ITEM 1 BUSINESS
BRIEF HISTORY
Peoples Financial Services Corp. was incorporated under the laws of the Commonwealth of Pennsylvania on February 6, 1986, and is a one-bank holding company headquartered in Hallstead, Pennsylvania.
The Company is engaged primarily in commercial and retail banking services and in businesses related to banking services through its sole subsidiary, Peoples National Bank ("PNB" or the "Bank"). PNB was chartered in Hallstead, Pennsylvania in 1905 under the name of The First National Bank of Hallstead. In 1965, the Hop Bottom National Bank (chartered in 1910) merged with and into the First National Bank of Hallstead to form Peoples National Bank of Susquehanna County. In 2001, the Bank changed its name to Peoples National Bank. PNB is currently in its 96th year of operation.
SUPERVISION AND REGULATION
The Company and PNB are extensively regulated under federal and state law. Generally, these laws and regulations are intended to protect depositors, not shareholders. The following is a summary description of certain provisions of certain laws that affect the regulation of bank holding companies and banks. This discussion is qualified in its entirety by reference to applicable laws and regulations. Changes in such laws and regulations may have a material effect on the business and prospects of the Company and PNB.
The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended, and is subject to regulation, supervision, and examination by the Federal Reserve Bank ("FRB"). The Company is required to file annual and quarterly reports with the FRB and to provide the FRB with such additional information as the FRB may require. The FRB also conducts examinations of the Company.
With certain limited exceptions, the Company is required to obtain prior approval from the FRB before acquiring direct or indirect ownership or control of more than 5% of any voting securities or substantially all of the assets of a bank or bank holding company, or before merging or consolidating with another bank holding company. Additionally, with certain exceptions, any person or entity proposing to acquire control through direct or indirect ownership of 25% or more of any voting securities of the Company is required to give 60 days written notice of the acquisition to the FRB, which may prohibit the transaction, and to publish notice to the public.
The Company's banking subsidiary is a federally chartered national banking association regulated by the Office of the Comptroller of the Currency ("OCC"). The OCC may prohibit the institution over which it has supervisory authority from engaging in activities or investments that the agency believes constitute unsafe or unsound banking practices. Federal banking regulators have extensive enforcement authority over the institutions they regulate to prohibit or correct activities that violate law; regulation or a regulatory agreement or which are deemed to constitute unsafe or unsound practices.
Enforcement actions may include: the appointment of a conservator or receiver, the issuance of a cease and desist order, the termination of deposit insurance, the imposition of civil money penalties on the institution, its directors, officers, employees and institution affiliated parties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the removal of or restrictions on directors, officers, employees and institution-affiliated parties, and the enforcement of any such mechanisms through restraining orders or any other court actions.
PNB is subject to certain restrictions on extensions of credit to executive officers, directors, principal shareholders or any related interests of such persons which generally require that such credit extensions be made on substantially the same terms as are available to third persons dealing with PNB and not involving more than the normal risk of repayment. Other laws tie the maximum amount that may be loaned to any one customer and its related interests to capital levels of the bank.
Limitations on Dividends and Other Payments The Company's current ability to pay dividends is largely dependent upon the receipt of dividends from its banking subsidiary, PNB. Both federal and state laws impose restrictions on the ability of the Company to pay dividends. The FRB has issued a policy statement that provides that, as a general matter, insured banks and bank holding companies may pay dividends only out of prior operating earnings. Under the National Bank Act, a national bank such as PNB, may pay dividends only out of the current year's net profits and the net profits of the last two years. In addition to these specific restrictions, bank regulatory agencies in general, also have the ability to prohibit proposed dividends by a financial institution that would otherwise be permitted under applicable regulations if the regulatory body determines that such distribution would constitute an unsafe or unsound practice.
Permitted Non-Banking Activities Generally, a bank holding company may not engage in any activities other than banking, managing, or controlling its bank and other authorized subsidiaries, and providing service to those subsidiaries. With prior approval of the FRB, the Company may acquire more than 5% of the assets or outstanding shares of a company engaging in non-bank activities determined by the FRB to be closely related to the business of banking or of managing or controlling banks. The FRB provides expedited procedures for expansion into approved categories of non-bank activities.
Subsidiary banks of a bank holding company are subject to certain quantitative and qualitative restrictions: on extensions of credit to the bank holding company or its subsidiaries, on investments in their securities, and on the use of their securities as collateral for loans to any borrower.
These regulations and restrictions may limit the Company's ability to obtain funds from PNB for its cash needs, including funds for the payment of dividends, interest and operating expenses. Further, subject to certain exceptions, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. For example, PNB may not generally require a customer to obtain other services from itself or the Company, and may not require that a customer promise not to obtain other services from a competitor as a condition to an extension of credit to the customer.
Under FRB policy, a bank holding company is expected to act as a source of financial strength to its subsidiary banks and to make capital injections into a troubled subsidiary bank, and the FRB may charge the bank holding company with engaging in unsafe and unsound practices for failure to commit resources to a subsidiary bank when required. A required capital injection may be called for at a time when the holding company does not have the resources to provide it. In addition, depository institutions insured by the FDIC can be held liable for any losses incurred by, or reasonably anticipated to be incurred by, the FDIC in connection with the default of or assistance provided to, a commonly controlled FDIC-insured depository institution. Accordingly, in the event that any insured subsidiary of the Company causes a loss to the FDIC, other insured subsidiaries of the Company could be required to compensate the FDIC by reimbursing it for the estimated amount of such loss. Such cross guarantee liabilities generally are superior in priority to the obligation of the depository institutions to its stockholders due solely to their status as stockholders and obligations to other affiliates.
Gramm-Leach-Bliley Act The Gramm-Leach-Bliley Act has made major changes in the way that the financial services industry has been organized. By eliminating distinctions between different types of financial institutions and allowing them to merge, the bill enables one company to meet all of its consumers' financial needs. It allows banks and securities firms to own the other. Over the past two decades, the products offered by banks and securities firms have gradually come to resemble each other. Both types of firms offer checking accounts in which idle balances are invested in stocks or bonds, and credit cards. The new Act repeals portions of the 1933 Glass-Steagall that prohibit banks and securities firms from owning each other. This Act also protects consumer privacy by allowing customers to know how confidential information will be treated. Instead of hoping a financial services company will treat their personal data as confidential, consumers will receive an explicit disclosure of how such information will be used by the firm. The stated policy must specify how and under what circumstances confidential information, that is not available from other public sources, would be disclosed among the firm's affiliates and other firms. Customers who object to any portion of this policy would be able to take their business to another firm. This Act also allows consumers to control how their personal information is shared. Customers have the right to prohibit financial services companies from sharing their personal confidential information with other non-affiliated firms. Once a consumer makes that decision, financial companies are prohibited from violating their instructions
The goal of this Act is to ensure that the interest of consumers are protected, both by assuring that their personal information is safeguarded and by giving financial institutions the flexibility to serve their needs.
Pennsylvania Law As a Pennsylvania bank holding company, the Company is subject to various restrictions on its activities as set forth in Pennsylvania law. This is in addition to those restrictions set forth in federal law. Under Pennsylvania law, a bank holding company that desires to acquire a bank or bank holding company that has its principal place of business in Pennsylvania must obtain permission from the Pennsylvania Department of Banking.
Interstate Banking Legislation The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 was enacted into law on September 29, 1994. The law provides that, among other things, substantially all state law barriers to the acquisition of banks by out-of-state bank holding companies were eliminated effective September 29, 1995. The law also permits interstate branching by banks effective as of June 1, 1997, subject to the ability of states to opt-out completely or to set an earlier effective date.
FIRREA (Financial Institution Reform, Recovery, and Enforcement Act) FIRREA was enacted into law in order to address the financial condition of the Federal Savings and Loan Insurance Corporation, to restructure the regulation of the thrift industry, and to enhance the supervisory and enforcement powers of the Federal bank and thrift regulatory agencies. As the primary federal regulator of the bank, the OCC is responsible for the supervision of the bank. When dealing with capital requirements, the OCC and FDIC have the flexibility to impose supervisory agreements on institutions that fail to comply with regulatory requirements. The imposition of a capital plan, termination of deposit insurance, and removal or temporary suspension of an officer, director or other institution-affiliated person may cause enforcement actions. There are three levels of civil penalties under FIRREA. The first tier provides for civil penalties of up to $5,000 per day for any violation of law or regulation. The second tier provides for civil penalties of up to $25,000 per day if more than a minimal loss or a pattern is involved. Finally, civil penalties of up to $1 million per day may be assessed for knowingly or recklessly causing a substantial loss to an institution or taking action that results in a substantial pecuniary gain or other benefit.
Criminal penalties are increased to $1 million per violation and may be up to $5 million for continuing violations or for the actual amount of gain or loss. These penalties may be combined with prison sentences of up to five years.
FDICIA (Federal Deposit Insurance Corporation Improvement Act of 1991) In December 1991, Congress enacted FDICIA which substantially revised the bank regulatory and funding provisions of the Federal Deposit Insurance Act and made significant revisions to several other federal banking statutes. FDICIA provides for, among other things,publicly available annual financial condition and management reports for financial institutions, including audits by independent accountants, the establishment of uniform accounting standards by federal banking agencies, the establishment of a "prompt corrective action" system of regulatory supervision and intervention, based on capitalization levels, with more scrutiny and restrictions placed on depository institutions with lower levels of capital, additional grounds for the appointment of a conservator or receiver, and restrictions or prohibitions on accepting brokered deposits, except for institutions which significantly exceed minimum capital requirements. FDICIA also provides for increased funding of the FDIC insurance funds and the implementation of risk based premiums.
A central feature of FDICIA is the requirement that the federal banking agencies take "prompt corrective action" with respect to depository institutions that do not meet minimum capital requirements. Pursuant to FDICIA, the federal bank regulatory authorities have adopted regulations setting forth a five-tiered system for measuring the capital adequacy of the depository institutions that they supervise. Under these regulations, a depository institution is classified in one of the following capital categories: "well capitalized," "adequately capitalized," "under capitalized," "significantly undercapitalized," and "critically undercapitalized."
PNB is currently classified as "well capitalized." An institution may be deemed by the regulators to be in a capitalization category that is lower than is indicated by its actual capital position if, among other things, it receives an unsatisfactory examination rating with respect to asset quality, management, earnings or liquidity.
FDICIA generally prohibits a depository institution from making any capital distribution (including payment of a cash dividend) or paying any management fees to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to growth limitations and are required to submit capital restoration plans. If a depository fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. Significantly undercapitalized depository institutions may be subject to a number of other requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and stop accepting deposits from correspondent banks. Critically undercapitalized institutions are subject to the appointment of a receiver or conservator, generally within 90 days of the date such institution is determined to be critically under capitalized.
FDICIA provides the federal banking agencies with significantly expanded powers to take enforcement action against institutions that fail to comply with capital or other standards. Such actions may include the termination of deposit insurance by the FDIC or the appointment of a receiver or conservator for the institution. FDICIA also limits the circumstances under which the FDIC is permitted to provide financial assistance to an insured institution before appointment of a conservator or receiver.
Under FDICIA each federal banking agency is required to prescribe, by regulation, non-capital safety and soundness standards for institutions under its authority. The federal banking agencies, including the OCC, have adopted standards covering: internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, and compensation fees and benefits. Any institution that fails to meet these standards may be required by the agency to develop a plan acceptable to the agency, specifying the steps that the institutions will take to meet the standards. Failure to submit or implement such a plan may subject the institution to regulatory sanctions. The Company, on behalf of PNB, believes that it meets substantially all the standards that have been adopted. FDICIA also imposed new capital standards on insured depository institutions. Before establishing new branch offices, PNB must meet certain minimum capital stock and surplus requirements and must obtain OCC approval.
Risk-Based Capital Requirements The federal banking regulators have adopted certain risk-based capital guidelines to assist in the assessment of the capital adequacy of a banking organization's operations for both transactions reported on the balance sheet as assets and transactions, such as letters of credit, and recourse agreements, which are recorded as off balance sheet items. Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as certain US Treasury securities, to 100% for assets with relatively high credit risk, such as business loans.
A banking organization's risk based capital ratios are obtained by dividing its qualifying capital by its total risk adjusted assets. The regulators measure risk-adjusted assets, which include off balance sheet items, against both total qualifying capital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) and Tier 1 capital. "Tier 1", or core capital, includes common equity, perpetual preferred stock (excluding auction rate issues) and minority interest in equity accounts of consolidated subsidiaries, less goodwill and other intangibles, subject to certain exceptions. "Tier 2", or supplementary capital, includes, among other things, limited life preferred stock, hybrid capital instruments, mandatory convertible securities, qualifying subordinated debt, and the allowance for loan and lease losses, subject to certain limitations and less restricted deductions.
The inclusion of elements of Tier 2 capital is subject to certain other requirements and limitations of the federal banking agencies.
Banks and bank holding companies subject to the risk-based capital guidelines are required to maintain a ratio of Tier 1 capital to risk-weighted assets of at least 4% and a ratio of total capital to risk-weighted assets of at least 8%. The appropriate regulatory authority may set higher capital requirements when particular circumstances warrant. As of December 31, 2001, PFSC's ratio of Tier 1 capital to risk-weighted assets stood at 14.51% and its ratio of total capital to risk- weighted assets stood at 15.37%. In addition to risk-based capital, banks and bank holding companies are required to maintain a minimum amount of Tier 1 capital to total assets, referred to as the leverage capital ratio, of at least 4%. As of December 31, 2001, the Company's leverage capital ratio was 9.89%.
Failure to meet applicable capital guidelines could subject a banking organization to a variety of enforcement actions including: limitations on its ability to pay dividends, the issuance by the applicable regulatory authority of a capital directive to increase capital, and in the case of depository institutions, the termination of deposit insurance by the FDIC, as well as to the measures described under FDICIA as applicable to under capitalized institutions.
In addition, future changes in regulations or practices could further reduce the amount of capital recognized for purposes of capital adequacy. Such a change could affect the ability of PNB to grow and could restrict the amount of profits, if any, available for the payment of dividends to the Company.
Interest Rate Risk In August 1995 and May 1996, the federal banking agencies adopted final regulations specifying that the agencies will include, in their evaluations of a bank's capital adequacy, an assessment of the bank's interest rate risk ("IRR") exposure. The standards for measuring the adequacy and effectiveness of a banking organization's IRR management includes a measurement of Board of Directors and senior management oversight, and a determination of whether a banking organization's procedures for comprehensive risk management are appropriate to the circumstances of the specific banking organization. PNB has internal IRR models that are used to measure and monitor IRR. In addition, an outside source also assesses IRR using its model on a quarterly basis. Additionally, the regulatory agencies have been assessing IRR on an informal basis for several years. For these reasons, the Company does not expect the IRR evaluation in the agencies' capital guidelines to result in significant changes in capital requirements for PNB.
FDIC Insurance Assessments As a FDIC member institution, PNB's deposits are insured to a maximum of $100,000 per depositor through the Bank Insurance Fund ("BIF") that is administered by the FDIC and each institution is required to pay semi-annual deposit insurance premium assessments to the FDIC. The PNB assessment for 2001 was $42,947. These figures can be compared to FDIC assessments in 2000 of $44,063 and in 1999 of $24,307. Prior to 1997, only thrift institutions were subject to assessments to raise funds to pay the Financing Corporate bonds. On September 30, 1996, as part of the Omnibus Budget Act, Congress enacted the Deposit Insurance Funds Act of 1996, which recapitalized the Savings Association Insurance Fund ("SAIF") and provided that BIF deposits would be subject to 1/5 of the assessment to which SAIF deposits are subject for FICO bond payments through 1999. Beginning in 2000, BIF deposits and SAIF deposits were subject to the same assessment for FICO bonds. The FICO assessment for PNB for 2001 was $.0190 for each $100 of BIF deposits.
Community Reinvestment Act The Community Reinvestment Act of 1977, (the CRA) is designed to create a system for bank regulatory agencies to evaluate a depository institution's record in meeting the credit needs of its community. Until May 1995, a depository institution was evaluated for CRA compliance based on twelve assessment factors.
The CRA regulations were completely revised as of July 1, 1995, (the revised CRA regulation) to establish new performance-based standards for use in examining for compliance. This revised CRA regulation established new tests for evaluating both small and large depository institutions. A small bank is defined as one that has total assets of less than $250 million and is independent or is an affiliate of a holding company with less than $1 billion in assets.
The Bank had its last CRA compliance examination in 1998 and received a "satisfactory" rating.
Concentration Payment risk is a function of the economic climate in which the Bank's lending activities are conducted. Economic downturns in the economy generally or in a particular sector could cause cash flow problems for customers and make loan payments more difficult. The Bank attempts to minimize this risk by avoiding loan concentrations to a single customer or to a small group of customers whose loss would have a materially adverse effect on the financial condition of the Bank.
Monetary Policy The earnings of a bank holding company are affected by the policies of regulatory authorities, including the FRB, in connection with the FRB's regulation of the money supply. Various methods employed by the FRB are open market operations in United States Government securities, changes in the discount rate on member bank borrowings, and changes in reserve requirements against member bank deposits.
These methods are used in varying combinations to influence overall growth and distribution of bank loans, investments, and deposits, and their use may also affect interest rates charged on loans or paid on deposits. The monetary policies of the FRB have had a significant effect on the operating results of commercial banks in the past and are expected to do so in the future.
Legislation and Regulatory Changes From time to time, legislation is enacted that effects the cost of doing business or limits the activities of a financial institution. No prediction can be made as to the likelihood of any major changes or the impact of those changes might have on the Company.
MARKET AREAS
The PNB market areas are in the northeastern part of Pennsylvania with the primary focus being Susquehanna and Wyoming Counties. Since Susquehanna County borders the State of New York, the southern portion of Broome County, New York is also considered part of the market area of PNB. In addition, parts of Lackawanna, Wayne, and Bradford Counties in Pennsylvania that border Susquehanna and Wyoming Counties are also considered part of the PNB market area.
The PNB market area is situated between: the city of Binghamton, Broome County, New York, located to the north the city of Scranton, Lackawanna County, Pennsylvania, to the south, and Wilkes Barre, Luzerne County, Pennsylvania, to the southwest. Susquehanna County could best be described as a bedroom county with a high percentage of its residents commuting to work in Broome County, New York, or to the Scranton, Pennsylvania, area. The southern part of Susquehanna County tends to gravitate south for both employment and shopping while the northern part of the county goes north to Broome County, New York. The western part of Susquehanna County gravitates south and west to and through Wyoming County. Wyoming County is home to a Proctor & Gamble manufacturing facility. This is an economic stimulus to Wyoming County and the surrounding areas.
Our offices are located in counties that would be considered sparsely populated as they are made up of many small towns and villages. The latest population figures show Susquehanna County at approximately 42,000 and Wyoming County at approximately 30,000 residents. Both counties are experiencing growth, but not robust growth. Interstate 81 runs north and south through the eastern half of Susquehanna County and has brought an influx of people from New Jersey and the Philadelphia area. These people have purchased homes and land to build homes that are used as vacation/recreation retreats and, quite often, become retirement homes.
BUSINESS
Lending Activities PNB provides a full range of retail and commercial banking services designed to meet the borrowing and depository needs of small and medium sized businesses and consumers in its market areas. Substantially all of PNB's loans are to customers located within its service areas. PNB has no foreign loans or highly leveraged transaction loans, as defined by the FRB. Substantially all of the loans in PNB's portfolio have been originated by PNB. Policies adopted by the Board of Directors are the basis by which PNB conducts its lending activities. These loan policies grant individual lending officers authority to make secured and unsecured loans in specific dollar amounts. Larger loans must be approved by senior officers or by the Board of Directors. PNB's management information systems and loan review policies are designed to monitor lending sufficiently to ensure adherence to PNB's loan policies.
The commercial loans offered by PNB include commercial real estate loans, working capital, equipment and other commercial loans, construction loans, SBA guaranteed loans, and agricultural loans.
PNB's commercial real estate loans are used to provide financing for retail operations, manufacturing operations, farming operations, multi-family housing units, and churches. Commercial real estate secured loans are generally written for a term of 15 years or less or amortized over a longer period with balloon payments at shorter intervals. Personal guarantees are obtained on nearly all commercial loans. Credit analysis, loan review, and an effective collections process are also used to minimize any potential losses. PNB employs two full-time commercial lending officers. These two people are augmented by branch managers who are authorized to make smaller, less complex, commercial loans.
Risk with respect to PNB's commercial lending activities involves payment risk, interest rate risk, or collateral risk.
Payment risk is a function of the economic climate in which PNB's lending activities are conducted; economic downturns in the economy generally or in a particular sector could cause cash flow problems for customers and make loan payments more difficult. PNB attempts to minimize this risk by avoiding concentrations of credit to single borrowers or borrowers in a particular industry. Interest rate risk would occur if PNB were to make loans at fixed rates in an environment in which rates were rising thereby preventing PNB from making loans at the higher prevailing rates. PNB attempts to mitigate this risk by making adjustable rate commercial loans and, when extending fixed rate commercial loans, fixing loan maturities at five years or less. Finally, collateral risk can occur if PNB's position in collateral taken as security for loan repayment is not adequately secured. PNB attempts to minimize collateral risk by avoiding loan concentrations to particular borrowers, by perfecting liens on collateral and by obtaining appraisals on property prior to extending loans.
Consumer loans offered by PNB include: residential real estate loans, automobile loans, manufactured housing loans, personal installment loans secured and unsecured for almost any purpose, student loans, and home equity loans (fixed-rate term and open ended revolving lines of credit).
PNB offers credit cards as an agent bank through another correspondent bank.
Risks applicable to consumer lending are similar to those applicable to commercial lending. PNB attempts to mitigate payment risk in consumer lending by limiting consumer lending products to a term of five years or less. To the extent that PNB extends unsecured consumer loans, there is greater collateral risk; however, credit checks and borrower history are obtained in all consumer loan transactions.
Residential mortgage products include adjustable-rate as well as conventional fixed-rate loans. Terms vary from 1, 5, 7 and 10-year adjustable rate loans to 5, 10, 15, 20, and 30-year fully amortized fixed rate loans. Bi-weekly payment plans are also available. The longer term fixed rate loans have been underwritten as conforming and may be sold to the secondary market to reduce interest rate risk. Personal secured and unsecured revolving lines of credit with variable interest rates and principal amounts ranging from $1,000 to $10,000 are offered to credit-worthy customers. The largest segment of PNB's installment loan portfolio is fixed-rate loans. Most are secured either by automobiles, motorcycles, snowmobiles, boats, other personal property, or by liens filed against real estate. These loans are generally available in terms of up to 15 years with automobile loans having maturities of up to 60 months and real estate loans having maturities up to 15 years. Loans secured by other collateral usually require a maturity of less than 60 months. Home equity products include both fixed-rate term products and also an open-end revolving line of credit with a maximum loan-to-value ratio of 80% of current appraisal. A special MGIC program now offered through the Bank, allows for loans of up to 100% of the appreciated value for qualified applicants. Credit checks, credit scoring, and debt-to-income ratios within preset parameters are used to qualify borrowers.
Mortgage loans have historically had a longer average life than commercial or consumer loans. Accordingly, payment and interest rate risks are greater in some respects with mortgage loans than with commercial or consumer lending. Deposits, which are used as the primary source to fund mortgage lending, tend to be of shorter duration than the average maturities on residential mortgage loans and are more susceptible to interest rate changes. As a result of the relatively long life of mortgage products, mortgages are written as either conforming or nonconforming. In an effort to minimize interest rate and payment risk, only conforming mortgage loans, which can be sold in the secondary mortgage market, are written for periods of 30 years. Nonconforming mortgages are made with adjustable rates or fixed rates with maturities shorter than 30 years. Nonconforming mortgages also historically have higher interest rates. Mortgage lending is also subject to economic downturns, in that increases in unemployment could adversely affect the ability of borrowers to repay mortgage loans and decreases in property values could affect the value of the real estate serving as collateral for the loan.
The general good economy allowed good growth in loans that ended 2001 up 12.72% from year-end 2000. Industry standard debt-to-income ratios and credit checks are used to qualify borrowers on all consumer loans. Managers, assistant managers, and customer service officers have retail lending authorities at each of the full-service branch office locations. PNB has centralized loan administration at its operations/administrative offices where mortgage underwriting and loan review and analysis take place.
Loan Approval Individual loan authorities are established by PNB's Board of Directors upon recommendation by the senior credit officer. In establishing an individual's loan authority, the experience of the lender is taken into consideration, as well as the type of lending in which the individual is involved. The President of PNB has the authority to approve loans up to $500,000 following an analysis and review by loan administration and a written recommendation by the Chief Credit Officer. The full Board of Directors reviews on a monthly basis, all loans approved by individual lenders and the officers loan committee. All loan requests which are either complex in nature or exceed $500,000 must be analyzed and reviewed by loan administration and presented with a recommendation to the full Board of Directors for approval or denial.
PNB generally requires that loans secured by first mortgages or real estate have loan-to-value ratios within specified limits, ranging from 50% for loans secured by raw land to 80% for improved property, with the exception of secondary market programs which allow loan-to-value ratios as high as 95%. In addition, in some instances for qualified borrowers, private mortgage insurance is available for purchase that allows loan-to-value ratios to go as high as 95%. PNB also participates in a guaranteed mortgage insurance program. This allows PNB to make loans secured by second mortgages on real estate up to 100% of the value of the property. Adjustable rate mortgage products, as well as conventional fixed-rate products, are also available at PNB.
Deposit Activities PNB also offers a full range of deposit and personal banking services insured by the FDIC, including commercial checking and small business checking products, cash management services, retirement accounts such as Individual Retirement Accounts ("IRA"), retail deposit services such as certificates of deposit, money market accounts, saving accounts, a variety of checking account products, automated teller machines ("ATM's"), point of sale and other electronic services such as automated clearing house ("ACH") originations, and other personal miscellaneous services. These miscellaneous services would include safe deposit boxes, night depository services, traveler's checks, merchant credit cards, direct deposit of payroll and other checks, U.S. Savings Bonds, official bank checks, and money orders. The principal sources of funds for PNB are core deposits that include demand deposits, interest bearing transaction accounts, money market accounts, savings deposits, and certificates of deposit. These deposits are solicited from individuals, businesses, non-profit entities, and government authorities. Substantially all of PNB's deposits are from the local market areas surrounding each of its offices.
Investment Products In 1999, PNB entered into an agreement with T.H.E. Financial Services to hire a joint employee to sell investment products. An agent was hired and has an office located in the Bank's Hallstead Plaza building.
Investment Portfolio and Activities PNB's investment portfolio has several objectives.
A key objective is to provide a balance in PNB's asset mix of loans and investments consistent with its liability structure, and to assist in management of interest rate risk. The investments augment PNB's capital position in the risk-based capital formula, providing the necessary liquidity to meet fluctuations in credit demands of the community and also fluctuations in deposit levels.
In addition, the portfolio provides collateral for pledging against public funds, and a reasonable allowance for control of tax liabilities. Finally, the investment portfolio is designed to provide income for PNB.
In view of the above objectives, the portfolio is treated conservatively by management and only securities that pass those criteria are purchased.
Competition PNB operates in a fairly competitive environment, competing for deposits and loans with commercial banks, thrifts, credit unions, and finance and mortgage companies. Some of these competitors possess substantially greater financial resources than those available to PNB. Also, certain of these institutions have significantly higher lending limits then PNB and may provide various services for their customers, such as trust services, that are not presently available at PNB.
Financial institutions generally compete on the basis of rates and service. PNB is subject to increasing competition from credit unions, finance companies, and mortgage companies that may not be subject to the same regulatory restrictions and taxations as commercial banks.
PNB will seek to remain competitive with interest rates that it charges on its loans and offers on deposits. It also believes that its success has been, and will continue to be, due to its emphasis on community involvement, customer services, and relationships. With consolidation continuing in the financial industry, and particularly in PNB's markets, smaller profitable banks are gaining opportunities where larger institutions exit markets that are only marginally profitable for them.
SEASONALITY
Management does not feel that the deposits or the business of PNB in general are seasonal in nature. The deposits may, however, vary with local and national economic conditions but should not have a material effect on planning and policy making.
ITEM 2
ITEM 2 PROPERTIES
PNB has four full-service banking offices in Susquehanna County that are located in: Borough of Susquehanna Depot, Hallstead Plaza, Great Bend Township, Borough of Hop Bottom, Montrose office in Bridgewater Township.
PNB's presence in Wyoming County, Pennsylvania had been limited to a de novo branch in Nicholson, which reopened in 1992 until the purchase of the two Mellon offices in 1997. The Wyoming County locations are: Borough of Nicholson, Meshoppen Township, Tunkhannock Borough
The administrative/operations office of the Company and PNB is located at 50 Main Street, Hallstead, Pennsylvania. The following departments are located at that office: commercial, mortgage and consumer lending operations, executive offices, marketing department, human resources office, deposit account support services, data processing services All offices are owned in fee title by PNB with the exception of the Hallstead Plaza office and the Meshoppen office. The Hallstead Plaza and Meshoppen offices are subject to ground leases. Each lease is either long-term expiring in September 2028 or includes renewal options. Current lease payments range from $2,535 to $17,760 annually. The leases provide that the Bank pay property taxes, insurance, and maintenance costs. Six of the seven offices provide drive-up banking services and five offices have 24-hour ATM services.
ITEM 3
ITEM 3 LEGAL PROCEEDINGS
The nature of the Company's business generates a certain amount of litigation involving matters arising out of the ordinary course of business. In the opinion of management, there are no legal proceedings that might have a material effect on the results of operations, liquidity, or the financial position of the Company at this time.
ITEM 4
ITEM 4 Submissions of Matters to a Vote of Security Holders
NONE
PART II
ITEM 5
ITEM 5 Market for Registrant's Common Equity and Related Stockholder Matters
The Company's Common Stock is not listed on an exchange or quoted on the National Association of Securities Dealers, Inc. Automated Quotation system (NASDAQ). The Company's Common Stock is traded sporadically in the over-the-counter market and, accordingly, there is no established public trading market at this time. The Company's stock is listed on the OTC Bulletin Board under the symbol PFIS. The cusip number is 711040-10-5. The investment firms of Tucker Anthony Company, Incorporated from Lancaster, Pennsylvania, and Ferris, Baker Watts, Incorporated from Baltimore, Maryland, make a limited market in the Company's Common Stock. The Company and previously the Bank has continuously paid dividends for more than 90 years and it is the intention to pay dividends in the future. However, future dividends must necessarily depend upon earnings, financial condition, appropriate legal restrictions, and other factors at the time that the Board of Directors considers dividend payments. As of December 31, 2001, there were 43,634 outstanding options to purchase the Company's common stock. See Note 9 of the Consolidated Financial Statements for more information. Book value of common stock at December 31, 2001, was $16.03 and on December 31, 2000, it was $14.31. As of December 31, 2001, the Company had approximately 801 shareholders of record. At such date, 2,105,836 shares of Common Stock were outstanding.
The following table reflects high bid and low asked prices for shares of the Company's Common Stock to the extent such information is available, and the dividends declared with respect thereto during the preceding two years.
ITEM 6
ITEM 6 SELECTED FINANCIAL DATA
ITEM 7
ITEM 7 Management's Discussion and Analysis of Financial Condition and Results of Operation
This consolidated review and analysis of Peoples Financial Services Corp. (the Company) is intended to assist the reader in evaluating the Company's performance for the years ending December 2001 and 2000. The information should be read in conjunction with the consolidated financial statements and the accompanying notes to those statements.
Peoples Financial Services Corp. is the one-bank holding company of Peoples National Bank (the Bank), which is wholly owned by the Company. The Company and the Bank derive their primary income from the operation of a commercial bank, including earning interest on loans and investment securities. The Bank incurs interest expense in relation to deposits and other borrowings. The Bank operates seven full-service branches in the Hallstead Shopping Plaza, Hop Bottom, Montrose, Susquehanna, Nicholson, Tunkhannock, and Meshoppen, PA. The Bank has on-site automated teller machines at all offices except Hop Bottom and Meshoppen. The administrative offices and operations offices are located in Hallstead, PA. Principal market areas are Susquehanna and Wyoming Counties in PA and the bordering areas of those counties. As of December 31, 2001, the Bank employed 80 full-time employees and 17 part-time employees.
Forward Looking Statements When used in this discussion, the words "believes", "anticipates", "contemplated", "expects", or similar expressions are intended to identify forward looking statements. Such statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those projected. Those risks and uncertainties include changes in interest rates, the ability to control costs and expenses, and general economic conditions. The Company undertakes no obligation to publicly release the results of any revisions to those forward looking statements that may be made to reflect events or circumstances after this date or to reflect the occurrence of unanticipated events.
Critical Accounting Policies
Note 1 to the Company's consolidated financial statements lists significant accounting policies used in the development and presentation of its financial statements. This discussion and analysis, the significant accounting policies, and other financial statement disclosures identify and address key variables and other qualitative and quantitative factors that are necessary for an understanding and evaluation of the Company and its results of operations.
Results of Operations
Net Interest Income Net interest income is the main source of the Company's income. It is the difference between interest earned on assets and interest paid on liabilities. The discussion of net interest income should be read in conjunction with Table 2: "Distribution of Assets, Liabilities and Stockholders' Equity; Interest Rates and Interest Differential", and Table 3: "Rate/Volume Analysis of Changes in Net Interest Income."
The following table shows the net interest income on a fully tax equivalent basis for each of the three years ending December 2001, 2000, and 1999.
Table 2 includes the average balances, interest income and expense, and the average rates earned and paid for assets and liabilities. Yields on tax-exempt assets have not been calculated on a fully tax equivalent basis. For yield calculation purposes, nonaccruing loans are included in average loan balances. Table 3 analyzes the components contributing to the changes in net interest income in 2001 and indicates the impact in either changes in rate or changes in volume
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Net interest income on loans increased $1,036,000 from 2000 to 2001. This increase of 7.5% is attributable to growth in the loan portfolio during the Year 2001. Net loans increased 12.72%. Prime rate went from 9.5% to 4.75% during the year.
Interest income on taxable investments decreased $58,000 from 2000 due to lower interest rates during the year. Beginning in January and ending in December, the Federal Reserve Bank decreased interest rates 11 times. Interest income from Federal Funds sold decreased $27,000 from 2000 to 2001 because of lesser volume and lower rates. In addition, the growth in the loan portfolio did not provide for excess funds.
For comparison, interest income on loans increased $1,763,000 in 2000 from 1999. This increase of 14.6% was attributable to growth in the loan portfolio during the Year 2000. Net loans increased 13%. Although interest rates were higher at the end of the year than the beginning, competitive pricing pressures kept income lower. Prime rate increased from 8.5% to 9.5% during 2000.
Interest income on taxable investments increased $449,000 from 1999 to 2000 due to a combination of higher balances and investing at higher interest rates during the 2000. Beginning in June 1999 and ending in May of 2000, the Federal Reserve Bank increased interest rates 1 3/4%. During most of the Year 2000, interest rates were inverted, meaning that short-term rates were higher than long-term rates. Because of this situation and management's desire to shorten maturities on taxable investments, purchase of taxable securities were limited to those with maturities of 5 years or less.
As previously stated, short-term interest rates decreased during the Year 2001. Since deposit accounts are priced off the short end of the treasury curve, the Bank experienced an abnormal decrease in interest expense of $447,000 or 4.3% in 2001. Not only did deposits cost less, but borrowings also were less expensive. Funding loan growth through borrowing was deemed more economically sensible than through aggressive certificate of deposit rates. Interest on deposits decreased $616,000 in 2001.
Short-term interest rates increased during the Year 2000. Since deposit accounts are priced off the short end of the treasury curve, the Bank experienced an abnormal increase in interest expense during 2000 over 1999 of 23.4% or $1,988,000. Not only did deposits cost more, term borrowings also were more expensive as that line item went from $493,000 in 1999 to $1,201,000 in 2000. Funding loan growth through term borrowing was deemed more economically sensible than through aggressive certificate of deposit rates. Interest on deposits increased $1,280,000 in 2000 over 1999 due to the increase in short-term rates.
PROVISION FOR LOAN LOSS
The provision and allowance for loan losses are based on management's ongoing assessment of the Corporation's credit exposure and consideration of other relevant factors. The allowance for loan losses is a valuation reserve that is available to absorb future loan charge offs. The provision for loan losses is the amount charged to earnings on an annual basis. The factors considered in management's assessment of the reasonableness of the allowance for loan losses include prevailing and anticipated economic conditions, assigned risk ratings on loan exposures, the results of examinations and appraisals of the loan portfolio conducted by federal regulatory authorities and an independent loan review firm, the diversification and size of the loan portfolio, the level of and inherent risk in non-performing assets, and any other factors deemed relevant by management.
The provision for loan losses was $20,000, $240,000 and $240,000 for the years 2001, 2000, and 1999. Net charge-offs for 2001 were $122,000 compared to $78,000 in 2000. As of December 31, 2001, the allowance for loan loss was 0.94% of loans and at December 31, 2000, the ratio was 1.11% of loans. After allocation of reserves to all non-accrual and especially mentioned loans as well as applying a percentage of outstanding loans based on the loss history of such loans in each category, the opinion of management was that the provision for loan loss was proper and sufficient. The ratio of allowance for loan loss to non-performing loans was 306.28% at year end 2001.
Net charge-offs for 2000 were $78,000 compared to $198,000 in 1999, so the balance in allowance for loan loss increased 9.23%. The ratio of allowance for loan loss to non-performing loans was 381.43% at year-end 2000 as compared to 655.22% at year-end 1999. As of December 31, 2000, the allowance for loan loss was 1.11% of loans and at December 31, 1999, the ratio was 1.15% of loans.
OTHER INCOME
Non-Interest Income Non-interest income includes items that are not related to interest rates, but rather, to services rendered and activities conducted in conjunction with the operation of a commercial bank. Service charges earned on deposit accounts is the largest single item in this category and represents fees related to deposit accounts including overdraft fees, minimum balance fees, and transaction fees.
Several components of this category contributed strongly to the increase of $253,000 from $1,452,000 in 2000 to $1,705,000 in 2001, an increase of 17.4%. Bank-owned life insurance in the amount of $4 million was added to assets at midyear and contributed $124,000. The commissions from the sales of investment products from our third party provider increased $38,000 ending the year at $140,000 compared to $102,000 in 2000. Overdraft fees increased $104,000 in 2001 which was 16.6%.
Non-interest income in 2000 increased $146,000 or 11.2% from 1999. Increased volume and adjustments in fee schedules account for customer service fees increasing $78,000.
The following table analyzes the increase in total other income by comparing the years ending 2001 and 2000:
OTHER EXPENSE
Non-Interest Expense
Non-interest expense includes all other expenses associated with the Company. Salaries and related benefits is the largest expense in this category and it increased $207,000 or 7.3% over year end 2000. Annual salary increases, along with an increase for health insurance, were the reasons for this change. In comparison, the increase in this category from 1999 to 2000 was 11.2% or $285,000. New employees and annual salary increases along with an increase for health insurance were the reason.
Occupancy expense decreased 6.8% or $23,000 in 2001 as compared to 2000, when occupancy expense increased 4.6% or $15,000. This was considered a normal fluctuation for taxes, utilities, repairs and maintenance, and depreciation.
Furniture and equipment expense decreased a negligible amount with 2001 at $385,000 compared to 2000 at $388,000 which was consistent with 1999 expenses of $383.000.
Professional fees, which includes outside service, continues to increase as management and the Company find it efficient and cost effective to utilize outside services and consultants to facilitate management and operations. Professional fees and outside services were $231,000 in 2001 which compares to $216,000 in 2000 and $197,000 in 1999.
Computer services and supplies is another component of other expenses and it is as its name implies. This category covers the expense of data processing for the Company. Each year dependence grows as does the resultant expense. In 2001 the expense was $394,000 compared to $361,000 in 2000 and $306,000 in 1999. Technology has proven to be expensive, but necessary to provide excellent customer service and maintain efficiencies.
Taxes, other than payroll and income, are another component and in 2001, this expense was $290,000 compared to $255,000 in 2000, an increase considered to be normal. In 1999 taxes were $247,000.
Every other non-interest expense is in the category of other. In 2001 this expense increased $223,000 and the total for this year was $1,461,000. The biggest components in this figure were the amortization of premiums on the purchase of the Tunkhannock and Meshoppen branch offices at $258,000; operating costs other than salaries for our operation center, $151,000; directors' and associate directors' fees, employee education costs of $66,000; stationery printing and supplies, $120,000; and postage at $143,000. All were deemed to be in line with budget expectations. Also included in non-interest expense for 2001 was a $139,000 estimated loss on the alleged fraud in the sale of securities by Bentley Financial Services, Inc. for funds the Company had invested with them. Please refer to Note 12 to the Consolidated Financial Statements for a further discussion on this matter.
All other non-interest expense only increased $12,000 in 2000 compared to 1999. The Bently investment loss accounts for the largest share of the variance between the three years. Other variances are postage was up from $112,000 in 2000 to $143,000 in 2001. Automated teller machine costs were $131,000 in 2000 and $192,000 in 2001.
Federal Income Taxes
The provision for income taxes was $1,508,000 in 2001 compared to $1,097,000 in 2000 and $1,114,000 in 1999. The effective tax rate, which is the ratio of income tax expense to income before taxes, was 24% in 2001, up from 22% in 2000 and 23% in 1999. The tax rate for all periods was substantially less than the federal statutory rate of 34% primarily due to tax-exempt securities and tax-exempt loan income. Please refer to Note 10 of the Notes to Consolidated Financial Statements included as part of this report for further analysis of federal income tax expense for 2001.
Quarterly Results
The decline in interest rates in the first quarter and slower loan growth caused a loss in interest income in the first quarter. Interest income increased during the second and third quarters of 2001 as the loan portfolio grew. The rate declines caused a downturn again by the fourth quarter. Compare this to the scenario in 2000 when net income improved each of the first three quarters due to rising rates with a slight dip in the last quarter due to the larger gain in other income peaking during the third quarter of 2000.
Interest expense decreased each quarter of 2001 as interest rates dropped eleven times throughout the year. In 2000 interest rates were going up and interest expense reached a high in the fourth quarter at $2,844,000.
The combination of loan growth and falling rates made each quarter show improved net interest income numbers in 2001.
The provision for loan loss of $20,000 was made in the first quarter of 2001. Because of good credit quality and low past due ratios, the remaining quarters were at zero. The provision for the prior year was $240,000.
The changes in securities gains and losses were not significant during 2001. Some gains were taken in the first quarter as interest rates started to decline. As the rate declines continued, the portfolio's performance precluded any restructuring changes, and liquidity needs were met with short-term borrowings.
Net Income was highest during the third quarter due to lower Other Expenses in the third quarter and good interest income. The fourth quarter showed a small decrease with net interest income improving significantly in that quarter but Other Expenses coming in higher to diminish the effect. In 2000 net income grew each quarter as rates continued to rise.
Earnings per share increased $0.05 in the first quarter with the second quarter the same. The third quarter increased $0.08 with the fourth quarter the same. In 2000 there was a $0.03 increase in the second quarter, another $0.03 in the third quarter, and a $0.01 increase in the last quarter.
FINANCIAL CONDITION
The Corporation's financial condition can be evaluated in terms of trends in its sources and uses of funds. The following table illustrates how the Corporation has managed its sources and uses of funds that are directly affected by outside economic factors, such as interest rate fluctuations:
Total assets increased 9.64%, to $315,347,000 in the year ending December 31, 2001. There were increases in both borrowed funds and deposits on the liability side, which fueled this growth of assets. Loan and investment portfolios on the asset side reflected growth also. In 2000, total assets increased 10.07% to $287,625,000.
Investments at year-end 2001 totaled $100,783,000 compared to $99,678,000 on December 31, 2000.
Loans continued to increase in 2001, ending the year with $191,913,000 in net loans compared to $170,262,000 at year-end 2000, an increase of 12.72%. Commercial loans and individual mortgages were the biggest gainers. Commercial loans were up over 26% to close the year at $73,422,000 compared to $58,204,000 at year-end 2000. In 2000 loans grew 13.03%
Mortgages were up 7.9% to $101,934,000 compared to $94,429,000 on December 31, 2000, an increase of $7,505,000. Mortgage growth was higher in 2000 at 10.41%, an increase of $8,901,000.
With interest rates down during 2001, there was a stronger demand for mortgages. The growth in commercial lending is due, in part, to a concerted effort on our part to increase our exposure to this segment.
To fund loan growth, short and long-term borrowings increased $16,593,000. Short-term borrowings stood at $21,338,000 at year-end 2001 compared to $7,245,000 the previous year. However, the average short term borrowing for 2001 was $7,648,000 compared to $5,100,000 for 2000. As the Year 2001 progressed and especially after September 11, 2001, it became evident that interest rates would remain low and the short term borrowing position could be liquidated with maturing and called investments in the future. Long-term borrowings increased $2,500,000 during 2001.
Loan Portfolio Types All categories of loans except consumer loans showed growth in 2001. Consumer loans include personal lines of credit, installment loans, and home equity loans to individuals. These loans can be secured or unsecured and are generally used for purposes such as automobile financing, home improvement, recreational loans, and for educational purposes.
Loan Maturities The Bank has 19.27% of its loans maturing within the next year. Of those maturing within one year, most are commercial loans with the remainder split between mortgages and consumer loans. In the one to five year maturity range, the Bank has 25.2% of its portfolio. The over 5 year maturity group makes up 55.5% of the portfolio which reflects the Bank's significant investment in mortgages. Mortgages are 52.6% of the total loan portfolio.
Table 10 reflects the Corporation's non-accrual and past due loans for each of the past five years. A commercial loan is generally placed on non-accrual when the contractual payment of principal or interest has become 90 days past due or when management has serious doubts about further collectibility of principal or interest even though the loan is currently performing. Consumer loans, including mortgages, are generally placed on non-accrual at 120 days. A loan may remain on accrual status if it is in the process of collection and is either guaranteed or well secured.
Allowance for Loan Losses The balance in the allowance for loan losses is based on management's assessment of the risk in the loan portfolio. Allocations to specific commercial loans are made in adherence to SFAS 114, Accounting by Creditors for Impairments of a Loan. These allocations are based upon the present value of expected future cash flows or the fair value of the underlying collateral. In addition, management reviews the other components of the loan portfolio through the loan review function and assigns internal grades to loans based upon the perceived risks inherent in each loan. In that determination, management reviews a number of factors including historical analysis of similar credits, delinquency reports, ratio analysis as compared to peers, concentration of credit risks, local economic conditions, and regulatory evaluation of the allowance for loan losses. Although the Bank has sold some mortgages on the secondary market in the past, the Bank did not sell any in 2001. Management expects this trend to continue. Therefore, allocation methods are the same for all mortgages. This evaluation is reviewed monthly by management and by the Board of Directors. Management believes that on December 31, 2001, the allowance for loan losses was adequate to absorb potential losses in the loan portfolio. However, this judgement is subjective and a significant degradation in loan quality could require a change in the estimates and therefore, a change in net income.
This is the only year of the last five years where the allowance for loan loss decreased. During 2001, asset quality improved and past dues remained low. Therefore, management lowered the provision for loan losses made to $20,000 from $240,000 in 2001, despite the higher number of net charge-offs in 2001 compared to 2000. In 1998 and 1999, the net charge-offs were more than in 2001 and the Bank had a much smaller portfolio during those years.
The following is a summary of loans charged off, recoveries and provisions to the allowance for loan losses for the periods presented.
The following table details the allocation of the allowance for loan losses to various categories:
The unallocated portion of the allowance is intended to provide for possible losses that are not otherwise accounted for and to compensate for the imprecise nature of estimating future loan losses. Management believes the allowance is adequate to cover the inherent risks associated with the loan portfolio. While allocations have been established for particular loan categories, management considers the entire allowance to be available to absorb losses in any category.
Highly leveraged transactions (HLT's) that result in the borrower's debt-to-total assets ratio exceeding the 75%, generally include loans and commitments made in connection with recapitalization, acquisitions, and leveraged buyouts The Corporation had no loans at December 31, 2001 that qualified as HLT's.
Securities The Corporation's securities portfolio is classified, in its entirety, as "available for sale" as shown in Table 14. Management believes that a portfolio classification of all available for sale allows complete flexibility in the investment portfolio. Using this classification, the Corporation intends to hold these securities for an indefinite amount of time but not necessarily to maturity. Such securities are carried at fair value with the unrealized holding gains or losses, net of taxes, reported as a component of the Corporation's stockholders' equity on the balance sheet. The portfolio is structured to provide maximum return on investments while providing a consistent source of liquidity and meeting strict risk standards.
Table 14 shows the amortized cost and average yield of securities by maturity or call date at December 31, 2001.
Table 15 shows the balance of securities for the past three years on December 31. More details on Securities can be found in Note 3 of the Consolidated Financial Statement.
Deposits Deposits were harder to obtain during 2001 as a result of declining interest rates. The Bank was able to obtain funds at low cost from the Federal Home Loan Bank. As a result, there was little growth in certificates of deposits in the year 2001. For the same reason, there was less than 1% growth in IRA's.
The growth that did occur in deposits was in the savings and demand accounts. These core deposits were specifically the areas where growth was encouraged. Demand deposits increased $3,690,000 or 4.6% while savings increased 6.1% and $3,040,000.
MATURITIES OF TIME DEPOSITS The maturities on the time deposits over $100,000 are spread fairly evenly throughout the four categories. The largest percentage 34.48%, is in the first category of three months or less.
SHORT AND LONG TERM BORROWINGS
Short-term borrowings which are overnight or less than 30-day borrowings consist of federal funds purchased, securities sold under agreements to repurchase, Federal Home Loan Bank advances, and U.S. Treasury tax and loan notes. Long-term borrowings consist of notes from the Federal Home Loan Bank. These notes are secured under terms of a blanket collateral agreement by a pledge of qualifying investment and mortgage backed securities, certain mortgage loans and a lien on FHLB stock. For more detail on short and long-term borrowings see Note 7 and 8 of the Notes to Consolidated Financial Statements.
Capital Accounts Total stockholders' equity increased 9.41% or $2,902,000 over year-end 2000. This growth is primarily attributable to retained earnings. A common ratio used to determine effective use of capital is the return on average equity. For the year ending December 31, 2001, this ratio was 15.15% compared to 14.28% at December 31, 2000. A strong capital position has always been a goal of the Company, but we also recognize that investors want to see judicious use of capital. At year-end 2001, the equity-to-assets ratio was 10.70% compared to 10.71% at year-end 2000. It is the goal of management to implement ways to better leverage our capital. A capital-to-assets ratio closer to 8% is a target number.
Net Income increased capital by $4,836,000 in 2001 and dividends reduced that number by $1,529,000. The investment portfolio appreciated in value by $666,000 in 2001. Since all of our investments are available for sale, changes in market values adjusted for taxes are reflected in the equity portion of the balance sheet. A total of $1,071,000 in treasury stock purchases reduced the capital account to equal the total net change. From time to time the Company has purchased PFIS stock in the open market or from individuals to leverage the capital account and to provide stock for our dividend reinvestment plan. During the year 2001, 43,999 shares were purchased in this manner. There were no stock purchases from the treasury stock account by individuals exercising options or for our dividend reinvestment plan during 2001. The investment banking firms of Tucker Anthony, Inc. and Ferris, Baker Watts, Incorporated have been known to make markets in PFIS common stock.
The following table represents the Company's capital position as it compares to the regulatory guidelines at December 31, 2001.
Interest Rate Sensitivity
The operations of the Company do not subject it to foreign currency risk or commodity price risk. The Company does not utilize interest rate swaps, caps, or hedging transactions. In addition, the Company has no market risk sensitive instruments entered into for trading purposes. However, the Company is subject to interest rate risk and employs several different methods to manage and monitor the risk.
Interest rate sensitivity refers to the relationship between market interest rates and the earnings volatility of the Company due to the repricing characteristics of assets and liabilities. The responsibility for monitoring interest rate sensitivity and policy decisions has been given to the Asset/Liability Committee (ALCO) of the Bank. The tools used to monitor sensitivity are the Statement of Interest Sensitivity Gap and the interest rate shock analysis. The Bank uses a software model to measure and to keep track. In addition, an outside source does a quarterly analysis to make sure our internal analysis is current and correct. The Statement of Interest Sensitivity Gap is a good assessment of current position and is a very useful tool for the ALCO in performing its job. This report is monitored in an effort to "match" maturities or repricing opportunities of assets and liabilities in order to attain the maximum interest within risk tolerance policy guidelines. The statement does, although, have inherent limitations in that certain assets and liabilities may react to changes in interest rates in different ways with some categories reacting in advance of changes and some lagging behind the changes. In addition, there are estimates used in determining the actual propensity to change of certain items such as deposits without maturities. Because of the risks caused by embedded options in both assets and liabilities, the services of a consultant was utilized in 2001 to test the accuracy of the software model being used. The final analysis was positive and some policy changes were enacted to reflect the increased regulatory emphasis on the economic value of equity (EVE).
The following sets forth the Company's interest sensitivity analysis as of December 31, 2001:
The drop in the Federal Reserve Bank's discount and federal funds rate by 475 basis points during 2001 actually put to test the Company's ability to effectively manage its interest rate sensitivity. Throughout the year, the Company was able to effectively manage its net interest margin. As a result, the net interest margin remained fairly stable starting at 3.66% for the month of December 2000, compared to 3.84% for the year 2001 and ending at 3.93% for the month of December 2001.
Liquidity
The liquidity of the Company is reflected in its capacity to have sufficient amounts of cash available to fund the needs of customer withdrawal requests, accommodate loan demand, and maintain regulatory reserve requirements; that is to conduct banking business. Additional liquidity is obtained by either increasing liabilities or by decreasing assets. The primary source for increasing liabilities is the generation of additional deposit accounts which are managed through our system of branches. In addition, loan payments on existing loans, sales of loans held for sale, or investments available for sale can generate additional liquidity. Other sources include income from operations, decreases in federal funds sold or interest-bearing deposits in other banks, securities sold under agreements to repurchase, and borrowings from the Federal Home Loan Bank. On December 31, 2001, the Bank had a borrowing capacity from the Federal Home Loan Bank of approximately $107,034,000. During the Year 2001, maturities and sales of investments, increases in deposits, and short term borrowings provided the majority of additional cash with operating activities also contributing to liquidity. The funds were used primarily to grant loans to customers, purchase additional investment securities, and to pay dividends to our shareholders.
The financial statements do not reflect various commitments that are made in the normal course of business, which may involve some liquidity risk. These commitments consist mainly of unfunded loans and letters of credit made under the same standards as on-balance sheet instruments. Unused commitments, at December 31, 2001 totaled $16,417,000. Because these instruments have fixed maturity dates, and because many of them will expire without being drawn upon, they do not generally present any significant liquidity risk.
Management believes that any amounts actually drawn upon can be funded in the normal course of operations.
The Company has no investment in or financial relationship with any unconsolidated entities that are reasonably likely to have a material effect on liquidity or the availability of capital resources.
The following table represents the aggregate on and off balance sheet contractual obligations to make future payments.
The Company is not aware of any known trends or any known demands, commitments, events or uncertainties, which would result in any material increase or decrease in liquidity.
SUBSEQUENT EVENT
On November 19, 2001, the Bank entered into an agreement with another bank to purchase certain assets, including furniture and equipment and assume certain liabilities, including approximately $6,000,000 of deposits and a premises lease, of a branch located in Norwich, New York. The purchase price equals $50,000 for a deposit premium plus the book value cost of the personal property. Subsequently, the Company formed an interim national bank which was assigned the Bank's interest in the agreement. On March 6, 2002, the branch purchased was consummated and the interim national bank was merged with and into the Bank. The transaction closed on March 6, 2002.
EFFECTS OF INFLATION
The majority of assets and liabilities of a financial institution are monetary in nature and, therefore, differ greatly from commercial and industrial companies that have significant investments in fixed assets or inventories. The precise impact of inflation upon the Corporation is difficult to measure. Inflation may affect the borrowing needs of consumers, thereby impacting the growth rate of the Corporation's assets. Inflation may also affect the general level of interest rates, which can have a direct bearing on the Corporation.
Management believes that the most significant impact on financial results is the Corporation's ability to react to changes in interest rates. As discussed previously, management is attempting to maintain a position that is within conservative parameters for interest sensitive assets and liabilities in order to be protected against wide interest rate fluctuation.
NEW ACCOUNTING STANDARDS The following can be found under Note 1 of the Notes to Consolidated Financial Statements:
SFAS No. 141, "Business Combinations" SFAS No. 142 "Goodwill and Other Intangible Assets". SFAS No. 143, "Accounting for Asset Retirement Obligations" SFAS No. 144, "Accounting for Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of "
ITEM 7A
ITEM 7A Quantitative and Qualitative Disclosure About Market Risk
The Company is not a party to any forward contract, interest rate swap, option interest, or similar derivation instrument. The Company does not deal in foreign currency. The following table presents average interest rates that relate to assets and liabilities that are sensitive to changes in interest rates.
ITEM 8
ITEM 8 Financial Statements and Supplementary Data
INDEPENDENT AUDITOR'S REPORT
To the Board of Directors Peoples Financial Services Corp. Hallstead, Pennsylvania
We have audited the accompanying consolidated balance sheet of Peoples Financial Services Corp. and its subsidiary as of December 31, 2001, and the related consolidated statements of income, stockholders' equity and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. The consolidated financial statements of Peoples Financial Services Corp. and its subsidiary for the years ended December 31, 2000 and 1999 were audited by other auditors whose report, dated February 15, 2001, expressed an unqualified opinion on those statements.
We conducted our audit in accordance with auditing standards generally accepted in the United States of America. 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 2001 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Peoples Financial Services Corp. and its subsidiary as of December 31, 2001, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.
/s/BEARD MILLER COMPANY LLP
Allentown, Pennsylvania January 4, 2002
PEOPLES FINANCIAL SERVICES CORP. AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS
See Notes to Consolidated Financial Statements
CONSOLIDATED STATEMENTS OF INCOME
See Notes to Consolidated Financial Statements
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
See Notes to Consolidated Financial Statements
CONSOLIDATED STATEMENTS OF CASH FLOWS
See Notes to Consolidated Financial Statements
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
See Notes to Consolidated Financial Statements
PEOPLES FINANCIAL SERVICES CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of Peoples Financial Services Corp. and its wholly-owned subsidiary, Peoples National Bank. All significant intercompany accounts and transactions have been eliminated in consolidation.
Nature of Operations
The Company provides a variety of financial services, through the bank, to individuals, small businesses and municipalities through its seven Pennsylvania offices located in Hallstead, Hop Bottom, Susquehanna, Montrose, Nicholson, Meshoppen and Tunkhannock, which are small communities in a rural setting. The Bank's primary deposits are checking accounts, savings accounts and certificates of deposit. Its primary lending products are single-family residential loans and loans to small businesses. As a national bank, the Bank is subject to regulation of the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation. The Company is subject to regulation of the Federal Reserve Bank.
Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant change in the near term 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.
Presentation of Cash Flows
For purposes of cash flows, cash and cash equivalents include cash and due from banks, interest-bearing deposits in other banks and federal funds sold.
Securities
Securities classified as available for sale are those securities that the Company intends to hold for an indefinite period of time, but not necessarily to maturity. Any decision to sell a security classified as available for sale would be based on various factors, including significant movements in interest rates, changes in the maturity mix of the Company's assets and liabilities, liquidity needs, regulatory capital considerations and other similar factors. Securities available for sale are carried at fair value. Unrealized gains or losses are reported as increases or decreases in other comprehensive income, net of the related deferred tax effect. Realized gains or losses, determined on the basis of the cost of the specific securities sold, are included in earnings. Premiums and discounts are recognized in interest income using the interest method over the period to maturity. Common equity securities include restricted investments, primarily Federal Home Loan Bank and Federal Reserve Bank stock which is carried at cost. Federal law requires a member institution of the Federal Home Loan Bank and the Federal Reserve Bank to hold stock according to a predetermined formula.
NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Loans Receivable
Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are stated at their outstanding unpaid principal balances, net of an allowance for loan losses and any deferred fees or costs. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized over the contractual life of the related loan as an adjustment to the yield.
The accrual of interest is generally discontinued when the contractual payment of principal or interest has become 90 days past due or management has serious doubts about further collectibility of principal or interest, even though the loan is currently performing. A loan may remain on accrual status if it is in the process of collection and is either guaranteed or well secured. When a loan is placed on nonaccrual status, unpaid interest credited to income in the current year is reversed and unpaid interest accrued in prior years is charged against the allowance for loan losses. Interest received on nonaccrual loans generally is either applied against principal or reported as interest income, according to management's judgment as to the collectibility of principal. Generally, loans are restored to accrual status when the obligation is brought current, has performed in accordance with the contractual terms for a reasonable period of time and the ultimate collectibility of the total contractual principal and interest is no longer in doubt.
Allowance for Loan Losses
The allowance for loan losses is established through provisions for loan losses charged against income. 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 is maintained at a level considered adequate to provide for losses that can be reasonably anticipated. Management's periodic evaluation of the adequacy of the allowance is based on the Bank's past loan loss experience, known or inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant change, including the amounts and timing of future cash flows expected to be received on impaired loans.
A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price or the fair value of the collateral if the loan is collateral dependent.
NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Allowance for Loan Losses (Continued)
Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Bank does not separately identify individual consumer and residential loans for impairment disclosures.
Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line and various accelerated methods based on estimated useful lives. Maintenance, repairs and minor replacements are expensed when incurred. Gains and losses on routine dispositions are reflected in current operations.
Intangible Assets
The Bank has core deposit acquisition premiums which are being amortized over an estimated life of fifteen years using the straight-line method. These intangible assets of $2,627,000 and $2,885,000, net of accumulated amortization of $1,210,000 and $952,000, are included in other assets at December 31, 2001 and 2000, respectively. Amortization was $258,000 for each of the years ended December 31, 2001, 2000 and 1999.
Foreclosed Assets
Foreclosed assets are comprised of property acquired through a foreclosure proceeding or acceptance of a deed-in-lieu of foreclosure and loans classified as in-substance foreclosure. The Company includes such properties in other assets. A loan is classified as in-substance foreclosure when the Company has taken possession of the collateral regardless of whether formal foreclosure proceedings take place. Foreclosed assets initially are recorded at fair value, net of estimated selling costs, at the date of foreclosure establishing a new cost basis. Subsequent declines in the recorded value of the property prior to its disposal and costs to maintain the assets are included in other expense. In addition, any gain or loss realized upon disposal is included in other income or expense.
Income Taxes
Deferred income taxes are provided on the liability method whereby deferred tax assets are recognized for deductible temporary differences and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax basis. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. Peoples Financial Services Corp. and its subsidiary file a consolidated federal income tax return.
Advertising
The Company follows the policy of charging marketing and advertising costs to expense as incurred.
NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Earnings per Common Share
Basic earnings per share represents income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options, and are determined using the treasury stock method.
The following table shows the amounts used in computing earnings per share for the years ended December 31, 2001, 2000 and 1999:
Comprehensive Income
Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available for sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income.
NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Comprehensive Income (Continued)
The components of other comprehensive income (loss) and related tax effects for the years ended December 31, 2001, 2000 and 1999 are as follows:
Segment Reporting
The Bank acts as an independent community financial services provider and offers traditional banking and related financial services to individual, business and government customers. Through its branch and automated teller machine network, the Bank offers a full array of commercial and retail financial services, including the taking of time, savings and demand deposits; the making of commercial, consumer and mortgage loans; and the providing of other financial services.
Management does not separately allocate expenses, including the cost of funding loan demand, between the commercial, retail and trust operations of the Bank. As such, discrete information is not available and segment reporting would not be meaningful.
Off-Balance Sheet Financial Instruments
In the ordinary course of business, the Company has entered into off-balance sheet financial instruments consisting of commitments to extend credit and standby letters of credit. Such financial instruments are recorded in the financial statements when they are funded.
New Accounting Standards
In June of 2001, the Financial Accounting Standards Board issued Statement No. 141, "Business Combinations," and Statement No.142, "Goodwill and Other Intangible Assets."
Statement No. 141 requires all business combinations to be accounted for using the purchase method of accounting as use of the pooling-of-interests method is prohibited. In addition, this Statement requires that negative goodwill that exists after the basis of certain acquired assets is reduced to zero should be recognized as an extraordinary gain. The provisions of this Statement apply to all business combinations initiated after June 30, 2001.
NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
New Accounting Standards (Continued)
Statement No. 142 prescribes that goodwill associated with a business combination and intangible assets with an indefinite useful life should not be amortized but should be tested for impairment at least annually. The Statement requires intangibles that are separable from goodwill and that have a determinable useful life to be amortized over the determinable useful life. The provisions of this Statement will become effective for the Company in January of 2002. Upon adoption of this Statement, goodwill and other intangible assets arising from acquisitions completed before July 1, 2001 should be accounted for in accordance with the provisions of this Statement.
At December 31, 2001, the Company had core deposit acquisition premiums with a net book value of $2,627,000 which will continue to be amortized under the new rules.
In June of 2001, the Financial Accounting Standards Board issued Statement No. 143, "Accounting for Asset Retirement Obligations," which addresses the financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement cost. This Statement requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. This Statement will become effective for the Company on January 1, 2003 but is not expected to have a significant impact on the financial condition or results of operations.
In August of 2001, the Financial Accounting Standards Board issued Statement No. 144, "Accounting for the Impairment of or Disposal of Long-Lived Assets." This Statement supersedes FASB Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," and the accounting and reporting provisions of APB Opinion No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions for the Disposal of a Segment of a Business." This Statement also amends ARB No. 51, "Consolidated Financial Statements." The provisions of this Statement will be effective for the Company on January 1, 2002, but are not expected to have a significant impact on the financial condition or results of operations.
Reclassifications
Certain amounts in the 2000 and 1999 financial statements have been reclassified to conform with the 2001 presentation format. Such reclassifications had no impact on the Company's net income.
NOTE 2 - BRANCH ACQUISITION
On November 19, 2001, the Bank entered into an agreement with another bank to purchase certain assets, including furniture and equipment and assume certain liabilities, including approximately $6,000,000 of deposits and a premises lease, of a branch located in Norwich, New York. The purchase price equals $50,000 for a deposit premium plus the book value cost of the personal property. The acquisition is subject to obtaining regulatory approvals and is not expected to be completed until the first quarter of 2002.
NOTE 3 - SECURITIES
At December 31, 2001 and 2000, the amortized cost and fair values of securities available for sale are as follows:
NOTE 3 - SECURITIES (CONTINUED)
The amortized cost and fair value of securities as of December 31, 2001, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to prepay obligations with or without any penalties.
Proceeds from sale of available for sale securities during 2001, 2000 and 1999 were $12,703,000, $10,879,000 and $12,072,000, respectively. Gross gains realized on these sales were $100,000, $35,000 and $113,000, respectively. Gross losses on these sales were $68,000, $14,000 and $28,000, respectively.
Securities with a carrying value of $36,747,000 and $31,261,000 at December 31, 2001 and 2000, respectively, were pledged to secure public deposits and repurchase agreements as required or permitted by law.
NOTE 4 - LOANS RECEIVABLE
The composition of loans receivable at December 31, 2001 and 2000 is as follows:
A summary of the transactions in the allowance for loan losses is as follows:
Impaired loans, not requiring an allowance for loan losses, were $-0- at December 31, 2001 and 2000. Impaired loans requiring an allowance for loan losses were $125,000 and $253,000 at December 31, 2001 and 2000, respectively. At December 31, 2001 and 2000, the related allowance for loan losses associated with these loans was $23,000 and $74,000, respectively. For the years ended December 31, 2001, 2000 and 1999, average impaired loans were $125,000, $256,000 and $263,000, respectively. Interest income recognized on these impaired loans was $6,000, $18,000 and $14,000 in 2001, 2000 and 1999, respectively.
NOTE 4 - LOANS RECEIVABLE (CONTINUED)
Loans outstanding to directors, executive officers, principal stockholders or to their affiliates totaled $617,000 and $615,000 at December 31, 2001 and 2000, respectively. Advances and repayments during 2001 totaled $129,000 and $127,000, respectively. These loans are made during the ordinary course of business at the Company's normal credit terms. There were no related party loans that were classified as non-accrual, past due, restructured or considered a potential credit risk at December 31, 2001 and 2000.
NOTE 5 - PREMISES AND EQUIPMENT
Premises and equipment at December 31, 2001 and 2000 are comprised of the following:
NOTE 6 - DEPOSITS
The composition of deposits at December 31, 2001 and 2000 were as follows:
NOTE 6 - DEPOSITS (CONTINUED)
At December 31, 2001, the scheduled maturities of time deposits are as follows (in thousands):
NOTE 7 - SHORT-TERM BORROWINGS
Federal funds purchased, securities sold under agreements to repurchase and Federal Home Loan Bank advances generally represent overnight or less than 30-day borrowings. U.S. Treasury tax and loan notes for collections made by the Bank are payable on demand. Short-term borrowings consisted of the following at December 31, 2001 and 2000:
NOTE 7 - SHORT-TERM BORROWINGS (CONTINUED)
The Bank has an agreement with the Federal Home Loan Bank (FHLB) which allows for borrowings up to a percentage of qualifying assets. At December 31, 2001 and 2000, the Bank had a maximum borrowing capacity of approximately $107,034,000 and $109,345,000, respectively. All advances from FHLB are secured by qualifying assets of the Bank.
Securities sold under repurchase agreements are retained under the Bank's control at its safekeeping agent. The Bank may be required to provide additional collateral based on the fair value of the underlying securities.
The Bank has a $7,000,000 line of credit for the sale of federal funds with Atlantic Central Bankers Bank of which $-0- was outstanding at December 31, 2001 and 2000. These borrowings are unsecured.
NOTE 8 - LONG-TERM BORROWINGS
Long-term debt consisted of advances from the Federal Home Loan Bank under various notes.
Detail of long-term debt at December 31, 2001 and 2000 is as follows:
On convertible rate notes, the Federal Home Loan Bank has the option to convert the notes at rates ranging from the three-month LIBOR (1.88% at December 31, 2001) plus .10% to plus .20% on a quarterly basis commencing on the conversion date. If converted, the Bank has the option to repay these advances at each of the option dates without penalty. Accordingly, contractual maturities above may differ from expected maturities.
NOTE 8 - LONG-TERM BORROWINGS (CONTINUED)
Maturities of long-term debt in years subsequent to December 31, 2001 are as follows (in thousands):
The notes are secured under terms of a blanket collateral agreement by a pledge of qualifying investment and mortgage-backed securities, certain mortgage loans and a lien on FHLB stock.
NOTE 9 - STOCK PURCHASE PLANS
The Company has a stock option plan covering non-employee directors and a stock incentive plan for all officers and key employees. The Plan is administered by a committee of the Board of Directors. Under the Plan, 125,000 shares of common stock are reserved for possible issuance, subject to future adjustment in the event of specified changes in the Company's capital structure. Under the Plan, the exercise price cannot be less than 100% of the fair market value on the date of grant. The vesting period of options granted is at the discretion of the Board of Directors. Options granted during 2001, 2000 and 1999 expire in ten years.
A summary of transactions under this Plan were as follows:
The weighted-average remaining contractual life of the above options is approximately 7.7 years. Stock options outstanding at December 31, 2001 are exercisable at prices ranging from $22.20 to $27.50 a share.
NOTE 9 - STOCK PURCHASE PLANS (CONTINUED)
The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation." Accordingly, no compensation costs have been recognized for options granted in 2001, 2000 and 1999. Had compensation costs for stock options granted in 2001, 2000 and 1999 been determined based on the fair value at the grant dates for awards under the plan consistent with the provisions of SFAS No. 123, the Company's net income and earnings per share for the years ended December 31, 2001, 2000 and 1999 would have been reduced to the proforma amounts indicated below:
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions for 2001, 2000 and 1999, respectively: risk-free interest rate of 5.17%, 6.51% and 5.69%, volatility of 0.20, 0.24 and 0.17, dividend yield of $2.92%, 2.49% and 1.93%, and an expected life of 6 years. The weighted-average fair value of options granted was $5.18 per share in 2001, $7.77 per share in 2000 and $7.98 per share in 1999.
During 1999, the Company implemented a Dividend Reinvestment and Stock Purchase Plan. Under the Plan, the Company registered with the Securities and Exchange Commission 100,000 shares of the common stock to be sold pursuant to the Plan. Participation is available to all common stockholders. The Plan provides each participant with a simple and convenient method of purchasing additional common shares without payment of any brokerage commission or other service fees. A participant in the Plan may elect to reinvest dividends on all or part of their shares to acquire additional common stock. A participant may withdraw from the Plan at any time. Stockholders purchased 14,078, 11,880 and 2,527 shares in 2001, 2000 and 1999, respectively, through the Plan. Effective in 2002, the Plan was amended to permit stockholders participating in the Plan to purchase additional shares of common stock with voluntary cash payments of a minimum of $100 and a maximum of $2,500 each calendar quarter.
NOTE 10 - INCOME TAXES
The provision for federal income taxes consists of the following:
The components of the net deferred tax asset at December 31, 2001 and 2000 are as follows:
A reconciliation of the provision for income taxes and the amount that would have been provided at statutory rates for the years ended December 31 is as follows:
NOTE 10 - INCOME TAXES (CONTINUED)
The income tax provision includes $11,000, $7,000 and $29,000 in 2001, 2000 and 1999, respectively, of income tax expense to net realized securities gains.
NOTE 11 - EMPLOYEE BENEFIT PLANS
The Company has an employee stock ownership and profit-sharing plan with 401(k) provisions. The Plan is for the benefit of all employees who meet the eligibility requirements set forth in the Plan. The amount of employer contributions to the plan, including 401(k) matching contributions, is at the discretion of the Board of Directors. Employer ESOP contributions are allocated to participant accounts based on their percentage of total compensation for the Plan year. Shares of Bank stock owned by the Plan are included in the earnings per share calculation and dividends on these shares are deducted from undivided profits. During 2001, 2000 and 1999, ESOP contributions to the Plan charged to operations were $101,000, $77,000 and $72,000, respectively. During 2001, 2000 and 1999, employer 401(k) matching contributions to the Plan charged to operations were $53,000, $44,000 and $39,000, respectively. At December 31, 2001, 88,276 shares of the Company's common stock were held in the Plan. In the event a terminated Plan participant desires to sell his or her shares of the Company's stock, or for certain employees who elect to diversify their account balances, the Company may be required to purchase the shares from the participant at their fair market value.
The Bank has an agreement with its chief executive officer to establish an excess benefit retirement plan. The Plan is a non-qualified Deferred Compensation Plan in which the Bank is not required to establish a reserve. The Bank has obtained life insurance (designating the Bank as the beneficiary) on the life of the chief executive officer in an amount which is intended to cover the Bank's obligations under the Deferred Compensation Plan, based upon certain actuarial assumptions upon the death of the officer. The cost charged to operations was $100,000, $-0- and $23,000 for the years ended December 31, 2001, 2000 and 1999, respectively.
In June 2000, the Bank terminated a noncontributory pension plan covering eligible employees. The plan assets in excess of the projected benefit obligation were allocated to the Plan's eligible participants and the prepaid pension cost of $37,000 was charged to expense.
NOTE 12 - CONTINGENCIES
On October 23, 2001, the Securities and Exchange Commission filed suit against Robert L. Bentley, his d/b/a Entrust Group and Bentley Financial Services, Inc. alleging fraud in the sales of securities to financial institutions. Specifically, the Commission alleged that the defendants were representing to investors that they were selling bank-issued, federally insured certificates of deposit when they were actually selling uninsured securities issued by the defendants. The Commission alleged that the defendants have violated the broker-dealer registration and the antifraud provisions of the federal securities laws. The Commission's action seeks permanent injunctions prohibiting future violations of these provisions and others, disgorgement of the defendants/illgotten gains plus prejudgment interest, and civil penalties against each defendant. Additionally, the Commission's action sought emergency injunctive and equitable relief consisting principally of a temporary restraining order, an order freezing each defendant's assets and an order appointing a receiver. The Court granted the Commission's request on October 24, 2001 for a temporary restraining order and, on November 7, 2001, appointed a receiver for Robert L. Bentley, Entrust Group and Bentley Financial Services, Inc. (collectively the Bentley Receivership Entities). The receiver was required to take control of all investments and assets of the Bentley Receivership Entities.
NOTE 12 - CONTINGENCIES (CONTINUED)
The Bank regularly invested through Entrust Group and Bentley Financial Services, Inc. for certificates of deposit that the Bank had understood were bank issued, federally insured and the Entrust Group was holding in safekeeping for them. As of December 31, 2001, the Bank had $1,980,000 of these investments outstanding with Entrust Group. Based on preliminary information, management estimates the loss to be approximately $139,000, which has been charged against operations for the year ended December 31, 2001 and the asset has been written down to $1,841,000. Since the ultimate resolution of this matter is presently unknown, it is reasonably possible that the loss estimate could change and the change could be material. The $1,841,000 net claim with the receiver is included in other assets on the consolidated balance sheet of the Company as of December 31, 2001.
The Company is a defendant in various lawsuits wherein various amounts are claimed. In the opinion of the Company's management, these suits are without merit and should not result in judgments which, in the aggregate, would have a material adverse effect on the Company's consolidated financial statements.
NOTE 13 - FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND CONCENTRATION OF CREDIT RISK
The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contract or notional amounts of those instruments reflect the extent of involvement the Bank has in particular classes of financial instruments. Standby letters of credit commit the Bank to make payments on behalf of customers when certain specified future events occur. Commitments to extend credit are agreements to lend to the 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. Since many of the commitments are expected to expire in one year or less without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
The Bank's exposure to credit loss is essentially the same for these items as that involved in extending loans to customers. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Collateral is obtained based on management's credit assessment of the particular customer.
The contract or notional amounts at December 31, 2001 and 2000 were as follows:
NOTE 13 - FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND CONCENTRATION OF CREDIT RISK (CONTINUED)
The Bank grants commercial, consumer and residential loans to customers primarily in the Susquehanna/Wyoming County, Pennsylvania and Broome County, New York areas. The concentrations of credit by type of loan are set forth in Note 4. The Bank does not have any significant concentrations to any one industry or customer. Although the Bank has a diversified loan portfolio, its debtors' ability to honor their contracts is influenced by the region's economy.
NOTE 14 - REGULATORY MATTERS
The Bank is required to maintain average cash reserve balances in vault cash and with the Federal Reserve Bank based on a percentage of deposits. The required reserve balance at December 31, 2001 and 2000 was $2,225,000 and $1,534,000, respectively.
Dividends are paid by the Company from its assets, which are mainly provided by dividends from the Bank. However, certain restrictions exist regarding the ability of the Bank to transfer funds to the Company in the form of cash dividends, loans or advances. Under such restrictions, the Bank may not, without the prior approval of the Comptroller of the Currency, declare dividends in excess of the sum of the current year's earnings (as defined) plus the retained earnings (as defined) from the prior two years. Under this restriction, the Bank, without prior regulatory approval, can declare dividends to the Company totaling $4,385,000, plus an additional amount equal to the net profit for 2002, up to the date any such dividend is declared.
The Company is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of its assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the maintenance of minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier 1 capital to average assets (as defined). Management believes, as of December 31, 2001, that the Company and Bank meet all capital adequacy requirements to which they are subject.
NOTE 14 - REGULATORY MATTERS (CONTINUED)
As of December 31, 2001, the most recent notification from the Office of the Comptroller of the Currency categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table below. There are no conditions or events since that notification that management believes have changed the Bank's category.
The Company and Bank's actual capital ratios as of December 31, 2001 and 2000, and the minimum ratios required for capital adequacy purposes and to be well capitalized under the prompt corrective action provisions are as follows:
NOTE 15 - FAIR VALUE OF FINANCIAL INSTRUMENTS
Management uses its best judgment in estimating the fair value of the Company's financial instruments, however, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts the Company could have realized in a sales transaction on the dates indicated. The estimated fair value amounts have been measured as of their respective year ends, and have not been reevaluated or updated for purposes of these financial statements subsequent to those respective dates. As such, the estimated fair values of these financial instruments subsequent to the respective reporting dates may be different than the amounts reported at each year end.
The following information should not be interpreted as an estimate of the fair value of the entire Company since a fair value calculation is only provided for a limited portion of the Company's assets. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between the Company's disclosures and those of other companies may not be meaningful. The following methods and assumptions were used to estimate the fair values of the Company's financial instruments at December 31, 2001 and 2000:
Cash and Cash Equivalents
The carrying amounts of cash and cash equivalents approximate their fair value.
Securities
Fair values for securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments.
Loans Receivable
For variable-rate loans that reprice frequently and which entail no significant changes in credit risk, fair values are based on carrying amounts. The fair values of fixed rate loans are estimated using discounted cash flow analyses, based on interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.
Accrued Interest Receivable
The carrying amount of accrued interest receivable approximates its fair value.
Deposits
The fair values for demand deposits, savings accounts and certain money market accounts are, by definition, equal to the amount payable on demand at the reporting date (that is, their carrying amounts). The fair values for certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated contractual maturities on such time deposits.
Accrued Interest Payable
The carrying amount of accrued interest payable approximates fair value.
NOTE 15 - FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)
Short-Term Borrowings
The carrying amounts of short-term borrowings approximate their fair values.
Long-Term Borrowings
The fair values of the Bank's long-term debt are estimated using discounted cash flow analyses based on the Bank's current incremental borrowing rates for similar types of borrowing arrangements.
Commitments to Extend Credit and Standby Letters of Credit
These financial instruments are generally not subject to sale, and estimated fair values are not readily available. The carrying value, represented by the net deferred fee arising from the unrecognized commitment or letter of credit and the fair value, determined by discounting the remaining contractual fee over the term of the commitment using fees currently charged to enter into similar agreements with similar risk, are not considered material for disclosure. The contractual amounts of unfunded commitments and letters of credit are presented in Note 13.
The estimated fair values of the Company's financial instruments are as follows:
NOTE 16 - PARENT COMPANY ONLY FINANCIAL INFORMATION
BALANCE SHEETS
NOTE 16 - PARENT COMPANY ONLY FINANCIAL INFORMATION (CONTINUED)
STATEMENTS OF INCOME
NOTE 16 - PARENT COMPANY ONLY FINANCIAL INFORMATION (CONTINUED)
STATEMENTS OF CASH FLOWS
ITEM 9
ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE On February 28, 2001, the Board of Directors of the Company approved the engagement of the accounting firm of Beard Miller Company LLP as their independent accountants to replace Prociak & Associates, LLC. Information pertaining to this change can be found in the previously submitted 8-K dated March 7, 2001, and the 8-K/A dated March 12, 2001 and March 16, 2001.
PART III ITEM 10
ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT This item is incorporated by reference under the previously submitted document DEF 14A filed with the SEC on March 8, 2002.
ITEM 11
ITEM 11 EXECUTIVE COMPENSATION This item is incorporated by reference under the previously submitted document DEF 14A filed with the SEC on March 8, 2002.
ITEM 12
ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT This item is incorporated by reference under the previously submitted document DEF 14A filed with the SEC on March 8, 2002.
ITEM 13
ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS This item is incorporated by reference under the previously submitted document DEF 14A filed with the SEC on March 8, 2002.
PART IV ITEM 14
ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Financial Statement Schedules can be found under Item 8 of this report.
(b) Other events and reports on Form 8-K that have been previously filed are as follows: Press Release of Peoples Financial Services Corp. dated November 19, 2001, Purchase of Subsidiary, previously submitted as Exhibit 99.1 Press Release of Peoples Financial Services Corp. dated October 23, 2001, Third Quarter Results, previously submitted as Exhibit 99.012
Exhibits required by Item 601 of Regulation S-K: (3.1) Articles of Incorporation of Peoples Financial Services Corp. * (3.2) By laws of Peoples Financial Service Corp. as amended ** (10.1) Agreement dated January 14, 1997, between John W. Ord and Peoples Financial Services Corp. * (10.2) Excess Benefit Plan dated January 14, 1992, for John W. Ord * (10.4) Termination Agreement dated January 1, 1997, between Debra E. Dissinger and Peoples Financial Services Corp.* (11) The statement regarding computation of per share earnings required by this exhibit is contained in Note 1 to the consolidated financial statements captioned "Earnings Per Common Share" filed as part of Item 8 of this report. (21) Subsidiaries of Peoples Financial Services Corp. * (23.1) Consent of Independent Auditors - Beard Miller Company, LLP, filed herewith (23.2) Consent of Independent Auditors - Prociak & Associates, LLC, filed herewith (99) Report of Independent Auditors - Prociak & Associates, LLC, filed herewith
* Incorporated by reference to the Corporation's Registration Statement on Form 10 as filed with the U.S. Securities and Exchange Commission on March 4, 1998
** Incorporated by reference to Exhibit 99.6 on Form 8K as filed with the U.S. Securities and Exchange Commission on April 20, 2001
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
PEOPLES FINANCIAL SERVICES CORP
By /s/John W. Ord John W. Ord, President and Chief Executive Officer
/s/Debra E. Dissinger Debra E. Dissinger, Executive Vice President
/s/Frederick J. Malloy Frederick J. Malloy, Principal Accounting Officer
/s/Jack M. Norris Jack M. Norris, Member, Board of Directors
/s/Gerald R. Pennay Gerald R. Pennay, Member, Board of Directors
/s/George H. Stover, Jr. George H. Stover, Jr., Member, Board of Directors
/s/Thomas F. Chamberlain Thomas F. Chamberlain, Member, Board of Directors
/s/Russell Shurtleff Russell Shurtleff, Member, Board of Directors
EXHIBIT 23.1
CONSENT OF BEARD MILLER COMPANY LLP INDEPENDENT AUDITORS
We consent to the incorporation by reference in this Annual Report (Form 10-K) of Peoples Financial Services Corp. of our report dated January 4, 2002 included in the 2001 Annual Report to Stockholders of Peoples Financial Services Corp.
We consent to the incorporation by reference in the Registration Statement, No. 333-84169, of our report dated January 4, 2002, with respect to the consolidated financial statements of Peoples Financial Services Corp. included in this Annual Report (Form 10-K) for the year ended December 31, 2001.
/s/ BEARD MILLER COMPANY LLP
Allentown, Pennsylvania March 27, 2002
EXHIBIT 23.2
CONSENT OF PROCIAK & ASSOCIATES, L.L.C. INDEPENDENT AUDITORS
We consent to the incorporation by reference in this Annual Report (Form 10-K) of Peoples Financial Services Corp. of our report dated February 15, 2001 included in the 2001 Annual Report to Stockholders of Peoples Financial Services Corp.
We consent to the incorporation by reference in Registration Statement No. 333-84169 of Peoples Financial Services Corp. and in the related Prospectus of our report dated February 15, 2001 with respect to the consolidated financial statements of Peoples Financial Services Corp. incorporated by reference in this Annual Report (Form 10-K) for the year ended December 31, 2001.
/s/PROCIAK & ASSOCIATES, L.L.C.
Wilkes-Barre, Pennsylvania March 27, 2002
EXHIBIT 99
INDEPENDENT AUDITOR'S REPORT
To the Board of Directors Peoples Financial Services Corp. Hallstead, Pennsylvania
We have audited the accompanying consolidated balance sheet of Peoples Financial Services Corp. and its subsidiary as of December 31, 2000, and the related consolidated statements of income, stockholders' equity and cash flows for the years ended December 31, 2000 and 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Peoples Financial Services Corp. and its subsidiary as of December 31, 2000, and the results of their operations and their cash flows for the years ended December 31, 2000 and 1999 in conformity with accounting principles generally accepted in the United States of America.
/s/PROCIAK & ASSOCIATES, L.L.C.
Wilkes-Barre, Pennsylvania February 15, 2001