Sheets Consolidated Statements of Changes in Shareholders' Equity Consolidated Statements of Income Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements
The supplementary data regarding quarterly results of operations set forth under the table named "Summary of Selected Financial Data" on Page 12 of this report.
Report of Independent Auditors
Board of Directors and Shareholders IBT Bancorp
We have audited the accompanying consolidated balance sheets of IBT Bancorp and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of income, changes in shareholders' equity, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these consolidated 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 consolidated 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 IBT Bancorp and subsidiaries as of December 31, 1997 and 1996, and the consolidated results of their operations and their cash flows for each of the years then ended in conformity with generally accepted accounting principles.
Rehmann Robson, P.C. Saginaw, Michigan January 23, 1998
Andrews, Hooper & Pavlik, P.L.C. Report of Independent Auditors
Board of Directors IBT Bancorp
We have audited the accompanying consolidated statement of income, changes in shareholders' equity, and cash flows of IBT Bancorp and subsidiaries as of December 31, 1995. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit 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 audit provides a reasonable basis for our opinion.
In our opinion, the financial statements of IBT Bancorp and subsidiaries referred to above present fairly, in all material respects, the consolidated results of their operations and their cash flows for the year ended December 31, 1995, in conformity with generally accepted accounting principles.
Andrews Hooper & Pavlik, P.L.C.
February 2, 1996
CONSOLIDATED BALANCE SHEETS (Dollars in Thousands)
See notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Dollars in Thousands)
See notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF INCOME (Dollars in thousands except per share data)
See notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands)
See notes to consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
NOTE A - BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION AND CONSOLIDATION: The consolidated financial statements include the accounts of IBT Bancorp (the "Corporation") and its wholly owned subsidiaries, Isabella Bank and Trust (the "Bank") and IBT Financial Services. All intercompany transactions and accounts have been eliminated.
NATURE OF OPERATIONS: IBT Bancorp is a registered bank holding company offering a wide array of financial products and services in mid Michigan. Its principal subsidiary, Isabella Bank and Trust, offers banking services through 12 locations to businesses, institutions, and individuals. Lending services offered include commercial real estate loans and lines of credit, residential real estate loans, consumer loans, student loans, and credit cards. Although the Bank has a diversified loan portfolio, a substantial portion of its debtors' ability to honor their contracts is dependent upon the real estate in the Bank's principal market areas. Deposit services include interest and noninterest bearing checking accounts, savings accounts, money market accounts, and certificates of deposit. Other related financial products include trust services, 24-hour banking services locally and nationally through shared automatic teller machines, safe deposit box rentals, credit life insurance, and direct deposits. Active competition, principally from other commercial banks, savings banks and credit unions, exists in all of the Bank's principal markets. The Corporation's results of operations can be significantly affected by changes in interest rates or changes in the local economic environment.
IBT Financial Services is a full service retail brokerage offering stocks, bonds, and mutual fund sales to individuals. IBT Agency, an insurance agency, is authorized to sell life insurance, casualty insurance, and fixed and variable rate annuities.
USE OF ESTIMATES: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowance for loan losses and foreclosed real estate, management obtains independent appraisals for significant properties.
CASH AND CASH EQUIVALENTS: For purposes of the statement of cash flows, the Corporation considers cash, demand deposits due from banks, and federal funds sold as cash and cash equivalents.
SECURITIES HELD TO MATURITY AND AVAILABLE FOR SALE: Management determines the appropriate classification of debt securities at the time of purchase. Debt securities are classified as held to maturity when the Corporation has the positive intent and ability to hold the securities to maturity. Securities held to maturity are stated at amortized cost. Debt securities not classified as held to maturity are classified as available for sale and are stated at fair value, with the unrealized gains and losses, net of taxes, reported as a separate component of shareholders' equity.
The amortized cost of debt securities classified as either held to maturity or available for sale is adjusted for amortization of premiums and accretion of discounts to maturity, and is computed using a method that approximates the level yield method. Gains or losses on the sale of securities available for sale are calculated using the adjusted cost for the specific securities sold.
ALLOWANCE FOR LOAN LOSSES: Management determines the adequacy of the allowance for loan losses based on evaluation of the loan portfolio, past and recent loan loss experience, current economic conditions and other pertinent factors. The allowance is increased by a charge to income for provisions for loan losses. Loans deemed to be uncollectible are charged against the allowance for loan losses, and subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses on loans classified as impaired is based on discounted cash flows using the loans initial interest rate or the fair value of the collateral for certain collateral dependent loans.
PREMISES AND EQUIPMENT: Premises and equipment are stated at cost less accumulated depreciation. For financial reporting purposes, the provision for depreciation is computed principally by the straight line method based upon the useful lives of the assets which generally range from 5 to 30 years. Maintenance repairs and minor alterations are charged to current operations as expenditures occur and major improvements are capitalized. Management annually reviews these assets to determine whether carrying values have been impaired.
A summary of premises and equipment at December 31 follows:
INTEREST ON LOANS: Interest on loans is credited to income based upon the principal outstanding. The accrual of interest income is generally discontinued when a loan is considered impaired under SFAS No. 118 or becomes 90 days past due as to principal or interest. Loans are placed on nonaccrual status whenever the collectibility of principal or interest is considered doubtful.
MORTGAGE SERVICING RIGHTS: In 1996, the Corporation adopted Statement of Financial Accounting Standard (SFAS) No. 122, Accounting for Mortgage Servicing Rights, which was amended by SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities" in 1997. SFAS No. 125 provides for the recognition of originated mortgage servicing rights ("OMSR") retained for loans sold by allocating total costs incurred between the loan and the servicing rights based on their relative fair values. Previously, the value of OMSR was not recognized as an asset when the related loan was sold. Mortgage servicing rights ("MSR") are amortized in proportion to, and over the period of, estimated net servicing income. To determine the fair value of MSR, the Corporation estimates the present value of future cash flows incorporating a number of assumptions including servicing income, cost of servicing, discount rates, and prepayment rates.
SFAS No. 125 requires the establishment of a valuation allowance for the excess of book value of the capitalized MSR over estimated fair value. For purposes of measuring impairment, the rights are stratified based on their predominant risk characteristics, primarily period of origination, interest rate, and current prepayment rates.
FEDERAL INCOME TAXES: Federal income taxes have been provided based on amounts reported in the statement of income (after the exclusion of nontaxable interest income) and include deferred federal income taxes on temporary differences between financial statement and income tax reporting. The Corporation and its subsidiaries file a consolidated federal income tax return on a calendar year basis.
PER SHARE AMOUNTS: Net income per share amounts were computed by dividing net income by the weighted average number of shares outstanding. All per share amounts have been adjusted for the 10% stock dividend declared on December 15, 1997 and payable March 2, 1998. The weighted average number of common shares outstanding were 787,311 in 1997; 777,619 in 1996; and 767,878 in 1995. Taking into consideration the 10% stock dividend, the weighted average number of shares of common shares outstanding would be 866,042 in 1997; 855,381 in 1996; and 844,666 in 1995. During 1997, the Corporation adopted SFAS No. 128, "Earnings Per Share", which establishes new standards for the computation, presentation, and disclosure requirements for earnings per share ("EPS"). Given the simple capital structure of the Corporation, adoption of this standard had no effect on the EPS calculations and the restatement of prior EPS data.
RECENTLY ISSUED FINANCIAL ACCOUNTING STANDARDS
In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No. 130, "Reporting Comprehensive Income." The statement defines comprehensive income as "all changes in equity during a period, with exception of stock issuance and dividends." The new pronouncement establishes standards for the disclosure of comprehensive income and its components in the financial statements.
Also in June 1997, the FASB issued SFAS No. 131, "Disclosure About Segments of an Enterprise and Related Information." SFAS No. 131 requires companies to define and report financial and descriptive information about its operating segments. It also establishes standards for related disclosures about products and services, geographic areas, and major customers.
Both standards will be adopted in 1998. The adoption of these new standards is not expected to have a material impact on the Corporation's financial position or results of operation.
NOTE B - INVESTMENT SECURITIES The following is a summary of securities available for sale and held to maturity. Other securities include only the stock of the Federal Reserve Bank and the Federal Home Loan Bank, which are restricted investments and have no contractual maturities.
The following table summarizes the fair value, realized gains, and realized losses on sales of securities available for sale.
The following table shows the amortized cost and estimated fair value of securities owned at December 31, 1997 by contractual maturity. Expected maturities will differ from contractual maturities because the issuers of securities may have the right to prepay obligations without prepayment penalty.
Investment securities with a carrying value of approximately $5,010 and $4,019 were pledged to secure public deposits and for other purposes as necessary or required by law at December 31, 1997 and 1996, respectively.
NOTE C - LOANS
An analysis of changes in the allowance for loan losses follows:
At December 31, 1997 and 1996, nonaccrual and other impaired loans were not significant. Based on collateral values, no specific allowance for loan losses has been allocated to these loans.
Certain directors and executive officers (including their families and companies in which they have 10% or more ownership) of the Corporation and the Bank were loan customers of the Bank. Total loans to these customers aggregated $7,196 and $5,400 at December 31, 1997 and 1996, respectively. During 1997, $4,593 of new loans were made and repayments totalled $2,797. All such loans and commitments were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions and in the opinion of management do not involve more than normal risk of collectibility.
Mortgage loans serviced for others are not included in the accompanying consolidated balance sheets. The unpaid principal balances of mortgages serviced for others was $63,982 and $48,744 at December 31, 1997 and 1996, respectively. Servicing loans for others generally consists of collecting mortgage payments, maintaining escrow accounts, disbursing payments to investors and taxing authorities, and foreclosure processing. Loan servicing income is accounted for under the provisions of SFAS No. 125.
The following table summarizes the fair value of mortgage servicing rights as of December 31:
Residential mortgages committed for sale were $911 as of December 31, 1997 and $906 as of December 31, 1996.
NOTE D - FAIR VALUE OF FINANCIAL INSTRUMENTS
The Corporation utilizes quoted market prices, where available, to compute the fair value of its financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. Certain financial instruments and all nonfinancial instruments are excluded from the disclosure requirements. Accordingly, the aggregate of the fair value amounts presented are not necessarily indicative of the underlying value of the Corporation.
The following methods and assumptions were used by the Corporation in estimating fair value disclosures for financial instruments.
Cash and cash equivalents: The carrying amounts reported in the balance sheet for cash and demand deposits due from banks and federal funds sold approximate those assets' fair value.
Investment securities: Fair values for investment securities are based on quoted market prices, where available. If quoted market prices are unavailable, fair values are based on quoted market prices of comparable instruments.
Loans: Fair values for variable rate loans that reprice at least quarterly and have no significant change in credit risk are assumed to equal recorded book value. Fixed rate loans are valued using present value discounted cash flow techniques. The discount rate used in these calculations was the U.S. government bond rate for securities with similar maturities adjusted for servicing costs, credit loss, and prepayment risk.
Deposit liabilities: Demand, savings, and money market deposits have no stated maturities and are payable on demand, thus their estimated fair value is equal to their recorded book balance. Fair values for variable rate certificates of deposit approximate their recorded book balance. Fair values for fixed rate certificates of deposit are determined using discounted cash flow techniques that apply interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.
Off balance sheet instruments: Fair values for off balance sheet lending commitments are based on fees currently charged to enter into similar agreements, taking into consideration the remaining terms of the agreements and the counterparties' credit standings. The Bank does not charge fees for lending commitments, thus it is not practicable to estimate the fair value of these instruments.
The following sets forth the estimated fair value and recorded book balance of the Corporation's financial instruments as of December 31.
NOTE E - FEDERAL INCOME TAXES
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 the Corporation's deferred tax assets and liabilities, included in other assets, as of December 31 are as follows.
Components of the consolidated provision for income taxes are as follows.
The reconciliation of the provision for federal income taxes and the amount computed at the federal statutory tax rate of 34% of income before federal income tax expense is as follows.
The income tax effects on securities gains or (losses) were $(5) in 1997, $3 in 1996, and ($5) in 1995.
NOTE F - BENEFIT PLANS
The Bank has a defined benefit pension plan covering substantially all of its employees. The benefits are based on years of service and the employees' average compensation over their last five years of service. The funding policy is to contribute annually the maximum amount that can be deducted for federal income tax purposes. Contributions are intended to provide not only for benefits attributed to services to date but also for those expected to be earned in the future. The defined pension plan's assets are primarily invested in mutual funds.
Defined benefit pension plan costs included the following components:
The following table sets forth the defined benefit pension plan funding status and a reconciliation to the amounts recognized in the Corporation's consolidated balance sheets at December 31:
Actuarial assumptions used in determining the projected benefit obligation and the net periodic pension cost:
NOTE F - CONTINUED
The Corporation maintains a nonqualified supplementary retirement plan for officers to provide supplemental retirement benefits and preretirement death benefits to each participant. Insurance policies, designed primarily to fund preretirement benefits, have been purchased on the life of each participant with the Bank as the sole owner and beneficiary of the policies. Expenses related to this program are being recognized over the participants' expected years of service.
The Corporation maintains an employee stock ownership plan (ESOP) which covers substantially all of its employees. Contributions to the Plan are discretionary and are approved by the Board of Directors and recorded as compensation expense. Compensation expense related to this Plan for 1997, 1996 and 1995 was $70, $70, and $85 respectively. Total shares outstanding at December 31, 1997 and 1996 were 44,597 and 49,034 respectively, and were included in the computation of dividends and earnings per share in each of the respective years.
NOTE G - CONSOLIDATED STATEMENTS OF CASH FLOWS
The reconciliation of net income to net cash provided by operating activities is as follows.
NOTE H - FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK
The Corporation is party to financial instruments with off-balance-sheet risk. These instruments are entered into in the normal course of business to meet the financing needs of its customers. These financial instruments, which include commitments to extend credit and standby letters of credit, involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. The contract or notional amounts of these instruments reflect the extent of involvement the Corporation has in a particular class of financial instruments.
The Corporation's exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The Corporation uses the same credit policies in deciding to make these commitments as it does for extending loans to customers.
Commitments to extend credit, which totalled $29,761 at December 31, 1997, are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
Standby letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support private borrowing arrangements, including commercial paper, bond financing, and similar transactions. At December 31, 1997, the Corporation had a total of $367 in outstanding standby letters of credit.
NOTE H - CONTINUED
Generally, these commitments to extend credit and letters of credit mature within one year. The credit risk involved in these transactions is essentially the same as that involved in extending loans to customers. The Corporation evaluates each customer's credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation upon the extension of credit, is based on management's credit evaluation of the borrower. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, and other income producing commercial properties.
NOTE I - COMMITMENTS AND OTHER MATTERS
There were no material noncancelable lease commitments outstanding at December 31, 1997.
Banking regulations require banks to maintain cash reserve balances in currency or as deposits with the Federal Reserve Bank. The Bank's requirement was approximately $3,563 at December 31, 1997 and $3,800 at December 31, 1996.
Banking regulations also limit the transfer of assets in the form of dividends, loans, or advances from the Bank to the Corporation. At December 31, 1997, substantially all of the Bank's assets were restricted from transfer to the Corporation in the form of loans or advances. Consequently, Bank dividends are the principal source of funds for the Corporation. Payment of dividends without regulatory approval is limited to the current year's retained net income plus retained net income for the preceding two years, less any required transfers to capital surplus. At January 1, 1998, the amount available for dividends without regulatory approval was approximately $746.
The Corporation maintains a self-funded medical plan under which the Corporation is responsible for the first $30 per year of claims made by a covered individual with a maximum of $397. Claims in excess of these amounts are insured through an "excess loss" policy up to $1,000. Medical claims are subject to a lifetime maximum of $2,000 per covered individual.
During 1997 the Bank obtained approval to borrow up to $21.7 million from the Federal Home Loan Bank (FHLB) of Indianapolis. The Bank has limited, by Board resolution, the amount that it may borrow to $5.0 million. Under the terms of the agreement, the Bank may obtain advances at the stated rate at the time of the borrowings. The Bank has agreed to pledge eligible mortgage loans as collateral for any such borrowings. No borrowings were outstanding at December 31, 1997.
Certain directors and executive officers (including their families and companies in which they have 10% or more ownership) of the Corporation and the Bank were deposit customers of the Bank. Total deposits of these customers' aggregated approximately $4,190 and $3,701 at December 31, 1997 and 1996, respectively.
NOTE J - REGULATORY CAPITAL MATTERS
The Bank is subject to various regulatory capital requirements administered by its primary regulator, the Federal Reserve Bank. Failure to meet minimum capital requirements can initiate mandatory and/or discretionary actions by the Federal Reserve. These actions could have a material effect on the Bank's financial statements. Under the Federal Reserve's capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that include quantitative measures of the Bank's assets, certain off-balance sheet items, and capital, as calculated under regulatory accounting standards. The Bank's required capital is also subject to regulatory qualitative judgement regarding the Bank's interest rate risk exposure and credit risk.
Measurements established by regulation to ensure capital adequacy require the Bank to maintain minimum total capital to risk weighted assets, Tier 1 capital to risk weighted assets, and Tier 1 capital to average assets. Management believes, as of December 31, 1997, that the Bank meets all capital adequacy requirements to which it is subject.
As of December 31, 1997, the most recent notification from the Federal Reserve Bank categorized the Bank as well capitalized. To be categorized as well capitalized, the Bank must maintain total risk based capital, Tier 1 risk based, and Tier 1 leverage ratios as set forth in the following table. There have been no conditions or events since that notification that management believes has changed the institution's category.
NOTE J - CONTINUED
The Bank's actual capital amounts and ratios are also presented in the table (in thousands).
NOTE K - SUBSEQUENT EVENT
On January 13, 1998, Isabella Bank and Trust entered into an agreement to purchase the deposits, premises, equipment, and deposit related loans, of three Old Kent Bank branches. The branches are located in Barryton, Remus, and Stanwood (Canadian Lakes). All three branches are located in Mecosta County. Management expects the purchase to be completed by March 27, 1998. The purchase is subject to Federal Reserve approval. At the time the agreement was entered into, there was approximately $52 million of deposits.
NOTE L - PARENT COMPANY ONLY FINANCIAL INFORMATION CONDENSED BALANCE SHEETS
CONDENSED STATEMENTS OF INCOME
CONDENSED STATEMENTS OF CASH FLOWS
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
None PART III
Part III incorporated by reference from the Corporation's Definitive Proxy Statement pursuant to instruction G(3). The Corporation will file with the SEC a definitive Proxy Statement pursuant to Schedule 14A involving the election of directors no later than 120 days after the close of the calendar year (April 30, 1998).
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements: The following consolidated financial statements of IBT Bancorp are incorporated by reference in Item 8: Reports of Independent Auditors Consolidated Balance Sheets Consolidated Statements of Changes in Shareholders' Equity Consolidated Statements of Income Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements
2. Financial Statement Schedules: All schedules are omitted because they are neither applicable nor required, or because the required information is either included in the consolidated financial statements or related notes.
3. Exhibits:
3(a) Amended Articles of Incorporation* 3(b) Amendment to the Articles of Incorporation*** 3(c) Amended Bylaws* 3(d) Amendment to the Bylaws** 3(e) Amendment to the Bylaws*** 10(a) Isabella Bank & Trust Executive Supplemental Income Agreement***(1) 10(b) Isabella Bank & Trust Deferred Compensation Plan****(1) 21 Subsidiaries of the Registrant
ITEM 14 (CONTINUED)
23(a) Consent of Rehmann Robson, P.C., Independent Certified Public Accountants 23(b) Consent of Andrews, Hooper & Pavlik, P.L.C., Independent Certified Public Accountants 27 Financial Data Schedule
(b) No reports on Form 8-K were filed for the quarter ended December 31, 1997.
(c) The index to exhibits is on page 50 of this report.
(d) There are no financial statement schedules filed with this report.
* Previously filed as an Exhibit to the IBT Bancorp, Inc. Form 10-K, dated March 12, 1991, and incorporated herein by reference.
** Previously filed as an Exhibit to the IBT Bancorp, Inc. Form 10-K, dated March 13, 1990, and incorporated herein by reference.
*** Previously filed as an Exhibit to IBT Bancorp, Inc. Form 10-K, dated March 26, 1994, and incorporated herein by reference.
**** Previously filed as an Exhibit to IBT Bancorp, Inc. Form 10-K, dated March 26, 1996, and incorporated herein.
(1) Management's Contract or Compensatory Plan or Arrangement.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this annual report to be signed on its behalf by the undersigned, thereunto duly authorized.
IBT BANCORP, INC. (Registrant)
by:/s/David W. Hole Date: March 17, 1998 -------------------------------------- ------------------- David W. Hole President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
IBT Bancorp FORM 10-K
Index to Exhibits
Exhibit Form 10-K Number Exhibit Page Number - ------- ------- -----------
21 Subsidiaries of the Registrant 51
23(a) Consent of Rehmann Robson P.C. 52 Independent Certified Public Accountants
23(b) Consent of Andrews, Hooper & Pavlik, P.L.C. 53 Independent Certified Public Accountants
27 Financial Data Schedule 54