Item 1. Business
General
Franklin Financial Services Corporation (the "Corporation") was organized as a Pennsylvania business corporation on June 1, 1983 and is a registered bank holding company under the Bank Holding Company Act of 1956, as amended (the "BHCA"). On January 16, 1984, pursuant to a plan of reorganization approved by the shareholders of Farmers and Merchants Trust Company of Chambersburg ("F&M Trust" or "the Bank") and the appropriate regulatory agencies, the Corporation acquired all the shares of F&M Trust and issued its own shares to former F&M Trust shareholders on a share-for-share basis.
On May 1, 1995, the Mont Alto State Bank, also a commercial bank and a subsidiary of the Corporation, was merged into Farmers and Merchants Trust Company. In addition, on December 29, 1995, Franklin Founders Life Insurance Company, a credit life reinsurance company and a subsidiary of the Corporation, was liquidated. The Corporation conducts all of its business through its only direct subsidiary, F&M Trust, which is wholly owned. F&M Trust, established in 1906, is a full-service, Pennsylvania - -chartered commercial bank and trust company, which is not a member of the Federal Reserve System. F&M Trust, which operates 12 full service offices in Franklin and Cumberland Counties, Pennsylvania, engages in general commercial, retail banking and trust services normally associated with community banks and its deposits are insured (up to applicable limits) by the Federal Deposit Insurance Corporation (the "FDIC"). A wide variety of banking services are offered by F&M Trust to businesses, individuals, and governmental entities. These services include, but are not necessarily limited to, accepting and maintaining checking, savings, and time deposit accounts, providing investment and trust services, making loans and providing safe deposit facilities.
The Corporation's subsidiary is not dependent upon a single customer or a few customers for a material part of its business. Thus, the loss of any customer or identifiable group of customers would not materially affect the business of the Corporation or F&M Trust in an adverse manner. Also, none of the Corporation's business is seasonal. The Bank's lending activities consist primarily of commercial, agricultural and industrial loans, installment and revolving loans to consumers, residential mortgage loans, and construction loans. Secured and unsecured commercial and industrial loans, including accounts receivable, inventory financing and commercial equipment financing, are made to small and medium-sized businesses, individuals, governmental entities, and non-profit organizations. F&M Trust also participates in Pennsylvania Higher Education Assistance Act student loan programs and Pennsylvania Housing Finance Agency programs.
Installment loans involve both direct loans to consumers and the purchase of consumer obligations from dealers and others who have sold or financed the purchase of merchandise, including automobiles and mobile homes, to their customers. The Bank's mortgage loans include long- term loans to individuals and to businesses secured by mortgages on the borrower's real property. Construction loans are made to finance the purchase of land and the construction of buildings thereon, and are secured by short-term mortgages on real estate. In certain situations, the Bank acquires properties through foreclosure on delinquent loans. The Bank holds these properties until such time as they are in a marketable condition and a buyer can be obtained.
F&M Trust's Investment and Trust Services Department offers all of the personal and corporate trust services normally associated with trust departments of area banks including: estate planning and administration, corporate and personal trust fund management, pension, profit sharing and other employee benefits funds management, custodial services, and trustee services for publicly issued debentures. F&M Trust's Personal Investment Center sells mutual fund, annuity and selected insurance products.
Competition
The Corporation and its subsidiary operate in a competitive environment that has intensified in the past few years as they have been compelled to share their market with institutions that are not subject to the regulatory restrictions on domestic banks and bank holding companies. Profit margins in the traditional banking business of lending and gathering deposits has declined as deregulation has allowed nonbanking institutions to offer alternative services to many of F&M Trust's customers.
The principal market of F&M Trust is in Franklin County and western Cumberland County, Pennsylvania. Eleven commercial bank competitors of F&M Trust have offices in this region, in addition to credit unions, savings and loan associations, mortgage banks, brokerage firms and other competitors. F&M Trust is the largest financial institution headquartered in Franklin County and had total assets of approximately $444,700,000 on December 31, 1999.
All of the local commercial bank competitors of the Corporation are subsidiaries of bank holding companies. The Corporation ranks seventh in size of the twelve bank holding companies having offices in its primary market.
Staff
As of December 31, 1999, the Corporation and its subsidiary had 191 full-time equivalent employees. Most employees participate in pension, profit sharing/bonus, and employee stock purchase plans and are provided with group life, health and major medical insurance. Management considers employee relations to be excellent.
Supervision and Regulation
Various requirements and restrictions under the laws of the United States and under Pennsylvania law affect the Corporation and its subsidiaries.
General
The Corporation is registered as a bank holding company and is subject to supervision and regulation by the Board of Governors of the Federal Reserve System under the Bank Holding Act of 1956, as amended. As a bank holding company, the Corporation's activities and those of its bank subsidiary are limited to the business of banking and activities closely related or incidental to banking. Bank holding companies are required to file periodic reports with and are subject to examination by the Federal Reserve Board. The Federal Reserve Board has issued regulations under the Bank Holding Company Act that require a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks. As a result, the Federal Reserve Board, pursuant to such regulations, may require the Corporation to stand ready to use its resources to provide adequate capital funds to its bank subsidiary during periods of financial stress or adversity.
The Bank Holding Company Act prohibits the Corporation from acquiring direct or indirect control of more than 5% of the outstanding shares of any class of voting stock, or substantially all of the assets of, any bank, or from merging or consolidating with another bank holding company, without prior approval of the Federal Reserve Board. Additionally, the Bank Holding Company Act prohibits the Corporation from engaging in or from acquiring ownership or control of more than 5% of the outstanding shares of any class of voting stock of any company engaged in a non-banking business, unless such business is determined by the Federal Reserve Board to be so closely related to banking as to be a proper incident thereto. The types of businesses that are permissible for bank holding companies to own have been expanded by recent federal legislation.
As a Pennsylvania bank holding company for purposes of the Pennsylvania Banking Code, the Corporation is subject to regulation and examination by the Federal Reserve Board.
The Bank is a state chartered bank that is not a member of the Federal Reserve System and its deposits are insured (up to applicable limits) by the Federal Deposit Insurance Corporation (the "FDIC"). The Bank is subject to regulation and examination by the FDIC the Federal Reserve Board and the Pennsylvania Department of Banking., and to a lesser extent by the FDIC. The Bank is also subject to requirements and restrictions under federal and state law, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be granted and the interest that may be charged thereon, and limitations on the types of investments that may be made and the types of services that may be offered. The Community Reinvestment Act requires the Bank to help meet the credit needs of the entire community where the Bank operates, including low and moderate income neighborhoods. The Bank's rating under the Community Reinvestment Act, assigned by the FDIC Federal Reserve Board pursuant to an examination of the Bank, is important in determining whether the bank may receive approval for, or utilize certain streamlined procedures in, applications to engage in new activities. Various consumer laws and regulations also affect the operations of the Bank. In addition to the impact of regulation, commercial banks are affected significantly by the actions of the Federal Reserve Board as it attempts to control the money supply and credit availability in order to influence the economy.
Capital Adequacy Guidelines
Bank holding companies are required to comply with the Federal Reserve Board's risk-based capital guidelines. The required minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) is 8%. At least half of the total capital is required to be "Tier 1 capital," consisting principally of common shareholders' equity, less certain intangible assets. The remainder ("Tier 2 capital") may consist of certain preferred stock, a limited amount of subordinated debt, certain hybrid capital instruments and other debt securities, and a limited amount of the general loan loss allowance. The riskbased capital guidelines are required to take adequate account of interest rate risk, concentration of credit risk, and risks of nontraditional activities.
In addition to the risk-based capital guidelines, the Federal Reserve Board requires a bank holding company to maintain a leverage ratio of a minimum level of Tier 1 capital (as determined under the risk-based capital guidelines) equal to 3% of average total consolidated assets for those bank holding companies which have the highest regulatory examination ratings and are not contemplating or experiencing significant growth or expansion. All other bank holding companies are required to maintain a ratio of at least 1% to 2% above the stated minimum. The Bank is subject to almost identical capital requirements also adopted by the FDIC. Although not adopted in regulation form, the Pennsylvania Department of Banking utilizes capital standards requiring In addition to Federal Reserve capital requirements, the Pennsylvania Department of Banking also requires state chartered banks to maintain a minimum of 6% leverage capital level and 10% risk-based capital, defined substantially the same as those by the FDIC.as the federal regulations.
Prompt Corrective Action Rules
The federal banking agencies have regulations defining the levels at which an insured institution would be considered "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." The applicable federal bank regulator for a depository institution could, under certain circumstances, reclassify a "well-capitalized" institution as "adequately capitalized" or require an "adequately capitalized" or "undercapitalized" institution to comply with supervisory actions as if it were in the next lower category. Such a reclassification could be made if the regulatory agency determines that the institution is in an unsafe or unsound condition (which could include unsatisfactory examination ratings). The Corporation and the Bank each satisfy the criteria to be classified as "well capitalized" within the meaning of applicable regulations.
Regulatory Restrictions on Dividends
Dividend payments by the Bank to the Corporation are subject to the Pennsylvania Banking Code, the Federal Deposit Insurance Act, and the regulations of the FDIC Federal Reserve. Under the Banking Code, no dividends may be paid except from "accumulated net earnings" (generally, retained earnings). The Federal Reserve Board and the FDIC have formal and informal policies which provide that insured banks and bank holding companies should generally pay dividends only out of current operating earnings, with some exceptions. The Prompt Corrective Action Rules, described above, further limit the ability of banks to pay dividends, because banks which are not classified as well capitalized or adequately capitalized may not pay dividends.
FDIC Insurance Assessments
The FDIC has implemented a risk-related premium schedule for all insured depository institutions that results in the assessment of premiums based on capital and supervisory measures. Under the risk-related premium schedule, the FDIC assigns, on a semiannual basis, each depository institution to one of three capital groups (well - -capitalized, adequately capitalized or undercapitalized) and further assigns such institution to one of three subgroups within a capital group. The institution's subgroup assignment is based upon the FDIC's judgment of the institution's strength in light of supervisory evaluations, including examination reports, statistical analyses and other information relevant to measuring the risk posed by the institution. Only institutions with a total capital to risk-adjusted assets ratio of 10% or greater, a Tier 1 capital to risk-based assets ratio of 6% or greater, and a Tier 1 leverage ratio of 5% or greater, are assigned to the well-capitalized group. As of December 31, 1999, the Bank was well capitalized for purposes of calculating insurance assessments.
The Bank Insurance Fund is presently fully funded at more than the minimum amount required by law. Accordingly, the 2000 Bank Insurance Fund assessment rates range from zero for those institutions with the least risk, to $0.27 for every $100 of insured deposits for institutions deemed to have the highest risk. The Bank is in the category of institutions that presently pay nothing for deposit insurance. The FDIC adjusts the rates every six months.
While the Bank presently pays no premiums for deposit insurance, it is subject to assessments to pay the interest on Financing Corporation bonds. The Financing Corporation was created by Congress to issue bonds to finance the resolution of failed thrift institutions. Prior to 1997, only thrift institutions were subject to assessments to raise funds to pay the Financing Corporation 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 and provided that commercial banks would be subject to 1/5 of the assessment to which thrifts are subject for Financing Corporation bond payments through 1999. Beginning in 2000, commercial banks and thrifts are subject to the same assessment for Financing Corporation bonds. The FDIC sets the Financing Corporation assessment rate every quarter. The Financing Corporation assessment for the Bank (and all other banks) for the first quarter of 2000 is an annual rate of $.0212 for each $100 of deposits.
New Legislation
Landmark legislation in the financial services area was signed into law by the President on November 12, 1999. The Gramm-Leach-Bliley Act dramatically changes certain banking laws that have been in effect since the early part of the 20th century. The most radical changes are that the separation between banking and the securities businesses mandated by the Glass-Steagall Act has now been removed, and the provisions of any state law that prohibits affiliation between banking and insurance entities have been preempted. Accordingly, the new legislation now permits firms engaged in underwriting and dealing in securities, and insurance companies, to own banking entities, and permits bank holding companies (and in some cases, banks) to own securities firms and insurance companies. The provisions of federal law that preclude banking entities from engaging in non- financially related activities, such as manufacturing,have not been changed. For example, a manufacturing company cannot own a bank and become a bank holding company, and a bank holding company cannot own a subsidiary that is not engaged in financial activities, as defined by the regulators.
The new legislation creates a new category of bank holding company called a "financial holding company." In order to avail itself of the expanded financial activities permitted under the new law, a bank holding company must notify the Federal Reserve that it elects to be a financial holding company. A bank holding company can make this election if it, and all its bank subsidiaries, are well capitalized, well managed, and have at least a satisfactory Community Reinvestment Act rating, each in accordance with the definitions prescribed by the Federal Reserve and the regulators of the subsidiary banks. Once a bank holding company makes such an election, and provided that the Federal Reserve does not object to such election by such bank holding company, the financial holding company may engage in financial activities (i.e., securities underwriting, insurance underwriting, and certain other activities that are financial in nature as to be determined by the Federal Reserve) by simply giving a notice to the Federal reserve within thirty days after beginning such business or acquiring a company engaged in such business. This makes the regulatory approval process to engage in financial activities much more streamlined than it was under prior law.
The Corporation believes it qualifies to become a financial holding company, but has not yet determined whether it will file to become treated as one. The Federal Reserve has only recently promulgated rules implementing these provisions of the new legislation, and the Corporation may wait to see what the experience of other companies is under the new rules before it makes an election.
The new law also permits certain financial activities to be undertaken by a subsidiary of a national bank. As the Bank is not a national bank, these provisions do not apply directly to the Bank. Generally, for financial activities that are conducted as a principal, such as an underwriter or dealer holding an inventory, a national bank must be one of the 100 largest national banks in the United States and have debt that is rated investment grade. National banks that are not one of the 100 largest national banks in the United States are not authorized under the new law to conduct financial activities as a principal. However, such smaller national banks may own a securities broker or an insurance agency and certain other financial agency entities under the new law. Under prior law, national banks could only own an insurance agency if it was located in a town of fewer than 5,000 residents, or under certain other conditions. Under the new law, there is no longer any restriction on where the insurance agency subsidiary of a national bank is located or does business. As a Pennsylvania bank, the Bank is permitted under Pennsylvania law to own and operate an insurance agency without restriction, and could also own and operate a securities brokerage.
In addition to the foregoing provisions of the new law that make major changes to the federal banking laws, the new legislation also makes a number of additions and revisions to numerous federal laws that affect the business of banking. For example, there is now a federal law on privacy with respect to customer information held by banks. The federal banking regulators are authorized to adopt rules regarding privacy for customer information. Banks must establish a disclosure policy for non-public customer information, disclose the policy to their customers, and give their customers the opportunity to object to non-public information being disclosed to a third party. Also, the Community Reinvestment Act has been amended by the new law to provide that small banks (those under $250 million in assets) that previously received an "outstanding" on their last CRA exam will not have to undergo another CRA exam for five years, or for four years if their last exam was "satisfactory." In addition, any CRA agreement entered into between a bank and a community group must be disclosed, with both the bank and the group receiving any grants from the bank detailing the amount of funding provided and what it was used for. The new law also requires a bank's policy on fees for transactions at ATM machines by non-customers to be conspicuously posted on the ATM. Several other provisions affecting other general regulatory requirements for banking institutions were also adopted.
It is too early to tell what effect the Gramm-Leach-Bliley Act may have on the Corporation and the Bank. The intent and scope of the act is positive for the financial industry, and is an attempt to modernize federal banking laws and make U. S. institutions competitive with those from other countries. While the legislation makes significant changes in U. S. banking law, such changes may not directly affect the Corporation's business unless it decides to avail itself of new opportunities available under the new law. The Corporation does not expect any of the provisions of the new Act to have a materially adverse effect on its existing operations, or to significantly increase its costs.
Separately from the Gramm-Leach-Bliley Act, Congress is often considering some financial industry legislation. The Corporation cannot predict how any new legislation, or new rules adopted by the federal banking agencies, may affect its business in the future.
Selected Statistical Information
Certain statistical information is included in this report as part of Management's Discussion and Analysis of Financial Condition and Results of Operations.
Item 2.
Item 2. Properties
The Corporation's headquarters is located in the main office of F&M Trust at 20 South Main Street, Chambersburg, Pennsylvania. The Corporation owns one property in Franklin County, Pennsylvania that is used by F&M Trust for bank operations.
In addition to its main office, F&M Trust owns eleven properties and leases one property, all of which are used for banking offices and operations. F&M Trust also leases three locations for off-site ATM facilities. The bank owns one property slated for demolition as part of an expansion of the headquarters facility. This project is scheduled to begin in 2000. All of the properties owned by the bank are located in Franklin and Cumberland Counties, Pennsylvania.
Item 3.
Item 3. Legal Proceedings
None
Item 4.
Item 4. Submission 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
Market and Dividend Information
The Corporation's common stock is not actively traded in the overthe-counter market. The Corporation's stock is listed under the symbol "FRAF" on the O.T.C. Electronic Bulletin Board, an automated quotation service. Current price information is available from account executives at most brokerage firms as well as the registered market makers of Franklin Financial Services Corporation common stock as listed below under Shareholders' Information.
There were 1,945 shareholders of record as of December 31, 1999. The range of high and low bid prices, as reported by local sources is shown below for the years 1999 and 1998. Also shown are the cash dividends declared for the same years.
Per Share 1999 High Low Cash dividends declared*
First quarter $30.00 $28.00 $0.56 Second quarter 31.25 29.75 0.16 Third quarter 29.75 23.00 0.18 Fourth quarter 23.125 20.375 0.18
$1.08
Per Share 1998 High Low Cash dividends declared*
First quarter $36.00 $32.83 $- Second quarter 37.75 36.00 0.15 Third quarter 37.00 30.00 0.16 Fourth quarter 30.00 29.00 0.16
$0.47
* In the first quarter of 1999 the Board declared a special cash dividend of $.40 per share in addition to a regular cash dividend of $.16 per share. In November, 1997, the Board declared the first quarter 1998 cash dividend of $.15 per share.
Shareholders' Information
Dividend Reinvestment Plan
Franklin Financial Services Corporation offers a dividend reinvestment program whereby shareholders with stock registered in their own names may reinvest their dividends in additional shares of the Corporation. Information concerning this optional program is available by contacting the Corporate Secretary at 20 South Main Street, P.O. Box 6010, Chambersburg, PA 17201-6010, telephone 717/264-6116.
Dividend Direct Deposit Program
Franklin Financial Services Corporation offers a dividend direct deposit program whereby shareholders with registered stock in their own names may choose to have their dividends deposited directly into the bank account of their choice on the dividend payment date. Information concerning this optional program is available by contacting the Corporate Secretary at 20 South Main Street, P.O. Box 6010, Chambersburg, PA 17201-6010, telephone 717/264-6116.
Annual Meeting
The Annual Shareholders' Meeting will be held on Tuesday, April 25, 2000, at the Lighthouse Restaurant, 4301 Philadelphia Avenue, Chambersburg. The Business Meeting will begin at 10:30 a.m. and will be followed by a luncheon served at 12:00 noon.
Stock Information
The following brokers are registered as market makers of Franklin Financial Services Corporation's common stock:
Ferris Baker Watts 17 East Washington Street Hagerstown, MD 21740 800/344-4413
Tucker Anthony Cleary Gull (A division of Tucker Anthony Inc.)
2101 Oregon Pike Lancaster, PA 17601 800/646-8647
F.J. Morrissey & Co., Inc. 1700 Market Street, Suite 1420, Philadelphia, PA 19103-3913 215/563-3296
Ryan, Beck & Co. 3 Parkway, Philadelphia, Pa 19102 800/223-8969
Registar and Transfer Agent
The registrar and transfer agent for Franklin Financial Services Corporation is Fulton Bank, P.O. Box 4887, Lancaster, PA 17604.
Item 6.
Item 6. Selected Financial Data
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis is intended to assist the reader in reviewing the financial information presented and should be read in conjunction with the consolidated financial statements and other financial data presented elsewhere herein.
Results of Operations: Summary
Franklin Financial Services Corporation reported steady improvement in earnings for 1999. Net income reached $5,084,000 for the year ended December 31, 1999, an increase of $279,000, or 5.81%, over the $4,805,000 reported for the year ended December 31, 1998. Net income reported for the year ended December 31, 1997, was $4,363,000. Basic earnings per share for 1999 were $1.86 compared to $1.76 and $1.59 per share for 1998 and 1997, respectively. Return on average equity increased to 12.95% for 1999 compared to 12.58% and 12.03% for 1998 and 1997, respectively. The improvement in net income came primarily from net interest income, trust fee income and controlled noninterest expense. Average interest-earning assets grew $55.5 million, or 15.82% to $406.3 million for 1999 compared to $350.8 million for 1998. Average interest- bearing liabilities grew $55.0 million, or 19.01%, to $344.7 million for 1999 compared to $289.7 million for 1998 and contributed to the decline in net interest margin to 3.88% in 1999 from 4.36% in 1998. Noninterest income, excluding securities gains, was up 4.46% to $4.2 million for 1999, primarily the result of a $400,000 growth in trust fee income. Noninterest expense was up 1.81% to $11.8 million due to higher salaries and employee benefits, higher advertising and data processing expense, all of which were largely offset by lower other expense related to nonrecurring demolition and real estate write-down expenses occurring in 1998.
A more detailed discussion on the areas having the greatest impact on the reported results for 1999 follows.
Net Interest Income
The most important source of the Corporation's earnings is net interest income which is defined as the difference between income on interest-earning assets and the expense of interest-bearing liabilities supporting those assets. Principal categories of interest-earning assets are loans and securities, while deposits, securities sold under agreements to repurchase (Repos), short-term borrowings and long-term debt are the principal categories of interestbearing liabilities. For the purpose of this discussion net interest income is adjusted to a tax-equivalent basis. This adjustment facilitates performance comparisons between taxable and tax-free assets by increasing the tax-free income an amount equivalent to the Federal income taxes which would have been paid if this income were taxable at the Corporation's 34% Federal statutory rate. Net interest income increased $494,000 to $15.8 million in 1999 from $15.3 million in 1998. The net interest margin, which reflects interest rate spread plus the contribution of assets funded by noninterest-bearing sources, decreased to 3.88% for the year ended December 31, 1999, from 4.36% and 4.59% for the years ended December 31, 1998 and 1997, respectively. A strong competitive environment for loans and deposits, market-indexed deposit products and a steady rise in interest rates all contributed to the Corporation's declining net interest margin.
Table 1 presents net interest income on a tax-equivalent basis for each of the years in the three-year period ended December 31, 1999. Table 2 presents average balances (which will be used in this discussion unless otherwise noted), tax equivalent interest income and interest expense and average rates earned and paid on the Corporation's interest-earning assets and interest-bearing liabilities. Table 3 analyzes the changes attributable to the volume and rate components of net interest income.
Table 1. Net Interest Income (Unaudited)
Net interest income is affected primarily by variations in the volume and mix of the Corporation's assets and liabilities, as well as by changes in the level of interest rates. Short-term interest rates rose steadily during 1999 from lows at year-end 1998. The average prime rate and Federal funds rate in 1999 were 8.00% and 4.95%, respectively, versus 8.35% and 5.36%, respectively, in 1998. Intermediate and long-term interest rates rose steadily throughout the year as the credit markets became increasingly concerned about the prospects of a tighter monetary policy. This concern caused a significant reduction in mortgage origination volume which adversely impacted the Corporation.
The volume of average interest-earning assets and average interest-bearing liabilities each increased approximately $55.0 million in 1999 over 1998. The yield on interest-earning assets declined 53 basis points to 7.58% for 1999 from 8.11% for 1998. Concurrently, the rates paid on interest-bearing liabilities declined only 19 basis points to 4.35% for 1999 from 4.54% in 1998. Table 3 indicates that, although the decline in yields on interest-earning assets outpaced the decline in rates paid on interest-bearing liabilities by 34 basis points, the strong growth in asset volume helped to offset the adverse impact to the net interest margin and net interest income from the unequal decline in yields earned on earning assets and interest rates paid on interest-bearing liabilities.
The growth in average earning assets came primarily from the investment portfolio (up $35.3 million, or 38.6%) and the loan portfolio (up $19.9 million, or 7.86%). Asset growth was funded primarily from interest-bearing deposits (up $32.0 million, or 12.4%), Repos (up $5.6 million, or 27.7%) and long-term debt (up $18.8 million or 143.8%).
Interest rates were marginally lower in 1998 versus 1997. The average prime rate and the average Federal funds rates in 1998 were 8.35% and 5.36%, respectively, versus 8.44% and 5.48%, respectively, in 1997. Net interest income on a tax-equivalent basis rose $401,000 to $15.3 million in 1998 from $14.9 million in 1997. Average earning assets grew $26.4 million to $350.8 million for 1998 compared to $324.3 million in 1997 while the yield decreased 25 basis points to 8.11%. Average interest-bearing liabilities grew $20.3 million to $289.7 million in 1998 versus $269.4 million in 1997 with the rate paid on those liabilities remaining unchanged at 4.54%. The net interest margin decreased to 4.36% for the year ended December 31, 1998 from 4.59% for the year ended December 31, 1997 and resulted more from changes in volume than in changes in interest rates.
Table 2. Analysis of Net Interest Income (Unaudited)
Table 3. Rate-Volume Analysis of Net Interest Income (Unaudited)
Provision for Possible Loan Losses
The provision for possible loan losses charged against earnings in 1999 was $830,000 compared to $1.061 million and $936,000 in 1998 and 1997, respectively. The lower provision in 1999 versus 1998 was directly related to lower net charge-offs in 1999 versus 1998. Net charge-offs in 1999 totaled $520,000 compared to $816,000 and $692,000 in 1998 and 1997, respectively. Management performs a quarterly analysis of the loan portfolio considering current economic conditions and other relevant factors to determine the adequacy of the allowance for possible loan losses. For more information, refer to the loan quality discussion and Table 13.
Noninterest Income and Expense
1999 versus 1998: Noninterest income, excluding securities gains, grew 4.46%, or $180,000 to $4.2 million for the year ended December, 31, 1999, compared to the same period ended December 31, 1998. Trust fee income was up $400,000 to $2.2 million in 1999 from $1.8 million in 1998. An aggressive sales culture from traditional trust business contributed to the strong increase in trust fee income. Trust assets were up $18.5 million to $419.5 million in market value at December 31, 1999 compared to $401.0 million at December 31, 1998.
Other income was down $185,000, or 74.0%, to $65,000 in 1999 from $250,000 in 1998. The recognition of a deferred gain in 1998 from the 1993 sale of a real estate subsidiary accounted for the large variance in other income between 1999 and 1998.
The Corporation recognized securities gains totaling $289,000 in 1999, down $336,000 from the $625,000 recognized in 1998. Securities gains produced from the sale of available for sale equity securities offset expenses associated with an executive management long-term incentive plan and loan loss provision expense.
Total noninterest expense was up $210,000, or 1.81% to $11.8 million for the year ended December 31, 1999 compared to $11.6 million for the year ended December 31, 1998. Salaries and employee benefits, advertising, data processing and other expense are the primary expense categories related to the net increase. Salaries and benefits increased $797,000, or 14.2%, largely from general merit increases and commissions and incentives including a pay for performance pilot program, up $305,000; a decrease of $105,000 in a pension expense credit year over year; additional expense of $210,000 related to an executive long-term incentive plan; and $185,000 less in deferred costs related to a lower volume of loan originations. Advertising expense was up $67,000, or 15.3% to $505,000 for 1999 compared to $438,000 in 1998 due to more intense marketing in some newer markets. Data processing fees increased $74,000, or 9.2%, to $878,000 in 1999 compared to $804,000 in 1998 largely because of greater loan and deposit activity and the related processing fees (up $38,500) associated with our service bureau, higher ATM and data processing equipment maintenance and rental costs, up $22,100, and higher software related costs, up $13,400. Other noninterest expense recorded a decrease of $743,000, or 26.9%, to $2.0 million in 1999 compared to $2.7 million in 1998. A decrease of $183,000 for amortization of intangibles and $684,000 less in real estate writedown and demolition expense associated with improved real estate held or acquired for a planned headquarters expansion accounted for most of the decrease. Higher expenses totaling $124,000 associated with normal everyday operations offset a portion of the reduction in other expense from 1998 to 1999.
1998 versus 1997: Noninterest income, excluding securities gains, increased $888,000, or 28.2%, to $4.0 million in 1998 compared to $3.1 million in 1997. Trust fees totaling $1.8 million, an increase of $416,000 accounted for half of the increase. Trust fees were up due to attracting new business and the higher market value of trust assets. Service charges, commissions and fees were up $222,000, largely due to higher loan fees associated with an unusually high volume of mortgage refinancing in 1998. Other income was up $250,000 due primarily to the recognition of a deferred gain of approximately $207,000 from the 1993 sale of a real estate subsidiary. Gains from the sale of available for sale equity securities were down $162,000 to $625,000 in 1998 from $787,000 in 1997. In 1998, gains realized offset expenses associated with the write-down and demolition of improved real estate targeted in connection with a future expansion of corporate headquarters.
Noninterest expense increased $338,000, or 3.0%, to $11.6 million in 1998 compared to $11.3 million in 1997. Salaries and benefits expense decreased $381,000 in 1998 versus 1997 due primarily to salary expense, up $90,500, commissions and incentives, up $162,000, offset by a decrease of $676,000 in pension expense. The large decrease in pension expense was related to the overfunded status of the Corporation's pension plan. Other noninterest expense increased $680,000 primarily due to write-down and demolition expense associated with improved real estate held or acquired and targeted for demolition in connection with a future expansion of corporate headquarters.
Year 2000
The Corporation successfully planned for the Year 2000 event and did not experience system problems, deposit run-off or loan problems related to our customer's Year 2000 readiness. In anticipation of the potential for deposit run-off and as part of its cash contingency plan, the Corporation purchased a sufficient amount of cash from the Federal Reserve to add to the Bank's normal cash inventory. This cash was used to increase the normal cash levels in the Bank's ATMs for a higher volume of customer withdrawal activity via that medium and to have extra cash on hand in the event of heavier than normal customer withdrawals. Neither event occurred and the extra cash was sold back to the Federal Reserve Bank of Philadelphia the week following December 31, 1999. In the months following December 31, 1999, the Corporation has not experienced any problems from customers or systems related to the Year 2000 event. The cost to the Corporation for Y2K preparations was immaterial.
Provision for Income Taxes
Federal income tax expense equaled $1.2 million in 1999 compared to $1.5 million and $1.4 million in 1998 and 1997, respectively. The Corporation's effective tax rate for the years ended December 31, 1999, 1998 and 1997, was 18.9%, 23.8% and 24.2%, respectively. An increase in tax-free income over the past three years relative to pretax income was primarily responsible for the declining effective rate over the three-year period. For a more comprehensive analysis of Federal income tax expense refer to Note 10 of the accompanying financial statements.
Financial Condition
One method of evaluating the Corporation's condition is in terms of its sources and uses of funds. Liabilities represent sources of funds while assets represent uses of funds. At December 31, 1999 total assets reached $444.7 million, an increase of $19.7 million, or 4.63%, compared to $425.0 million at December 31, 1998. Table 2 presents average balances of the Corporation's assets and liabilities over a three-year period. The following financial condition discussion will reference the average balance sheet presented in Table 2 unless otherwise noted.
Investment Securities: The Corporation invests in both taxable and tax-free securities as part of its asset liability management. In 1999, investment securities averaged $126.8 million versus $91.5 million in 1998, an increase of 38.57%. Average taxable securities in 1999 increased $19.0 million, or 31.5%. The increase in taxable securities was comprised primarily of commercial paper, mortgage-backed securities and asset-backed securities. Average tax-free securities increased $16.2 million, or 52.5 %. A $15.0 million investment leverage transaction involving long-term callable municipal securities occurring in the fourth quarter of 1998 primarily accounted for the $16.2 million increase in nontaxable securities in 1999. As of October 1, 1998, the Corporation classified all investment securities as available for sale (Refer to Note 1). With the exception of two nonrated securities totaling $1.2 million, the investment portfolio is made up entirely of investment grade securities.
Table 4. Investment Securities at Amortized Cost (Unaudited)
Table 5. Maturity Distribution of Investment Portfolio (Unaudited)
Loans: Total loans, net of unearned discount, averaged $272.4 million in 1999 compared to $252.6 million in 1998, an increase of 7.3%. As Table 6 reflects, the growth in the loan portfolio occurred mostly in the commercial, industrial and agricultural category which was up $14.5 million to $123.0 million at December 31, 1999 compared to $108.5 million at December 31, 1998. Growth in this arena has come from local municipalities and local small and medium sized businesses. In addition, the Corporation has attracted corporate customers from other area financial institutions who have become disenchanted as a result of recent local bank mergers. Mortgage loan growth slowed in 1999 versus 1998 due to a higher interest rate environment in 1999. Mortgage loans at December 31, 1999, totaled $105.0 million compared to $95.9 million at December 31, 1998, an increase of 9.6%. Consumer loan growth, which includes home equity lines of credit, was slow in 1999, recording an increase of $2.2 million, or 3.8%, to $59.8 million at December 31, 1999, from $57.6 million at December 31, 1998. Lower consumer loan demand, tighter credit underwriting standards and increased competition are primarily responsible for the slow consumer loan growth.
Table 6. Loan Portfolio (Unaudited)
Table 7. Maturities and Interest Rate Terms of Selected Loans (Unaudited)
Table 8. Time Deposits of $100,000 or More (Unaudited)
Table 9. Short-Term Borrowings and Securities Sold Under Agreements to Repurchase (Unaudited)
Deposits and Borrowings: Funding for asset growth came from deposits, Repos and long-term debt. Interest-bearing deposits averaged $286.5 million in 1999 compared to $254.9 million in 1998. Noninterest-bearing deposits averaged $43.0 million in 1999 versus $39.9 million in 1998. Deposit growth in 1999 came primarily from money-market deposits which averaged $65.7 million for the year, an increase of $15.8 million, or 31.7%, over an average of $49.9 million for 1998. At December 31, 1999, total deposits equaled $333.3 million compared to $326.6 million at December 31, 1998. In 1999, Repos averaged $25.8 million, an increase of 5.6 million from an average of $20.2 million in 1998. Repos represent corporate customer cash management accounts. The banking industry in general has experienced increased difficulty in relying totally on deposit growth to fund the growth in assets. The Corporation is no exception to this phenomenon and finds it necessary to look to alternate funding sources. One source of alternate funding for the Corporation is the Federal Home Loan Bank of Pittsburgh (FHLB). The Corporation has entered into both short-term and long-term debt arrangements with FHLB. In 1999, short-term borrowings with FHLB averaged $.5 million compared to $1.5 million in 1998. Long-term debt with FHLB averaged $31.9 million in 1999 versus $13.1 million in 1998, an increase of 143.8%. Most of the increase in long-term debt was used to fund a $15.0 million tax-free investment leverage transaction. As of December 31, 1999, the Corporation had the ability to borrow a total of $120.6 million from FHLB. At December 31, 1999, the Corporation's total debt with FHLB was $42.2 million - $12.5 million in short-term debt and $29.7 million in long-term debt.
Shareholders' Equity: Total Shareholders' equity totaled $39.2 million at December 31, 1999, a decrease of $641,000, or 1.61% from $39.9 million at December 31, 1998. A decrease of $2.7 million in accumulated other comprehensive income (loss) was primarily responsible for the decrease in Shareholders' equity and more than offset the $2.1 million increase in retained earnings for 1999. The large swing in comprehensive income was related entirely to a net unrealized loss in available for sale investment securities.
Cash dividends declared by the Board of Directors in 1999 totaled $1.08 per common share and reduced Shareholders' equity by $3.0 million. Included in cash dividends declared was a special cash dividend of $.40 per common share and regular quarterly cash dividends of $.68 per common share. Cash dividends declared by the Board of Directors in 1998 totaled $.47 and reduced Shareholders' equity by $1.3 million. The ratio of regular cash dividends declared to net income in 1999 was 36.56%; including the special cash dividend, the ratio of cash dividends declared to net income increased to 59.38%. In 1998, the ratio of cash dividends declared to net income was 27.4%.
On March 4, 1999, the Board of Directors authorized the repurchase of up to 50,000 shares of the Corporation's common stock for a twelve-month period ending in March 2000. Treasury stock repurchased is used for general corporate purposes including stock dividends and splits, employee benefit and executive compensation plans, and the dividend reinvestment plan. Under this program, the Corporation repurchased 7,000 shares for approximately $175,000. In March 1998, the Board of Director authorized a similar plan for a twelve-month period ended March, 1999. Under this program, in 1999, the Corporation repurchased 8,975 common shares for a cost of approximately $260,000. At December 31, 1999 and 1998, the Corporation held a total of 252,830 and 242,871, respectively, in Treasury shares acquired through Board authorized stock repurchase programs.
Subsequent to year-end, on March 2, 2000, the Board of Directors approved a new stock repurchase program which authorizes the repurchase of up to 75,000 shares during a one-year period beginning on the date of Board approval.
A strong capital position is important to the Corporation and provides a solid foundation for the future growth of the Corporation. A strong capital position also instills confidence in the Bank by depositors, regulators and investors, and is considered essential by management.
Common measures of adequate capitalization for banking institutions are capital ratios. These ratios indicate the proportion of permanently committed funds to the total asset base. Guidelines issued by Federal and State regulatory authorities require both banks and bank holding companies to meet minimum leverage capital ratios and risk-based capital ratios.
The leverage ratio compares Tier 1 Capital to total balance sheet assets while the risk-based ratio compares Tier 1 and Tier 2 capital to risk-weighted assets and off-balance-sheet activity in order to make capital levels more sensitive to the risk profiles of individuals banks.
Current regulatory capital guidelines call for a minimum Tier 1 leverage ratio of 4.0% and minimum Tier I and Tier 2 risk-based capital ratios of 4.0% and 8.0%, respectively. Well capitalized banking institutions are determined to have leverage capital ratios greater than or equal to 5.0% and Tier 1 and Tier 2 risk-based capital ratios greater than or equal to 6.0% and 10.0%, respectively.
Tier 1 capital is composed of common stock, additional paid-in capital and retained earnings reduced by goodwill, other intangible assets and the effect of unrealized losses on available for sale equity securities.
Total capital is composed of Tier 1 capital plus the includable portion of the allowance for possible loan losses. Table 10 presents the capital ratios for the consolidated Corporation at December 31, 1999, 1998 and 1997. At year-end, the Corporation and its banking subsidiary exceeded all regulatory capital requirements. For additional information on capital adequacy refer to Note 2 of the accompanying financial statements.
Table 10. Capital Ratios (Unaudited)
Because of its contribution to the Corporation's financial performance, improving loan quality remains a top priority of management. In 1999, management focused its loan quality control efforts on consumer lending, which has experienced high losses in recent years. According to the American Bankruptcy Institute (ABI), personal bankruptcy filings decreased 5.3% nationally to 1.3 million, down from a record level of 1.4 million in 1998. Despite the decrease in bankruptcy filings nationally, the ABI cautions that bankruptcy filings remain very high in historical terms. Personal bankruptcies continue to be a concern in the Corporation's consumer loan portfolio, and remain a significant factor in loan losses. The central Pennsylvania region reported a 7.9% reduction in bankruptcy filings in 1999 but the number of filings still remains high and the trend has continued into 2000. To combat the issues surrounding consumer loan losses, management made further revisions to the Consumer Lending Policy in 1999 to tighten underwriting standards and to institute annual reviews on consumer lines of credit. Additionally, ongoing lending training programs verify management's emphasis on loan quality control. As in prior years, the Corporation is prepared to maintain the adequacy of the allowance for possible loan losses.
Liquidity
The Corporation must meet the financial services needs of the customers which it serves, while providing a satisfactory return on the shareholders' investment. In order to accomplish this, the Corporation must maintain sufficient liquidity in order to respond quickly to the changing level of funds required for both loan and deposit activity. The goal of liquidity management is to meet the ongoing cash flow requirements of depositors who want to withdraw funds and of borrowers who request loan disbursements. Historically, the Corporation has satisfied its liquidity needs from earnings, repayment of loans and amortizing investment securities, maturing investment securities, deposit growth and its ability to borrow through existing lines of credit. Investments classified as available for sale provide an additional source of readily available liquidity.
Growth in deposits generally provides a major portion of the funds required to meet increased loan demand. During 1999, deposits grew by $6.7 million while other borrowings increased by $11.5 million and securities sold under agreements to repurchase increased by $2.8 million. Funding from these sources together with decreased deposits in other banks of $11.4 million were sufficient to meet the increased loan demand and increased investments in securities. Table 9 presents specific information concerning short-term borrowings.
Market Risk
In the course of its normal business operations, the Corporation is exposed to certain market risks. The Corporation has no foreign currency exchange rate risk, no commodity price risk or material equity price risk. However, it is exposed to interest rate risk. Financial instruments, which are sensitive to changes in market interest rates, include fixed and variable-rate loans, fixed-income securities, interest-bearing deposits and other borrowings. All interest rate risk arises in connection with financial instruments entered into for purposes other than trading.
Changes in interest rates can have an impact on the Corporation's net interest income and the economic value of equity. The objective of interest rate risk management is to identify and manage the sensitivity of net interest income and economic value of equity to changing interest rates in order to achieve consistent earnings that are not contingent upon favorable trends in interest rates. The Corporation uses several tools to measure and evaluate interest rate risk. One tool is interest rate sensitivity or gap analysis. Gap analysis classifies assets and liabilities into maturity and repricing time intervals. The interest rate gap, the difference between maturing or repricing assets and liabilities, provides management with an indication of how net interest income will be impacted by different interest rate scenarios. Table 14 presents a gap analysis of the Corporation at December 31, 1998 and 1999. The negative gaps in the under one-year time intervals suggest that the Corporation's near-term earnings would decline in a higher interest rateenvironment. The larger negative gap as of December 31, 1999 as compared to 1998 indicates that the Corporation's exposure to rising interest rates increased during the period.
Another tool for analyzing interest rate risk is financial simulation modeling which captures the impact of not only changing interest rates but also other sources of cash flow variability including loan and securities prepayments, loan repricing, deposit pricing and customer preferences. Financial simulation modeling forecasts both net interest income and the economic value of equity under a variety of different interest rate environments. Economic value of equity is defined as the estimated discounted present value of assets minus the discounted present value of liabilities and is a surrogate for long-term earnings. The Corporation regularly measures the effects of an up or down 200-basis point "rate shock" which is deemed to represent the outside limits of any reasonably probable movement in market interest rates during a one-year time frame. As indicated in Table 15, the financial simulation analysis revealed that both prospective net interest income over a one-year time period and the economic value of equity as of December 31, 1999 are adversely affected by higher market interest rates and favorably affected by lower interest rates. The 1999 analysis reveals that both measures of market interest rate sensitivity indicate greater sensitivity than at December 31, 1998. The Corporation establishes tolerance guidelines for these measures of interest rate sensitivity. As of December 31, 1999 the Corporation was slightly outside the prescribed tolerance range for net interest income sensitivity to higher market interest rates but within the prescribed tolerance for sensitivity of economic value of equity.
Computations of the prospective effects of hypothetical interest rate changes are based on many assumptions, including relative levels of marke t interest rates, loan prepayments and deposit decay. Certain shortcomings are inherent in the computation of discounted present value and, if key relationships do not unfold as assumed, actual values may differ from those presented. Further, the computations do not contemplate any actions management could undertake in response to changes in market interest rates.
Forward-Looking Statement
Certain statements appearing herein which are not historical in nature are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements refer to a future period or periods, reflecting managemen's current views as to likely future developments, and use the words "may," "will," "expect," "believe," "estimate," "anticipate," or similar terms. Because forward-looking statements involve certain risks, uncertainties and other factors over which the Corporation has no direct control, actual results could differ materially from those contemplated in such statements. These factors include (but are not limited to) the following: general economic conditions, changes in interest rates, change in the Corporation's cost of funds, changes in government monetary policy, changes in government regulation and taxation of financial institutions, changes in the rate of inflation, changes in technology, the intensification of competition within the Corporation's market area, and other similar factors.
Impact of Inflation
The impact of inflation upon financial institutions such as the Corporation differs from its impact upon other commercial enterprises. Unlike most other commercial enterprises, virtually all of the assets and liabilities of the Corporation are monetary in nature. As a result, interest rates have a more significant impact on the Corporation's performances than do the effects of general levels of inflation. Although inflation (and inflationary expectations) may affect the interest rate environment, it is not possible to measure with any precision the impact of future inflation upon the Corporation.
Item 7a.
Item 7a. Quantitative and Qualitative Disclosures about Market Risk
The information related to this item is included in Management's Discussion and Analysis of Financial Condition and Results of Operations
Item 8.
Item 8. Financial Statements and Supplementary Data
INDEPENDENT AUDITOR'S REPORT
To the Board of Directors and Shareholders Franklin Financial Services Corporation Chambersburg, Pennsylvania
We have audited the accompanying consolidated balance sheets of Franklin Financial Services Corporation and subsidiary as of December 31, 1999, and the related consolidated statements of income, changes in shareholders' 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 Franklin Financial Services Corporation and subsidiary for the years ended December 31, 1998 and 1997 were audited by other auditors whose report, dated January 29, 1999, expressed an unqualified opinion on those statements.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the 1999 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Franklin Financial Services Corporation and subsidiary as of December 31, 1999, and the results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles.
/s/ Beard & Company, Inc.
Harrisburg, Pennsylvania January 28, 2000
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Summary of Significant Accounting Policies
The accounting policies of Franklin Financial Services Corporation and its subsidiary conform to generally accepted accounting principles and to general industry practices. A summary of the more significant accounting policies which have been consistently applied in the preparation of the accompanying consolidated financial statements follows:
Principles of Consolidation - The consolidated financial statements include the accounts of Franklin Financial Services Corporation (the Corporation) and its wholly- owned subsidiary, Farmers and Merchants Trust Company, a commercial bank (the Bank). All significant intercompany transactions and account balances have been eliminated.
Nature of Operations - The Corporation conducts all of its business through its subsidiary bank, Farmers and Merchants Trust Company. The Bank serves its customer base through twelve community offices located in Franklin and Cumberland Counties in Pennsylvania.
The Bank is a community-oriented commercial bank that emphasizes customer service and convenience. As part of its strategy, the Bank has sought to develop a variety of products and services that meet the needs of both its retail and commercial customers.
Use of Estimates in the Preparation of Financial Statements - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures 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.
Statement of Cash Flows - For purposes of reporting cash flows, cash and cash equivalents include Cash and due from banks, Interest-bearing deposits in other banks and Federal funds sold. Generally, Federal funds are purchased and sold for one-day periods.
Investment Securities - On September 27, 1999, the Corporation entered into an interest rate cap transaction as a vehicle to partially hedge net interest income against the effect of rising market interest rates. The transaction was effective September 29, 1999, has a notional amount of $5,000,000, a term of five years, a strike rate of 6.00% and is indexed to a 3-month LIBOR. At December 31, 1999, the cost of the cap was $180,000 and the fair value was $238,000. Accordingly, a gain of $38,280 (net of tax) was recorded as other comprehensive income for the year ended December 31, 1999.
On October 1, 1998, the Corporation adopted Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities." As permitted under Statement No. 133, the Corporation transferred investment securities classified as "held to maturity" with a book value of $22,961,000 to the "available for sale" classification. The transfer resulted in an increase to Shareholders' equity of approximately $985,000, net of tax.
Available for sale securities are stated at estimated fair value, adjusted for amortization of premiums and accretion of discounts which are recognized as adjustments of interest income. The related unrealize d holding gains and losses are reported as a separate component of shareholders' equity, net of tax, until realized. Realized securities gains and losses are computed using the specific identification method.
Interest and dividends on investment securities are recognized as income when earned. Gains or losses on the disposition of investment securities are based on the net proceeds and the adjusted carrying amount of the specific securities sold.
Loans - Interest on all loans is accrued over the term of the loans based on the amount of principal outstanding. Unearned interest on installment loans is recognized on a basis which approximates the interest method.
Accrual of interest income is generally discontinued when a loan becomes 90 days past due as to principal or interest and management considers the collection of principal or interest to be doubtful. When interest accruals are discontinued, interest credited to income in the current year is reversed and interest accrued in any prior year is charged to the allowance for loan losses.
Allowance for Possible Loan Losses - For financial reporting purposes, the provision for loan losses charged to current operating income is based on estimates, and ultimate losses may vary from the current estimates. These estimates are reviewed periodically and, as adjustments become necessary, they are reported in earnings in the period in which they become known. The adequacy of the level of the reserve is determined by a continuing review of the composition of the loan portfolio, overall portfolio quality, specific problem loans, prior loan loss experience and current and prospective economic conditions that may affect a borrower's ability to pay.
Premises and Equipment - Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is computed using the straight-line method. When assets are retired or sold, the asset cost and related accumulated depreciation are eliminated from the respective accounts, and any resultant gain or loss is included in net income. The cost of maintenance and repairs is charged to operating expense as incurred, and the cost of major additions and improvements is capitalized.
Federal Income Taxes - The Corporation and its subsidiary file a consolidated Federal income tax return. The Corporation accounts for income taxes in accordance with Statement No. 109, "Accounting for Income Taxes." Deferred tax assets or liabilities are computed based on the difference between the financial statement and income tax bases of assets and liabilities using the applicable enacted marginal tax rate. Deferred income tax expenses or benefits are based on the changes in the deferred tax asset or liability from period to period.
Earnings per share - Earnings per share is computed based on the weighted average number of shares outstanding during each year, adjusted retroactively for stock splits and dividends.
The Corporation's basic earnings per share is calculated as net income divided by the weighted average number of shares outstanding. For diluted earnings per share, net income is divided by the weighted average number of shares outstanding plus the incremental number of shares added as a result of converting common stock equivalents, calculated using the treasury stock method. The Corporation's common stock equivalents consist of outstanding restricted stock and stock options.
A reconciliation of the weighted average shares outstanding used to calculate basic earnings per share and diluted earnings per share follows:
(In thousands) 1999 1998 1997
Weighted average shares outstanding (basic) 2,728 2,731 2,738
Impact of common stock equivalents 42 38 29 _____ _____ _____ Weighted average shares outstanding (diluted) 2,770 2,769 2,767
Reclassifications - Certain prior period amounts have been reclassified to conform with the current year presentation.
Segment Reporting - The Bank acts as an independent community financial service provider and offers traditional banking and related financial services to individual, business and government customers. Through its community office 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 safe deposit services. The Bank also performs personal, corporate, pension and fiduciary services through its Investment and Trust Services Department.
Management does not separately allocate expenses, including the cost of funding loan demand, between the commercial, retail, mortgage banking and trust operations of the Bank. As such, discrete information is not available and segment reporting would not be meaningful.
Comprehensive Income - Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. Comprehensive income includes net income plus all other components of comprehensive income. The only changes in equity that are excluded from comprehensive income are those resulting from investments by owners and distributions to owners. Comprehensive income is reflected in the Consolidated Statements of Changes in Shareholders' Equity and includes net income, unrealized gains on securities, and the unrealized gain on the interest rate cap.
Note 2. Regulatory Matters
The Bank is limited as to the amount it may loan the Corporation, unless such loans are collateralized by specific obligations. The Corporation's subsidiary Bank is subject to various regulatory capital requirements administered by 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 Corporation's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of December 31, 1999 and 1998, that the Bank met all capital adequacy requirements to which it is subject.
As of December 31, 1999, the most recent notification from the FDIC 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, Tier 1 leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the institution's category.
The table that follows presents the total risk-based, Tier 1 risk- based and Tier 1 leverage requirements for the Corporation and the Bank as defined by the FDIC. Actual capital amounts and ratios are also presented.
Although not adopted in regulation form, the Pennsylvania Department of Banking utilizes capital standards requiring a minimum of 6% leverage capital and 10% risk-based capital, defined substantially the same as those by the FDIC.
Note 3. Restricted Cash Balances
The Corporation's subsidiary bank is required to maintain reserves in the form of cash and balances with the Federal Reserve Bank, against its deposit liabilities. At December 31, 1999 and 1998, required reserves held at the Federal Reserve Bank for the bank subsidiary, were approximately $4,965,000 and $3,225,000. In addition, as compensation for check clearing and other services, a compensatory balance maintained at the Federal Reserve Bank at December 31, 1999 and 1998, equaled approximately $900,000.
The following table summarizes information concerning options outstanding at December 31, 1999:
The Corporation has adopted Statement No. 123, "Accounting for Stock-Based Compensation." As provided for in the Statement, the Corporation elected to continue the intrinsic value method of expense recognition. Accordingly, no compensation expense for the Plan has been recognized in the financial statements of the Corporation. Had compensation cost for the Plan been recognized in accordance with Statement No. 123, the Corporation's net income and net income per share amounts would have been reduced to the following pro-forma amounts:
The fair value of the options granted has been estimated using the following assumptions for 1999, 1998 and 1997, respectively: risk-free interest rate of 5.98%, 4.53% and 5.49%, expected volatility of the Corporation's stock of 14.14%, 14.00% and 20.10% and an expected dividend yield of 3.09%, 2.08% and 3.67%. The expected life of the optionsin 1999,1998 and 1997 was .74 year, .76 year and .81 year, respectively.
Note 13. Deferred Compensation Agreement
The Corporation has entered into deferred compensation agreements with several officers and directors which provide for the payment of benefits over a ten-year period, beginning at age 65. At inception, the present value of the obligations under these deferred compensation agreements amounted to approximately $600,000, which is being accrued over the estimated remaining service period of these officers and directors. These obligations are partially funded through life insurance covering these individuals.
Note 14. Shareholders' Equity
In March, 1999, the Board of Directors authorized the repurchase of up to 50,000 shares of the Corporation's common stock for a twelve month period ending in March 2000. The Corporation uses the repurchased common stock (Treasury stock) for general corporate purposes including stock dividends and splits, employee benefit and executive compensation plans, and the dividend reinvestment plan. Under this program, the Corporation repurchased 15,975 shares for $434,700 in 1999. In March, 1998, the Board of Directors authorized a similar plan for a twelve month period ended March, 1999. No shares were repurchased under this plan. At December 31, 1999 and 1998, the Corporation held Treasury shares totaling 252,830 and 242,871, respectively, that were acquired through Board authorized stock repurchase programs.
Note 15. Commitments and Contingencies
In the normal course of business, the Bank is party to financial instruments which are not reflected in the accompanying financial statements and are commonly referred to as off-balance-sheet instruments. These financial instruments are entered into primarily to meet the financing needs of the Bank's customers and include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk not recognized in the statement of financial position.
The Corporation's exposure to credit loss in the event of nonperformance by other parties to the financial instruments for commitments to extend credit and standby letters of credit is represented by the contract or notional amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as they do for on-balance-sheet instruments. Unless noted otherwise, th e Bank does not require collateral or other security to support financial instruments with credit risk. The Corporation had the following outstanding commitments as of December 31:
(Amounts in thousands) 1999 1998 Financial instruments whose contract amounts represent credit risk:
Commercial commitments to extend credit . . . . $46,405 $32,032
Consumer commitments to extend credit (secured) 17,291 15,767
Consumer commitments to extend credit (unsecured) 13,344 12,608 ______ _______ $77,040 $60,407
Standby letters of credit . . . . . . . . . . . 2,544 2,547
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses with the exception of home equity lines and personal lines of credit and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation of the counterparty. Collateral for most commercial commitments varies but may include accounts receivable, inventory, property, plant, and equipment and incomeproducing commercial properties. Collateral for secured consumer commitments consists of liens on residential real estate.
Standby letters of credit are instruments issued by the Bank which guarantee the beneficiary payment by the Bank in the event of default by the Bank's customer in the nonperformance of an obligation or service. Most standby letters of credit are extended for one-year periods. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank holds collateral supporting those commitments for which collateral is deemed necessary primarily in the form of certificates of deposit and liens on real estate.
Most of the Bank's business activity is with customers located within Franklin County, Pennsylvania and surrounding counties and does not involve any significant concentrations of credit to any one entity or industry.
The Bank has entered into various noncancellable operating leases. Total rental expense on these leases was $53,000, $50,000, and $36,000 in the years 1999, 1998 and 1997, respectively. Future minimum payments under these leases are as follows:
2000. . . . . . . . . $57,800 2001. . . . . . . . . $50,000 2002. . . . . . . . . $28,800 2003. . . . . . . . . $ 7,300 2004 and beyond . . . $27,700
In the normal course of business, the Corporation has commitments, lawsuits, contingent liabilities and claims. However, the Corporation does not expect that the outcome of these matters will have a materially adverse effect on its consolidated financial position or results of operations.
Note 16. Disclosures About Fair Value of Financial Instruments
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:
Cash, Federal funds sold and Interest-bearing deposits:
For these short-term instruments, the carrying amount is a reasonable estimate of fair value.
Investment securities:
For debt and marketable equity securities available for sale fair values are based on quoted market prices or dealer quotes. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.
Loans, net:
The fair value of loans is estimated for each major type of loan (e.g. real estate, commercial, industrial and agricultural and consumer) by discounting the future cash flows associated with such loans. The model considers scheduled principal maturities, repricing characteristics, prepayment assumptions and interest cash flows. The discount rates used are estimated based upon consideration of a number of factors including the treasury yield curve, credit quality factors, expense and service charge factors.
Deposits, Securities sold under agreements to repurchase and Other borrowings:
The fair market value of demand deposits, savings accounts, and money market deposits is the amount payable on demand at the reporting date. This fair value does not include the benefit that results from the low cost of funding provided by these deposits compared to the cost of borrowing funds in the market. The fair value of fixed maturity certificates of deposit and long-term debt are estimated by discounting the future cash flows using rates approximating those currently offered for certificates of deposit and borrowings with similar remaining maturities. The other borrowings consist of borrowings on a line of credit with the FHLB at a variable interest rate and securities sold under agreements to repurchase for which the carrying value approximates a reasonable estimate of the fair value.
Off balance sheet financial instruments:
Outstanding commitments to extend credit and commitments under standby letters of credit include fixed and variable rate commercial and consumer commitments. The fair value of the commitments are estimated using the fees currently charged to enter into similar agreements. The fair value of the interest rate cap was based on current settlement value. The estimated fair value of the Corporation's financial instruments at December 31 are as follows:
The above values do not necessarily reflect the premium or discount that could result from offering for sale at one time the Corporation's entire holdings of a particular instrument. In addition, these values, derived from the methods and assumptions described above, do not consider the potential income taxes or other expenses that would be incurred on an actual sale of an asset or settlement of a liability.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
The information related to this item is incorporated by reference to the information appearing under the heading "Relationship With Independent Public Accountants" on page 13 of the Corporation's Proxy Statement for the 2000 Annual Meeting of Shareholders.
Part III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The information related to this item is incorporated by reference to the material set forth under the headings "Information about Nominees and Continuing Directors" on Pages 4 through 6, and "Executive Officers" on Page 7 of the Corporation's Proxy Statement for the 2000 Annual Meeting of Shareholders.
Item 11.
Item 11. Executive Compensation
The information related to this item is incorporated by reference to the material set forth under the headings "Compensation of Directors" on Page 7 and "Executive Compensation and Related Matters" on Pages 7 through 12 of the Corporation's Proxy Statement for the 2000 Annual Meeting of Shareholders, except that information appearing under the headings "Compensation Committee Report on Executive Compensation" and "Stock Performance Graph" on Pages 10 through 12 is not incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information related to this item is incorporated by reference to the material set forth under the headings "Voting of Shares and Principal Holders Thereof" on Page 2 and 3, and "Information about Nominees and Continuing Directors" on Pages 4 through 6 of the Corporation's Proxy Statement for the 2000 Annual Meeting of Shareholders.
Item 13.
Item 13. Certain Relationships and Related Transactions
The information related to this item is incorporated by reference to the material set forth under the heading "Transactions with Directors and Executive Officers" on Page 13 of the Corporation's Proxy Statement for the 2000 Annual Meeting of Shareholders.
Part IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a) The following documents are filed as part of this report: (1) The following Consolidated Financial Statements of the Corporation:
Report of Independent Public Accountants,
Consolidated Balance Sheets - December 31, 1999 and 1998,
Consolidated Statements of Income - Years ended December 31, 1999, 1998 and 1997,
Consolidated Statements of Changes in Shareholders' Equity Years ended December 31, 1999, 1998 and 1997,
Consolidated Statements of Cash Flows - Years ended December 31, 1999, 1998 and 1997,
Notes to Consolidated Financial Statements.
(2) All financial statement schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and have therefore been omitted.
(3) The following exhibits are filed as part of this report:
3.1 Articles of Incorporation of the Corporation. Filed as Exhibit 3 to Form 10-Q Quarterly Report of the Corporation for the quarter ended September 30, 1999 and incorporated herein by reference.
3.2 Bylaws of the Corporation. Filed as Exhibit 3 (i) Current Report on Form 8-K, filed December 3, 1999 and incorporated herein by reference.
10.1 Deferred Compensation Agreements with Bank Directors.* Filed as Exhibit 10.1 to the 1995 Form 10-K -- Annual Report of the Corporation and incorporated herein by reference.
10.2 Director's Deferred Compensation Plan.* Filed as Exhibit 10.2 to the 1995 Form 10-K --Annual Report of the Corporation and incorporated herein by reference.
10.3 Long-Term Incentive Plan of 1990.* Filed as Exhibit 10.3 to the 1995 Form 10-K --Annual Report of the Corporation and incorporated herein by reference.
10.4 Senior Management Incentive Program, as amended, October 15, 1992.* Filed as Exhibit 10.2 to Form 10-Q Quarterly Report of the Corporation for the quarter ended June 30, 1999 and incorporated herein by reference.
10.5 Severance Benefit Agreement between the Corporation and Theodore D. McDowell* Filed as Exhibit 10 to the Form 10-Q Quarterly Report of the Corporation for the quarter ended September 30, 1999 and incorporated herein by reference.
21 Subsidiaries of the Corporation.
23.1 Consent of Beard & Company, Inc.
23.2 Consent of Arthur Andersen LLP
27 Financial Data Schedule
99 Report of Arthur Andersen LLP
* Identifies a management contract or a compensatory plan or arrangement.
(b) Reports on Form 8-K:
A current report on Form 8-K, dated December 2, 1999 was filed December 3, 1999 in conjunction with the filing of amendments to the Bylaws of Farmers and Merchants Trust Company and to the Bylaws of Franklin Financial Services Corporation.
(c) The exhibits required to be filed as part of this report are submitted as a separate section of this report.
(d) Financial Statement Schedules: None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
FRANKLIN FINANCIAL SERVICES CORPORATION
By:/s/William E. Snell, Jr. ------------------------ William E. Snell,Jr. President and Chief Executive Officer
Date: March 23, 2000
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signature Title Date
/s/ Robert G. Zullinger Chairman of the Board March 23, 2000 Robert G. Zullinger and Director
/s/William E. Snell, Jr. President and Chief Executive March 23, 2000 William E. Snell, Jr. Officer and Director
/s/ Charles S. Bender II Executive Vice President March 23, 2000 Charles S. Bender II and Director
/s/ Elaine G. Meyers Treasurer and Chief March 23, 2000 Elaine G. Meyers Financial Officer (Principal Financial and Accounting Officer)
/s/ G. Warren Elliott Director March 23, 2000 G. Warren Elliott
_________________ Director March 23, 2000 Omer L. Eshleman
/s/ Donald A. Fry Director March 23, 2000 Donald A. Fry
_________________ Director March 23, 2000 Dennis W. Good, Jr.
/s/ H. Huber McCleary Director March 23, 2000 H. Huber McCleary
/s/ Jeryl C. Miller Director March 23, 2000 Jeryl C. Miller
/s/ Stephen E. Patterson Director March 23, 2000 Stephen E. Patterson
/s/ Charles M. Sioberg Director March 23, 2000 Charles M. Sioberg
/s/ Martha B. Walker Director March 23, 2000 Martha B. Walker
Exhibit Index for the Year Ended December 31, 1999
Item Description 3.1 Articles of Incorporation of the Corporation. Filed as Exhibit 3 to Form 10-Q Quarterly Report of the Corporation for the quarter ended September 30,1999 and incorporated by reference.
3.2 Bylaws of the Corporation. Filed as Exhibit 3 (i) to Current Report on Form 8-K Filed on December 3, 1999 and incorporated herein by reference.
10.1 Deferred Compensation Agreements with Bank Directors. Filed as Exhibit 10.1 to the 1995 Form 10-K -- Annual Report of the Corporation and incorporated herein by reference.
10.2 Director's Deferred Compensation Plan. Filed as Exhibit 10.2 to the 1995 Form 10-K -- Annual Report of the Corporation and incorporated herein by reference.
10.3 Long-Term Incentive Plan of 1990. Filed as Exhibit 10.3 to the 1995 Form 10-K -- Annual Report of the Corporation and incorporated herein by reference.
10.4 Senior Management Incentive Program, as amended, October 15, 1992. Filed as Exhibit 10.2 to Form 10-Q Quarterly Report of the Corporation for the quarter ended June 30, 1999 and incorporated herein by reference.
10.5 Severance Benefit Agreement between the Corporation and Theodore D. McDowell* Filed as Exhibit 10 to the Form 10-Q Quarterly Report of the Corporation for the quarter ended September 30, 1999 and incorporated herein by reference.
21 Subsidiaries of Corporation
23.1 Consent of Beard & Company, Inc.
23.2 Consent of Arthur Andersen LLP
27 Financial Data Schedule
99 Report of Arthur Andersen LLP
* Identifies a management contract or a compensatory plan or arrangement.
Exhibit 21
Subsidiaries of
Franklin Financial Services Corporation
Farmers and Merchants Trust Company of Chambersburg - Direct (A Pennsylvania Bank and Trust Company)
Exhibit 23.1 Consent of Beard & Company, Inc., Independent Auditors
Regarding:
Registration Statements, File No. 2-92212, No. 2-98880, No. 33-36509, No. 33-64294, 33-82420, and No. 333-82675.
We consent to the incorporation by reference in the above listed Registration Statements of our report dated January 28, 2000, with respect to the consolidated financial statements of Franklin Financial Services Corporation included in this Annual Report (Form 10-K) for the year ended December 31, 1999.
/s/ BEARD & COMPANY, INC.
Harrisburg, Pennsylvania March 23, 2000
Exhibit 23.2
CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS
As independent public accountants, we hereby consent to the incorporation of our report dated January 29, 1999, on the December 31, 1998, consolidated financial statements of Franklin Financial Services Corporation, in this Form 10-K, into the Corporation's previously filed Registration Statements; File No. 2-92212, No. 2-98880, No. 33-36509, No. 33-64294, No. 33-82420, and No. 333-82675. It should be noted that we have not audited any financial statements of Franklin Financial Services Corporation subsequent to December 31, 1998, or performed any procedures subsequent to the date of our report.
/s/ Arthur Andersen LLP
Lancaster, PA March 23, 2000
Exhibit 99
Report of Independent Public Accountants
To the Shareholders and Board of Directors, Franklin Financial Services Corporation:
We have audited the accompanying consolidated balance sheet of FRANKLIN FINANCIAL SERVICES CORPORATION (a Pennsylvania corporation) and subsidiary as of December 31, 1998, and the related consolidated statements of income, changes in shareholders' equity and cash flows for each of the two years in the period ended December 31, 1998. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of FRANKLIN FINANCIAL SERVICES CORPORATION and subsidiary as of December 31, 1998, and the consolidated results of their operations and cash flows for each of the two years in the period ended December 31, 1998, in conformity with generally accepted accounting principles.
/s/ Arthur Andersen LLP
Lancaster, PA January 29, 1999