Item 1. Business
The disclosures set forth in this item are qualified by Item 1A
Item 1A. Risk Factors
Investing in the Company’s common stock is subject to risks inherent to the Company’s business. The material risks and uncertainties that management believes affect the Company are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones facing the Company. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair the Company’s business operations. This report is qualified in its entirety by these risk factors.
If any of the following risks actually occur, the Company’s financial condition and results of operations could be materially and adversely affected. If this were to happen, the market price of the Company’s common stock could decline significantly, and shareholders could lose all or part of their investment.
The Company operates in a highly regulated environment and may be adversely affected by changes in federal and state laws and regulations.
The Company is subject to extensive regulation, supervision, and examination by federal and state banking authorities. Any change in applicable regulations or laws could have a substantial adverse impact on the Company and its operations. Additional legislation and regulations that could significantly affect the Company’s powers, authority, and operations may be enacted or adopted in the future, which could have a material adverse effect on the Company’s results of operations and financial condition. Further, in the performance of their supervisory duties and enforcement powers, the Company’s banking regulators have significant discretion and authority to prevent or remedy practices they deem as unsafe or unsound or violations
of law. The exercise of regulatory authority may have a negative impact on the Company’s operations, which may be material to its results of operations and financial condition.
The Company presently is subject to, and in the future may become subject to, additional supervisory actions and/or enhanced regulation that could have a material negative effect on its business, operating flexibility, financial condition and the value of its common stock.
Under federal and state laws and regulations pertaining to the safety and soundness of insured depository institutions, the KDFI (for state-chartered banks), the Federal Reserve (for bank holding companies), and the FDIC as the insurer of bank deposits, have the authority to compel or restrict certain actions on the Company’s part if they determine that the Company has insufficient capital or is otherwise operating in a manner that may be deemed to be inconsistent with safe and sound banking practices. Under this authority, bank regulators can require the Company to enter into informal or formal enforcement orders, including board resolutions, memoranda of understanding, written agreements and consent or cease and desist orders, pursuant to which the Company would be required to take identified corrective actions to address cited concerns and to refrain from taking certain actions.
If the Company is unable to comply with the terms of its current or future regulatory orders to which it may become subject, then it could become subject to additional, heightened supervisory actions and orders, possibly including cease and desist orders, prompt corrective actions, and/or other regulatory enforcement actions. If the Company’s regulators were to take such additional supervisory actions, then we could, among other things, become subject to significant restrictions on our ability to develop any new business, as well as restrictions on our existing business, and we could be required to raise additional capital, dispose of certain assets and liabilities within a prescribed period of time, or both. If one or more of the Company’s banks were unable to comply with regulatory requirements, such banks could ultimately face failure. The terms of any such supervisory action could have a material negative effect on our business, operating flexibility, financial condition and the value of our common stock.
Our nonperforming assets adversely affect our results of operations and financial condition and take significant management time to resolve.
The Company’s level of nonperforming assets (which include performing restructured loans) continue to improve, but remain elevated. Nonperforming assets adversely affect the Company’s net income in various ways. The Company does not record interest income on nonaccrual loans or other real estate owned, thereby adversely affecting interest income. When the Company repossesses collateral in foreclosures and similar proceedings, it is required to record the property at its fair value less estimated selling costs, which decreases net income.
Nonperforming loans and other real estate owned also increase our risk profile and the amount of capital the Company’s regulators believe is appropriate in light of such risks. While the Company seeks to reduce its problem loans through workouts, restructurings, and otherwise, decreases in the value of these assets, the underlying collateral, or our borrowers’ performance or financial conditions have adversely affected, and may continue to adversely affect, the Company’s results of operations and financial condition. Moreover, the resolution of nonperforming assets requires significant time commitments from management of our banks, which can be detrimental to the performance of their other responsibilities. There can be no assurance that the Company will not experience further increases in nonperforming loans in the future. If economic conditions do not improve or worsen in our markets, the Company could continue to incur additional losses relating to an increase in nonperforming assets.
Losses from loan defaults may exceed the allowance established for that purpose, which will have an adverse effect on the Company’s financial condition.
Volatility and deterioration in the broader economy increases the Company’s risk of credit losses, which could have a material adverse effect on its operating results. If a significant number of loans in the Company’s portfolio are not repaid, it would have an adverse effect on its earnings and overall financial condition. Like all banks, the Company’s subsidiaries maintain an allowance for loan losses to provide for losses inherent in the loan portfolio. The allowance for loan losses reflects management of each subsidiary’s best estimate of probable incurred credit losses in their loan portfolio at the balance sheet
date. This evaluation is primarily based upon a review of the bank’s historical loan loss experience, known risks contained in the bank’s loan portfolio, composition and growth of the bank’s loan portfolio, and economic factors. Additionally, a bank’s regulators may require additional provision for the loan portfolio in connection with their examinations, agreements, or orders. The determination of an appropriate level of loan loss allowance is an inherently difficult process and is based on numerous assumptions. As a result, the Company’s allowance for loan losses may be inadequate to cover actual losses in its loan portfolio. Consequently, the Company risks having additional future provision for loan losses that may materially affect its earnings.
If the Company’s local markets experience a prolonged recession or economic downturn, it may be required to make further increases in its allowance for loan losses and to charge off additional loans, which would adversely affect its results of operations and capital.
Substantially all of the Company’s loans are to businesses and individuals located in Kentucky. A continuing or prolonged decline in the Central and Northern Kentucky economies could negatively impact demand for the Company’s products and services, the ability of customers to repay their loans, collateral values securing loans, and the stability of funding sources. This could result in a material adverse effect on the Company’s financial condition, results of operations and prospects. Further, substantially all of the Company’s investments in municipal bonds are issued by political subdivisions or agencies located in Kentucky.
Generally, the Company’s nonperforming loans and assets reflect operating difficulties of individual borrowers; however, the overall economic decline of recent years and slow growth has become a significant contributing factor to the increased levels of delinquencies and nonperforming loans. Sluggish sales and excess inventory in the residential housing market continue to exist and has been the primary cause of elevated delinquencies and foreclosures. If trends in the housing and real estate markets worsen, the Company expects that it will continue to experience high levels of delinquencies and credit losses. As a result, the Company may be required to make increases to its provision for loan losses and charge off additional loans in the future, which could adversely affect the Company’s financial condition and results of operations, perhaps materially. If additional provisions and charge-offs cause the Company to experience losses, it may be required to contribute additional capital to its bank subsidiaries to maintain capital ratios required by regulators.
The Company’s exposure to credit risk is increased by its real estate development lending.
Real estate development lending has historically been considered to be higher credit risk than that of other types of lending, such as for single-family residential properties. At year-end 2013, 14% of the outstanding balance of real estate development loans was classified as impaired. Real estate development loans typically involve larger loan balances to a single borrower or related borrowers. These loans can be affected by adverse conditions in real estate markets or the economy in general because commercial real estate borrowers’ ability to repay their loans depends on successful development and, in most cases, sale of the underlying property. These loans also involve greater risk because they generally are not fully amortized over the loan period, but have a balloon payment due at maturity of the loan. A borrower’s ability to make a balloon payment typically depends on being able to either refinance the loan or timely sell the underlying property. In the current economic environment, the ability of borrowers to refinance or sell newly developed property or vacant land remains challenging. If the real estate markets were to worsen or not improve, the Company likely will experience increased credit losses and require additional provisions to our allowance for loan losses, which would adversely impact the Company’s earnings and financial condition.
The Company’s investment securities portfolio is comparatively larger than other community banks and it is more dependent on its investment portfolio to generate net income.
The Company relies more heavily on its investment securities portfolio as a source of interest income than many other community banks because it has a comparatively smaller loan portfolio. If the Company is not able to successfully manage the interest rate spread on the investment portfolio, its net interest income will decrease, which would adversely affect its results of operations and negatively impact net income. Investment securities tend to have a lower risk than loans, and as such, generally provide a lower yield. For 2013, average investment securities made up 32.5% of the Company’s average total assets. Interest income on investment securities accounted for 19.6% of total interest income for 2013.
The Company periodically sells investment securities at irregular intervals in the normal course of business to execute its current asset/liability management strategies. This will result in the realization of either a net gain or loss. Moreover, proceeds from sales may be reinvested in investment securities with lower yields, which could reduce future earnings from investment securities. The Company also monitors its investment securities portfolio for deteriorating values and for other-than-temporary impairment. Any material other-than-temporary impairment charges would likewise have an adverse effect on the Company’s results of operations and could lead to additional losses.
The Company cannot accurately predict the effect of the current economy on its future results of operations or the market price of its stock.
The national economy and the financial services sector in particular continue to face challenges stemming from the economic recession occurring between 2007 and 2009. The Company cannot accurately predict the severity or duration of the current economic slowdown, which has adversely impacted its performance and the markets it serves. Any further deterioration in the economies of the nation as a whole or in the Company’s local markets would have an adverse effect, which could be material, on the Company’s financial condition, results of operations, and prospects and could also cause the market price of the Company’s stock to decline. While it is impossible to predict how long these conditions may exist, the economic slowdown could continue to present risks for some time for our industry and the Company.
Interest rate volatility could significantly harm the Company’s results of operations.
The Company’s results of operations are affected by the monetary and fiscal policies of the federal government, the policies of its regulators, and the prevailing interest rates in the United States and the Company’s markets. In addition, it is increasingly common for the Company’s competitors, who may be aggressively seeking to attract deposits as a result of liquidity concerns arising from changing economic or other conditions, to pay rates on deposits that are much higher than normal market rates. A significant component of the Company’s earnings is net interest income, which is the difference between the income from interest earning assets, such as loans, and the expense on interest bearing liabilities, such as deposits. A change in market interest rates could adversely affect the Company’s earnings if market interest rates change such that the interest it pays on deposits and borrowings increases faster than the interest it collects on loans and investments; or, alternatively, if interest rates earned on earning assets decline faster than those rates paid on interest paying liabilities. Consequently, as with most financial institutions, the Company is sensitive to interest rate fluctuations. Changes in market interest rates may also affect the level of voluntary prepayments on loans and mortgage-back investment securities resulting in the receipt of funds that may be reinvested at a lower rate.
The FDIC periodically amends its deposit insurance rate assessment structure, which can increase costs to the Company.
Under the Federal Deposit Insurance Act, as amended by the Dodd-Frank Act, the FDIC must establish and implement a plan to restore the deposit insurance fund’s designated reserve ratio to 1.35% of insured deposits by 2020. The Dodd-Frank Act removed the previously established upper limit reserve ratio of 1.15%. The FDIC must continue to assess and consider the appropriate level of the reserve ratio annually by considering each of the following: risk of loss to the insurance fund; economic conditions affecting the banking industry; the prevention of sharp swings in the assessment rates; and any other factors the FDIC deems important. The FDIC’s current fund management strategy includes a targeted long-term reserve ratio of 2.0%.
The Dodd-Frank Act required changes to a number of components of the FDIC insurance assessment that were effective April 1, 2011. While these changes have resulted in a lower amount of deposit insurance assessments for the Company, future changes in assessment rates or methodology could adversely impact the Company’s future earnings and liquidity in a material amount.
The recent repeal of federal prohibitions on the payment of interest on demand deposits of business customers could increase the Company’s interest expense.
Federal prohibitions against financial institutions paying interest on demand deposit accounts of business customers were repealed as part of the Dodd-Frank Act. As a result, beginning on July 21, 2011, financial institutions could offer to pay interest on commercial demand deposits to compete for customers. The Company expects that its interest expense would increase and its net interest margin to decrease should it begin to pay interest on commercial demand deposits to attract additional customers or to keep current customers. This could result in a material adverse impact on the Company’s financial condition and results of operations. The Company does not offer interest bearing demand deposits to its business customers.
Any future losses may require the Company to raise additional capital; however, such capital may not be available to us on favorable terms or at all.
The Company is required by federal and state regulatory authorities to maintain levels of capital to support its operations. Furthermore, as a result of regularly scheduled examinations, regulators currently require two of the Company’s subsidiary banks to maintain capital levels significantly above the well-capitalized benchmark. The Company’s ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time and on the Company’s future financial condition and performance. Accordingly, the Company cannot make assurances with respect to its ability to raise additional capital on favorable terms, or at all. If the Company cannot raise additional capital when needed, its ability to further expand its operations through internal growth and acquisitions could be materially impaired and its financial condition and liquidity could be materially and adversely affected. The Parent Company is currently under no directive by its regulators to raise any additional capital.
The tightening of available liquidity could limit the Company’s ability to replace deposits and fund loan demand, which could adversely affect its earnings and capital levels.
A tightening of the credit and liquidity markets and the Company’s inability to obtain adequate funding to replace deposits may negatively affect its earnings and capital levels. In addition to deposit growth, maturity of investment securities, and loan payments from borrowers, the Company relies from time to time on advances from the Federal Home Loan Bank and other wholesale funding sources to fund loans and replace deposits. In the event of a downturn in the economy, these additional funding sources could be negatively affected which could limit the funds available to the Company. The Company’s liquidity position could be significantly constrained if it were unable to access funds from the Federal Home Loan Bank or other wholesale funding sources.
The Company’s financial condition and outlook may be adversely affected by damage to its reputation.
The Company’s financial condition and outlook is highly dependent upon perceptions of its business practices and reputation. Its ability to attract and retain customers and employees could be adversely affected to the extent its reputation is damaged. Negative public opinion could result from its actual or alleged conduct in any number of activities, including regulatory actions taken against the Company, lending practices, corporate governance, regulatory compliance, mergers of its subsidiaries, or sharing or inadequate protection of customer information. Damage to the Company’s reputation could give rise to loss of customers and legal risks, which could have an adverse impact on its financial condition.
The Company faces strong competition from financial services companies and other companies that offer banking services.
The Company conducts most of its operations in Central and Northern Kentucky. The banking and financial services businesses in these areas are highly competitive and increased competition in its primary market areas may adversely impact the level of its loans and deposits. Ultimately, the Company may not be able to compete successfully against current and future competitors. These competitors include national banks, regional banks, and other community banks. The Company also faces competition from other types of financial institutions, including savings and loan associations, finance companies, brokerage firms, insurance companies, credit unions, mortgage banks, and other financial intermediaries. In particular, the
Company’s competitors include major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous locations and mount extensive promotional and advertising campaigns. Areas of competition include interest rates for loans and deposits, efforts to obtain loan and deposit customers, and a range in quality of products and services provided, including new technology-driven products and services. If the Company is unable to attract and retain banking customers, it may be unable to increase its loans and level of deposits.
The price of the Company’s common stock may fluctuate significantly, and this may make it difficult to resell it when you want or at prices you find attractive.
The Company cannot predict how its common stock will trade in the future. The market value of its common stock will likely continue to fluctuate in response to a number of factors including the following, most of which are beyond our control, as well as the other factors described in this “Risk Factors” section:
●
general economic conditions and conditions in the financial markets;
●
changes in global financial markets, such as interest or foreign exchange rates, stock, commodity or real estate valuations or volatility, and other geopolitical events;
●
conditions in our local and national credit, mortgage, and housing markets;
●
developments with respect to financial institutions generally, including government regulation;
●
our dividend practice; and
●
actual and anticipated quarterly fluctuations in our operating results and earnings.
The market value of the Company’s common stock may also be impacted by conditions affecting the financial markets in general, including price and trading fluctuations. These conditions may result in: (1) volatility in the level of, and fluctuations in, the market prices of stocks generally and, in turn, the Company’s common stock and (2) sales of substantial amounts of the Company’s common stock in the market, in each case that could be unrelated or disproportionate to changes in the Company’s operating performance. These broad market fluctuations may adversely affect the market value of the Company’s common stock.
There may be future sales of additional common stock or other dilution of the Company’s equity, which may adversely affect the market price of the Company’s common stock.
The Company is not restricted from issuing additional common or preferred stock, including any securities that are convertible into or exchangeable for, or that represent the right to receive, common stock or preferred stock or any substantially similar securities. The market price of the Company’s common stock could decline as a result of sales by the Company of a large number of shares of common stock or preferred stock or similar securities in the market or from the perception that such sales could occur.
The Company’s board of directors is authorized generally to cause it to issue additional common and preferred stock without any action on the part of the Company’s shareholders, except as may be required under the listing requirements of the NASDAQ Stock Market. In addition, the board has the power, without shareholder approval, to set the terms of any series of preferred stock that may be issued, including voting rights, dividend rights, preferences, and other terms. This could include preferences over the common stock with respect to dividends or upon liquidation. If the Company issues preferred stock in the future that has a preference over the common stock with respect to the payment of dividends or upon liquidation, or if the Company issues preferred stock with voting rights that dilute the voting power of the common stock, the rights of holders of the common stock or the market price of the common stock could be adversely affected. The Parent Company is currently under no directive by its regulators to raise any additional capital.
You may not receive dividends on the Company’s common stock.
Holders of the Company’s common stock are entitled to receive dividends only when, as, and if its board of directors declares them and as permitted by its regulators. Although the Company has (up through 2009) historically declared quarterly cash
dividends on its common stock, it is not required to do so. The Company’s board of directors reduced its quarterly common stock dividend in January 2009 from $.33 per share to $.25 per share and again in October 2009 to $.10 per share. The Company also agreed to not make interest payments on its trust preferred securities or dividends on its common or preferred stock without prior approval from the FRB St. Louis and the KDFI. Representatives of the FRB St. Louis and the KDFI have indicated that any such approval for the payment of dividends will be predicated on a demonstration of adequate, normalized earnings on the part of the Company’s subsidiaries sufficient to support quarterly payments on the Company’s trust preferred securities and quarterly dividends on the Company’s common and preferred stock. However, there can be no assurance the Company’s regulators will provide such approvals in the future.
While both regulatory agencies have granted approval of all Company requests to make interest payments on its trust preferred securities and dividends on its preferred stock, the Company has not (based on the assessment by Company management of both the Company’s capital position and the earnings of its subsidiaries) sought regulatory approval for the payment of common stock dividends since the fourth quarter of 2009. Moreover, the Company will not pay any such dividends on its common stock in any subsequent quarter until the regulator’s assessment of the earnings of the Company’s subsidiaries, and the Company’s assessment of its capital position, both yield the conclusion that the payment of a Company common stock dividend is warranted.
Dividends declared and discount accretion on the Company’s Series A preferred stock reduce the net income available to common stockholders and reduce earnings per common share. Moreover, under the terms of the Company’s articles of incorporation, it is unable to declare dividend payments on shares of its common stock if it is in arrears on the dividends on the Series A preferred stock.
If the Company is in arrears on interest payments on its trust preferred securities, it may not pay dividends on its common stock until such interest obligations are brought current.
The Company’s ability to pay dividends depends upon the results of operations of its subsidiary banks and certain regulatory considerations.
The Parent Company is a bank holding company that conducts substantially all of its operations through its subsidiary banks. As a result, the Company’s ability to make dividend payments on its common stock depends primarily on certain federal and state regulatory considerations and the receipt of dividends and other distributions from its bank subsidiaries. There are also restrictions on the ability of two of our subsidiary banks to pay dividends or make other payments to the Parent Company related to current regulatory agreements that are in effect, thus further restricting the Parent Company’s ability to make payments to its shareholders.
The trading volume in the Company’s common stock is less than that of many other similar companies.
The Company’s common stock is listed for trading on the NASDAQ Global Select Stock Market. As of December 31, 2013, the 50-day average trading volume of the Company’s common stock on NASDAQ was 15,936 shares or .21% of the total common shares outstanding of 7,478,706. An efficient public trading market is dependent upon the existence in the marketplace of willing buyers and willing sellers of a stock at any given time. The Company has no control over such individual decisions of investors and general economic and market conditions. Given the lower trading volume of the Company’s common stock, larger sales volumes of its common stock could cause the value of its common stock to decrease. Moreover, due to its lower trading volume it may take longer to liquidate your position in the Company’s common stock.
There can be no assurance when the Company’s Series A preferred stock can be redeemed.
Subject to consultation with, and approval from, its banking regulators, the Company intends to repurchase the Series A preferred stock when it believes the credit metrics in its loan portfolio have improved for the long-term and the overall economy has rebounded. However, there can be no assurance when the Series A preferred stock can be repurchased, if at all. Until such time as the Series A preferred stock is repurchased, the Company will remain subject to the terms and conditions of the instrument, which, among other things, limit the Company’s ability to repurchase or redeem common stock.
Holders of the Company’s Series A preferred stock have rights that are senior to those of the Company’s common stockholders.
The Company’s Series A preferred stock is senior to the Company’s shares of common stock, and holders of the Series A preferred stock have certain rights and preferences that are senior to holders of the Company’s common stock. The restrictions on the Company’s ability to declare and pay dividends to common stockholders are discussed above. In addition, the Company and its subsidiaries may not purchase, redeem, or otherwise acquire for consideration any shares of the Company’s common stock unless the Company has paid in full all accrued dividends on the Series A preferred stock for all prior dividend periods, other than in certain circumstances. Furthermore, the Series A preferred stock is entitled to a liquidation preference over shares of the Company’s common stock in the event of liquidation, dissolution, or winding up.
Holders of the Company’s Series A preferred stock have limited voting rights.
Except (1) in connection with the election of two directors to the Company’s board of directors if its dividends on the Series A preferred stock are in arrears and we have missed six quarterly dividends and (2) as otherwise required by law, holders of the Company’s Series A preferred stock have limited voting rights. In addition to any other vote or consent of shareholders required by law or the Company’s articles of incorporation, the vote or consent of holders owning at least 66 2/3% of the shares of Series A preferred stock outstanding is required for (1) any authorization or issuance of shares ranking senior to the Series A preferred stock; (2) any amendment to the rights of the Series A preferred stock that adversely affects the rights, preferences, privileges, or voting power of the Series A preferred stock; or (3) consummation of any merger, share exchange, or similar transaction unless the shares of Series A preferred stock remain outstanding or are converted into or exchanged for preference securities of the surviving entity other than the Company and have such rights, preferences, privileges and voting power as are not materially less favorable than those of the holders of the Series A preferred stock.
The Company’s common stock constitutes equity and is subordinate to its existing and future indebtedness and its Series A preferred stock, and is effectively subordinated to all the indebtedness and other non-common equity claims against its subsidiaries.
Shares of the Company’s common stock represent equity interests in the Parent Company and do not constitute indebtedness. Accordingly, the shares of the Company’s common stock rank junior to all of its indebtedness and to other non-equity claims on Farmers Capital Bank Corporation with respect to assets available to satisfy such claims. Additionally, dividends to holders of the Company’s common stock are subject to the prior dividend and liquidation rights of the holders of the Company’s Series A preferred stock and any additional preferred stock we may issue. The Series A preferred stock has an aggregate liquidation preference of $30 million, plus any accrued and unpaid dividends.
The Company’s right to participate in any distribution of assets of any of its subsidiaries upon the subsidiary’s liquidation or otherwise, and thus the ability of the Company’s common stockholders to benefit indirectly from such distribution, will be subject to the prior claims of creditors of that subsidiary. As a result, holders of the Company’s common stock will be effectively subordinated to all existing and future liabilities and obligations of its subsidiaries, including claims of depositors.
If the Company is unable to redeem its Series A preferred stock after an initial five-year period, the cost of this capital will increase substantially.
If the Company is unable to redeem its Series A preferred stock prior to February 15, 2014, the cost of this capital to us will increase from approximately $1.5 million annually (5.0% per annum of the Series A preferred stock liquidation value) to $2.7 million annually (9.0% per annum of the Series A preferred stock liquidation value). The increase in the annual dividend rate on the Series A preferred stock would have a material negative effect on the amount of earnings the Company can retain
for growth and to pay dividends on its common stock. The Company did not redeem any portion of its Series A preferred stock prior to the dividend resetting to 9.0%.
The current economic environment exposes the Company to higher credit losses and expenses and may result in lower earnings or increase the likelihood of losses.
Although the Company remains well-capitalized, it continues to operate in a very challenging and uncertain economic environment. Financial institutions, including the Company, continue to being adversely effected by difficult economic conditions that have impacted not only local markets, but on a national and global scale. Substantial deterioration in real estate and other financial markets in recent years, although improving, have and may continue to adversely impact the Company’s financial performance. Declines in real estate values and home sales volumes, along with high levels of unemployment and other economic stresses can decrease the value of collateral securing loans extended to borrowers, particularly that of real estate loans. A decrease in the value of real estate securing loans may make it more difficult for the Company to recover amounts it is owed in the event of default by a borrower.
Current economic conditions may result in a higher degree of financial stress on the Company’s borrowers and their customers which could impair the Company’s ability to collect payments on loans, potentially increasing loan delinquencies, nonperforming assets, foreclosures, and losses. Current market forces have and may in the future cause the value of investment securities or other assets held by the Company to deteriorate, resulting in impairment charges, higher losses, and lower regulatory capital levels.
Market volatility could adversely impact the Company’s results of operations, liquidity position, and access to additional capital.
The capital and credit markets experienced heavy volatility and disruptions during much of the recent economic downturn, with unprecedented levels of volatility and disruptions that took place beginning in the last few months of 2008. In many cases, this led to downward pressure on stock prices and credit availability for certain issuers without regard to those issuers’ underlying financial strength. If similar market disruptions and volatility recur, the Company may experience a material adverse effect on its results of operations and liquidity position or on its ability to access additional capital.
Risks associated with unpredictable economic and political conditions may be amplified as a result of limited market area.
Commercial banks and other financial institutions, including the Company, are affected by economic and political conditions, both domestic and international, and by governmental monetary policies. These conditions and other factors beyond the Company’s control may adversely affect profitability. In addition, almost all of the Company’s primary business area is located in Central and Northern Kentucky. Significant downturns in this economic region may result in a deterioration of the Company’s credit quality or a reduced demand for credit and may harm the financial stability of the Company’s customers. Due to the Company’s regional market area, these negative conditions may have a more noticeable effect on the Company than would be experienced by an institution with a larger, more diverse market area.
The Company’s results of operations are significantly affected by the ability of its borrowers to repay their loans.
Lending money is an essential part of the banking business. However, borrowers do not always repay their loans. The risk of non-payment is affected by:
●
unanticipated declines in borrower income or cash flow;
●
changes in economic and industry conditions;
●
the duration of the loan; and
●
in the case of a collateralized loan, uncertainties as to the future value of the collateral.
Due to the fact that the outstanding principal balances can be larger for commercial loans than other types of loans, such loans present a greater risk to the Company than other types of loans when non-payment by a borrower occurs.
Consumer loans typically have shorter terms and lower balances with higher yields compared to real estate mortgage loans, but generally carry higher risks of frequency of default than real estate mortgage and commercial loans. Consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be affected by adverse personal circumstances. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount that can be recovered on these loans.
Inability to hire or retain certain key professionals, management, and staff could adversely affect the Company’s revenues and net income.
The Company relies on key personnel to manage and operate its business, including major revenue generating functions such as its loan and deposit portfolios. The loss of key staff may adversely affect the Company’s ability to maintain and manage these portfolios effectively, which could negatively affect our revenues. In addition, loss of key personnel could result in increased recruiting and hiring expenses, which could cause a decrease in our net income.
The Company’s controls and procedures may fail or be circumvented.
The Company’s management regularly reviews and updates its internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well-designed and operated, can provide only reasonable, not absolute, assurances that the objectives of the system of controls are met. Any failure or circumvention of the Company’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material and adverse effect on the Company’s business, results of operations, and financial condition.
The Company offers online banking services and both sends and receives confidential customer information electronically. This activity is vulnerable to security breaches and computer viruses which could expose the Company to litigation and adversely affect our reputation and overall operations.
The secure transmission of confidential information over the Internet is a significant element of online banking. The Company’s computer network or those of its customers could be vulnerable to unauthorized access, computer viruses, phishing schemes, and other security problems. The Company could be required to commit additional resources to protect against the threat of security breaches and computer viruses, or to remedy problems caused by security breaches or viruses. To the extent that the Company’s activities or the activities of its customers involve the storage and transmission of confidential information, security breaches and viruses could expose the Company to litigation and other possible liabilities. The inability to prevent security breaches or computer viruses could also cause existing customers to lose confidence in the Company’s systems and could adversely affect its reputation and overall operations.
The Company’s operations rely on certain external vendors.
The Company utilizes certain external vendors to provide products and services necessary to maintain its day-to-day operations. The Company is exposed to the risk that such vendors fail to perform under these arrangements. This could result in disruption to the Company’s business and have a material adverse impact on the Company’s results of operations and financial condition. There can be no assurance that the Company’s policies and procedures designed to monitor and mitigate vendor risks will be effective in preventing or limiting the effect of vendor non-performance.
The Company is subject to claims and litigation pertaining to fiduciary responsibility.
The Company’s customers or others may make claims and take legal action against us related to fiduciary responsibilities. If claims and legal action against the Company are not resolved in a favorable manner to the Company, it could result in a material financial liability or damage to our reputation.
The Dodd-Frank Act may increase the Company’s costs of operations which could adversely impact the Company's results of operations, financial condition or liquidity.
The goals of the Dodd-Frank Act include restoring public confidence in the financial system, preventing another financial crisis, and allowing regulators to identify failings in the system before another crisis can occur. As part of the reform, the Dodd-Frank Act created the Financial Stability Oversight Council, with oversight authority for monitoring and regulating systemic risk, and the Bureau of Consumer Financial Protection, which has broad regulatory and enforcement powers over consumer financial products and services. The Dodd-Frank Act also changes the responsibilities of the current federal banking regulators, imposes additional corporate governance and disclosure requirements in areas such as executive compensation and proxy access, and limits or prohibits proprietary trading and hedge fund and private equity activities of banks. It also impacts areas such as deposit insurance, mortgage lending, capital requirements, securitizations, and insurance.
The scope of the Dodd-Frank Act impacts many aspects of the financial services industry and requires the development and adoption of numerous implementing regulations, some of which have yet to be finalized. Consequently, the effects of the Dodd-Frank Act on the financial services industry and the Company will depend, in large part, upon the extent to which regulators exercise the authority granted to them and the approaches taken to implement the regulations. The Company continues to assess the impact of the Dodd-Frank Act on its business and operations and believes that compliance with these new laws and regulations will likely result in additional costs, but the probable impact cannot be measured with a high degree of certainty. Compliance with the new laws and regulations could adversely impact the Company’s results of operations, financial condition, or liquidity, any of which may impact the market price of the Company’s common stock.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
The Company owns or leases buildings that are used in the normal course of its business. The corporate headquarters is located at 202 W. Main Street, Frankfort, Kentucky, in a building owned by the Company. The Company’s subsidiaries own or lease various other offices in the counties and cities in which they operate. See the Notes to Consolidated Financial Statements contained in Item 8, “Financial Statement and Supplementary Data,” of this Form 10-K for information with respect to the amounts at which bank premises and equipment are carried and commitments under long-term leases.
Unless otherwise indicated, the properties listed below are owned by the Company and its subsidiaries as of December 31, 2013.
Corporate Headquarters
202 - 208 W. Main Street, Frankfort, KY
Banking Offices
Farmers Bank:
125 W. Main Street, Frankfort, KY
555 Versailles Road, Frankfort, KY
1401 Louisville Road, Frankfort, KY
154 Versailles Road, Frankfort, KY
1301 US 127 South, Frankfort, KY (leased)
128 S. Main Street, Lawrenceburg, KY
201 West Park Shopping Center, Lawrenceburg, KY
838 N. College Street, Harrodsburg, KY
1035 Ben Ali Drive, Danville, KY
United Bank:
100 United Drive, Versailles, KY
146 N. Locust Street, Versailles, KY
206 N. Gratz, Midway, KY
200 E. Main Street, Georgetown, KY
100 Farmers Bank Drive, Georgetown, KY (leased)
100 N. Bradford Lane, Georgetown, KY
3285 Main Street, Stamping Ground, KY
2509 Sir Barton Way, Lexington, KY
3098 Harrodsburg Road, Lexington, KY (leased)
201 N. Main Street, Nicholasville, KY
995 S. Main Street (Kroger Store), Nicholasville, KY (leased)
986 N. Main Street, Nicholasville, KY
106 S. Lexington Avenue, Wilmore, KY
First Citizens:
425 W. Dixie Avenue, Elizabethtown, KY
3030 Ring Road, Elizabethtown, KY
111 Towne Drive (Kroger Store), Elizabethtown, KY (leased)
645 S. Dixie Blvd., Radcliff, KY
4810 N. Preston Highway, Shepherdsville, KY
157 Eastbrooke Court, Mt. Washington, KY
Citizens Northern:
103 Churchill Drive, Newport, KY
7300 Alexandria Pike, Alexandria, KY
164 Fairfield Avenue, Bellevue, KY
8730 US Highway 42, Florence, KY
34 N. Ft. Thomas Avenue, Ft. Thomas, KY
2911 Alexandria Pike, Highland Heights, KY
2006 Patriot Way, Independence, KY
2774 Town Center Blvd., Crestview Hills, KY (leased)
Data Processing Center
102 Bypass Plaza, Frankfort, KY
Other
201 W. Main Street, Frankfort, KY
The Company considers its properties to be suitable and adequate based on its present needs.
Item 3.
Item 3. Legal Proceedings
As of December 31, 2013, there were various pending legal actions and proceedings against the Company arising from the normal course of business and in which claims for damages are asserted. It is the opinion of management, after discussion with legal counsel, that the disposition or ultimate resolution of such claims and legal actions will not have a material effect upon the consolidated financial statements of the Company.
Item 4.
Item 4. Mine Safety Disclosures
Not applicable.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
At various times, the Company’s Board of Directors has authorized the purchase of shares of the Company’s outstanding common stock. No stated expiration dates have been established under any of the previous authorizations. There were no shares of common stock repurchased by the Company during the quarter ended December 31, 2013. There are 84,971 shares that may still be purchased under the various authorizations. However, the Company must be granted permission by the Federal Reserve Bank of St. Louis and the Kentucky Department of Financial Institutions before it can repurchase or redeem any of its outstanding common or preferred stock as a result of its regulatory agreement.
Performance Graph
The following graph sets forth a comparison of the five-year cumulative total returns among the shares of Company Common Stock, the NASDAQ Composite Index ("broad market index"), and Southeastern Banks Under $1 Billion Market-Capitalization ("peer group index"). Cumulative shareholder return is computed by dividing the sum of the cumulative amount of dividends for the measurement period and the difference between the share price at the end and the beginning of the measurement period by the share price at the beginning of the measurement period.
The broad market index includes over 3,000 domestic and international based common shares listed on The NASDAQ Stock Market. The peer group index consists of 37 banking companies in the Southeastern United States. The Company is included among those in the peer group index.
Corporate Address
The headquarters of Farmers Capital Bank Corporation is located at:
202 West Main Street
Frankfort, Kentucky 40601
Direct correspondence to:
Farmers Capital Bank Corporation
P.O. Box 309
Frankfort, Kentucky 40602-0309
Phone: (502) 227-1668
www.farmerscapital.com
Annual Meeting
The annual meeting of shareholders of Farmers Capital Bank Corporation will be held Tuesday, May 13, 2014 at 11:00 a.m. at the main office of Farmers Bank & Capital Trust Company, Frankfort, Kentucky.
Form 10-K
For a free copy of Farmers Capital Bank Corporation's Annual Report on Form 10-K filed with the Securities and Exchange Commission, please write:
C. Douglas Carpenter, Executive Vice President, Secretary, and Chief Financial Officer
Farmers Capital Bank Corporation
P.O. Box 309
Frankfort, Kentucky 40602-0309
Phone: (502) 227-1668
Web Site Access to Filings
All reports filed electronically by the Company with the United States Securities and Exchange Commission, including annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports, are available at no cost on the Company’s website at www.farmerscapital.com.
NASDAQ Market Makers
J.J.B. Hilliard, W.L. Lyons, LLC
Morgan, Keegan & Company, Inc.
(502) 588-8400
(800) 260-0280
(800) 444-1854
UBS Securities, LLC
Raymond James & Associates, Inc.
(859) 269-6900
(800) 248-8863
(502) 589-4000
The Transfer Agent and Registrar for Farmers Capital Bank Corporation is American Stock Transfer & Trust Company, LLC.
American Stock Transfer & Trust Company, LLC
Shareholder Relations
59 Maiden Lane - Plaza Level
New York, NY 10038
Phone: (800) 937-5449
Fax: (718) 236-2641
Email: Info@amstock.com
Website: www.amstock.com
Additional information is set forth under the captions “Shareholder Information” and “Common Stock Price” on page 73 under Part II, Item 7 and Note 17 “Regulatory Matters” in the notes to the Company's 2013 audited consolidated financial statements on pages 117 to 120 of this Form 10-K and is hereby incorporated by reference.
Item 6.
Item 6. Selected Financial Data
Selected Financial Highlights
The Company recorded a $52.4 million pretax goodwill impairment charge during 2009, representing the entire amount of goodwill previously reported.
Represents total common equity less intangible assets divided by the number of common shares outstanding at the end of the period.
N/M-Not meaningful.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Glossary of Financial Terms
Allowance for loan losses
A valuation allowance to offset credit losses specifically identified in the loan portfolio, as well as management’s best estimate of probable incurred losses in the remainder of the portfolio at the balance sheet date. Management estimates the allowance balance required using past loan loss experience, an assessment of the financial condition of individual borrowers, a determination of the value and adequacy of underlying collateral, the condition of the local economy, an analysis of the levels and trends of the loan portfolio, and a review of delinquent and classified loans. Actual losses could differ significantly from the amounts estimated by management.
Dividend payout
Cash dividends paid on common shares, divided by net income.
Basis points
Each basis point is equal to one hundredth of one percent. Basis points are calculated by multiplying percentage points times 100. For example: 3.7 percentage points equals 370 basis points.
Interest rate sensitivity
The relationship between interest sensitive earning assets and interest bearing liabilities.
Net charge-offs
The amount of total loans charged off net of recoveries of loans that have been previously charged off.
Net interest income
Total interest income less total interest expense.
Net interest margin
Taxable equivalent net interest income expressed as a percentage of average earning assets.
Net interest spread
The difference between the taxable equivalent yield on earning assets and the rate paid on interest bearing funds.
Other real estate owned
Real estate not used for banking purposes. For example, real estate acquired through foreclosure.
Provision for loan losses
The charge against current income needed to maintain an adequate allowance for loan losses.
Return on average assets (ROA)
Net income (loss) divided by average total assets. Measures the relative profitability of the resources utilized by the Company.
Return on average equity (ROE)
Net income (loss) divided by average shareholders’ equity. Measures the relative profitability of the shareholders' investment in the Company.
Tax equivalent basis (TE)
Income from tax-exempt loans and investment securities has been increased by an amount equivalent to the taxes that would have been paid if this income were taxable at statutory rates. In order to provide comparisons of yields and margins for all earning assets, the interest income earned on tax-exempt assets is increased to make them fully equivalent to other taxable interest income investments.
Weighted average number of common shares outstanding
The number of shares determined by relating (a) the portion of time within a reporting period that common shares have been outstanding to (b) the total time in that period.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following pages present management’s discussion and analysis of the consolidated financial condition and results of operations of Farmers Capital Bank Corporation (the “Company” or “Parent Company”), a bank holding company, and its bank and nonbank subsidiaries. Bank subsidiaries include Farmers Bank & Capital Trust Company (“Farmers Bank”) in Frankfort, KY, United Bank & Trust Company (“United Bank”) in Versailles, KY, First Citizens Bank (“First Citizens”) in Elizabethtown, KY, and Citizens Bank of Northern Kentucky, Inc. (“Citizens Northern”) in Newport, KY.
At year-end 2013, Farmers Bank had three primary subsidiaries, which include EG Properties, Inc., Leasing One Corporation (“Leasing One”), and Farmers Capital Insurance Corporation (“Farmers Insurance”). EG Properties, Inc. is involved in real estate management and liquidation for certain repossessed properties of Farmers Bank. Leasing One is a commercial leasing company in Frankfort, KY, and Farmers Insurance is an insurance agency in Frankfort, KY. United Bank had one direct subsidiary at year-end 2013, EGT Properties, Inc. EGT Properties, Inc. is involved in real estate management and liquidation for certain repossessed properties of United Bank. First Citizens had one subsidiary at year-end 2013, HBJ Properties, LLC. HBJ Properties, LLC is involved in real estate management and liquidation for certain repossessed properties of First Citizens. Citizens Northern had one direct subsidiary at year-end 2013, ENKY Properties, Inc., which is involved in real estate management and liquidation for certain repossessed properties of Citizens Northern.
The Company has three active nonbank subsidiaries, FCB Services, Inc. (“FCB Services”), FFKT Insurance Services, Inc. (“FFKT Insurance”), and EKT Properties, Inc. (“EKT”). FCB Services is a data processing subsidiary located in Frankfort, KY that provides services to the Company’s banks as well as unaffiliated entities. FFKT Insurance is a captive property and casualty insurance company insuring primarily deductible exposures and uncovered liability related to properties of the Company. EKT was formed to manage and liquidate certain real estate properties repossessed by the Company. In addition, the Company has three subsidiaries organized as Delaware statutory trusts that are not consolidated into its financial statements. These trusts were formed for the purpose of issuing trust preferred securities. All significant intercompany transactions and balances are eliminated in consolidation.
For a complete list of the Company’s subsidiaries, please refer to the discussion under the heading “Organization” included in Part 1, Item 1 of this Form 10-K. The following discussion should be read in conjunction with the audited consolidated financial statements and related footnotes that follow.
Forward-Looking Statements
This report contains forward-looking statements with the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), under the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties. Statements in this report that are not statements of historical fact are forward-looking statements. In general, forward-looking statements relate to a discussion of future financial results or projections, future economic performance, future operational plans and objectives, and statements regarding the underlying assumptions of such statements. Although the Company believes that the assumptions underlying the forward-looking statements contained herein are reasonable, any of the assumptions could be inaccurate, and therefore, there can be no assurance that the forward-looking statements included herein will prove to be accurate.
Various risks and uncertainties may cause actual results to differ materially from those indicated by the Company’s forward-looking statements. In addition to the risks described under Part 1, Item 1A “Risk Factors” in this report, factors that could cause actual results to differ from the results discussed in the forward-looking statements include, but are not limited to: economic conditions (both generally and more specifically in the markets in which the Company and its subsidiaries operate) and lower interest margins; competition for the Company’s customers from other providers of financial services; deposit outflows or reduced demand for financial services and loan products; government legislation, regulation, and changes in monetary and fiscal policies (which changes from time to time and over which the Company has no control); changes in interest rates; changes in prepayment speeds of loans or investment securities; inflation; material unforeseen changes in the liquidity, results of operations, or financial condition of the Company’s customers; changes in the level of non-performing assets and charge-offs; changes in the number of common shares outstanding; the capability of the Company to successfully enter into a definitive agreement for and close anticipated transactions;
unexpected claims or litigation against the Company; technological or operational difficulties; the impact of new accounting pronouncements and changes in policies and practices that may be adopted by regulatory agencies; acts of war or terrorism; the ability of the parent company to receive dividends from its subsidiaries; the impact of larger or similar financial institutions encountering difficulties, which may adversely affect the banking industry or the Company; the Company or its subsidiary banks’ ability to maintain required capital levels and adequate funding sources and liquidity; and other risks or uncertainties detailed in the Company’s filings with the Securities and Exchange Commission, all of which are difficult to predict and many of which are beyond the control of the Company.
The Company’s forward-looking statements are based on information available at the time such statements are made. The Company expressly disclaims any intent or obligation to update any forward-looking statements to reflect changes in underlying assumptions or factors, new information, future events, or other changes.
Application of Critical Accounting Policies
The Company’s audited consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and follow general practices applicable to the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments 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 reported period. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility between reporting periods. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by third-party sources, when available. When third-party information is not available, valuation adjustments are estimated in good faith by management primarily through the use of internal cash flow modeling techniques.
The most significant accounting policies followed by the Company are presented in Note 1 of the Company’s 2013 audited consolidated financial statements. These policies, along with the disclosures presented in other financial statement notes and in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for loan losses and fair value measurements to be the accounting areas that require the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available.
Allowance for Loan Losses
The allowance for loan losses represents credit losses specifically identified in the loan portfolio, as well as management's estimate of probable incurred credit losses in the loan portfolio at the balance sheet date. Determining the amount of the allowance for loan losses and the related provision for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant changes. The loan portfolio also represents the largest asset group on the consolidated balance sheets. Additional information related to the allowance for loan losses that describes the methodology and risk factors can be found under the captions “Asset Quality” and “Nonperforming Assets” in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, as well as Notes 1 and 3 of the Company’s 2013 audited consolidated financial statements.
Fair Value Measurements
The carrying value of certain financial assets and liabilities of the Company is impacted by the application of fair value measurements, either directly or indirectly. Fair value is the price that would be received to sell an asset or paid to transfer a liability
(exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. In certain cases, an asset or liability is measured and reported at fair value on a recurring basis, such as investment securities classified as available for sale. In other cases, management must rely on estimates or judgments to determine if an asset or liability not measured at fair value warrants an impairment write-down or whether a valuation reserve should be established.
The Company estimates the fair value of a financial instrument using a variety of valuation methods. Where financial instruments are actively traded and have quoted market prices, quoted market prices are used for fair value. Active markets are those where transaction volumes are sufficient to provide objective pricing information with reasonably narrow bid/ask spreads and where quoted prices do not vary widely. When the financial instruments are not actively traded, other observable market inputs such as quoted prices of securities with similar characteristics may be used, if available, to determine fair value. Inactive markets are characterized by low transaction volumes, price quotations that vary substantially among market participants, or in which minimal information is released publicly.
When observable market prices do not exist, the Company estimates fair value primarily by using cash flow and other financial modeling methods. The valuation methods may also consider factors such as liquidity and concentration concerns. Other factors such as model assumptions, market dislocations, and unexpected correlations can affect estimates of fair value. Changes in these underlying factors, assumptions, or estimates in any of these areas could materially impact the amount of revenue or loss recorded.
Additional information regarding fair value measurements can be found in Notes 1 and 18 of the Company’s 2013 audited consolidated financial statements. The following is a summary of the Company’s more significant assets that may be affected by fair value measurements, as well as a brief description of the current accounting practices and valuation methodologies employed by the Company:
Available For Sale Investment Securities
Investment securities classified as available for sale are measured and reported at fair value on a recurring basis. Available for sale investment securities are valued primarily by independent third party pricing services under the market valuation approach that include, but are not limited to, the following inputs:
●
Mutual funds and equity securities are priced utilizing real-time data feeds from active market exchanges for identical securities; and
●
Government-sponsored agency debt securities, obligations of states and political subdivisions, mortgage-backed securities, corporate bonds, and other similar investment securities are priced with available market information through processes using benchmark yields, matrix pricing, prepayment speeds, cash flows, live trading data, and market spreads sourced from new issues, dealer quotes, and trade prices, among others sources.
At December 31, 2013, all of the Company’s available for sale investment securities were measured using observable market data.
Other Real Estate Owned
Other real estate owned (“OREO”) includes properties acquired by the Company through, or in lieu of, actual loan foreclosures and is initially carried at fair value less estimated costs to sell. Fair value is generally based on third party appraisals of the property that includes comparable sales data. The carrying value of each OREO property is updated at least annually and more frequently when market conditions significantly impact the value of the property. If the carrying amount exceeds fair value less estimated costs to sell, an impairment loss is recorded through expense. OREO is subsequently accounted for at the lower of carrying amount or fair value less estimated costs to sell. At December 31, 2013, OREO was $37.8 million compared to $52.6 million at year-end 2012.
Impaired Loans
Loans are considered impaired when it is probable that the Company will be unable to collect all amounts due under the contractual terms of the loan agreement. Impaired loans are measured at the present value of expected future cash flows, discounted at the
loan’s effective interest rate, at the loan’s observable market price, or at the fair value of the collateral based on recent appraisals if the loan is collateral dependent. If the value of an impaired loan is less than the unpaid balance, the difference is credited to the allowance for loan losses with a corresponding charge to provision for loan losses. Loan losses are charged against the allowance for loan losses when management believes the uncollectibility of a loan is confirmed.
Appraisals used in connection with valuing collateral-dependent loans may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Appraisers take absorption rates into consideration and adjustments are routinely made in the appraisal process to identify differences between the comparable sales and income data available. Such adjustments consist mainly of estimated costs to sell that are not included in certain appraisals or to update appraised collateral values as a result of market declines of similar properties for which a newer appraisal is available. These adjustments can be significant. Impaired loans were $58.3 million and $63.9 million at year-end 2013 and 2012, respectively.
EXECUTIVE LEVEL OVERVIEW
The Company offers a variety of financial products and services at its 36 banking locations in 23 communities throughout Central and Northern Kentucky. The Company has four separately chartered commercial banks that operate under a community banking philosophy. This philosophy focuses primarily on understanding the banking needs of those in our local and surrounding communities and providing them with competitively priced products and a high level of personalized service. The most significant products and services the Company offers include consumer and business lending, checking, savings, and other deposit accounts, automated teller machines, electronic bill payments, and providing trust services and other traditional banking products and services. The primary goals of the Company are to continually improve profitability and shareholder value, increase and maintain a strong capital position, provide excellent service to our customers through our community banking structure, and to provide a challenging and rewarding work environment for our employees.
The Company generates a significant amount of its revenue, cash flows, and net income from interest income and net interest income. The ability to properly manage net interest income under changing market environments is crucial to the success of the Company. Managing credit risk also has a significant influence on the operating results of the Company. Although the overall economy showed moderate growth during the year, the overall decline experienced from the early years of the recent economic downturn continue to weigh on the Company primarily in the form of still-elevated nonperforming assets. Unemployment rates remain high and federal fiscal policy is constraining economic growth.
The most significant issues to impact the Company’s operating results for 2013 continue to include elevated amounts of nonperforming assets and the lack of high quality loan demand. The Company remained focused on reducing nonperforming assets, which fell $18.1 million or 17.0% during the year to the lowest balance since the third quarter of 2009. The overall credit quality of the loan portfolio also improved, as historical loss rates and other measures showed widespread improvement. While certain measures of the economy are showing incremental improvements, economic growth is slow and quality loan demand remains soft.
For 2014, the Company intends to add to the improvements made over the last few years. Reducing nonperforming assets will continue to be a focal point. Seeking out and funding high quality loan demand and improving profitability is also an important goal. The Company plans to repay a portion of its outstanding preferred stock, although this is subject to approval by its banking regulators. United Bank, a subsidiary of the Company, in early 2014 received notice that the formal Consent Order it entered into with its regulators during 2011 had been terminated and replaced with a stepped-down enforcement action in the form of an informal Memorandum. Removal of formal enforcement actions by regulators, such as the Consent Order, is an important step toward being able to repay a portion of the preferred stock. The Company is diligently working to improve its overall financial condition and for the removal of all enforcement actions with its banking regulators.
RESULTS OF OPERATIONS
The Company reported net income of $13.4 million for 2013 an increase of $1.3 million or 10.7% compared to $12.1 million for 2012. On a per common share basis, net income was $1.54 and $1.37 for 2013 and 2012, respectively. Selected income statement amounts and related information is presented in the table below.
bp = basis points.
The more significant components related to the Company’s results of operations are included below.
Interest Income
Interest income results from interest earned on earning assets, which primarily includes loans and investment securities. Interest income is affected by volume (average balance), the composition of earning assets, and the related rates earned on those assets. Total interest income for 2013 was $66.7 million, a decrease of $4.5 million or 6.3% compared to $71.2 million for 2012. With the exception of nontaxable investment securities, interest income decreased across all major earning asset categories. The decrease in interest income relates to lower interest on loans and investment securities, which decreased due to a combination of both rate and volume declines. Rate declines continue to be driven by a slow-growth economy and related competitive factors combined with the overall strategy by the Company of being more selective in pricing both its loans and deposits. While longer-term market interest rates began to climb toward the last half of 2013, actions by the Federal Reserve Board (“Federal Reserve”) have kept the level of interest rates low, with the objective of holding short-term interest rates at exceptionally low levels until unemployment rates decline to a target of 6.5%. In general, the Company’s variable and floating rate assets and liabilities resetting since the prior year, as well as activity related to new earning assets and funding sources, have repriced downward in the current interest rate environment. The Company’s tax equivalent yield on earning assets was 4.1% for 2013, a decrease of 12 basis points compared to 4.2% for 2012.
Interest Expense
Interest expense results from incurring interest on interest bearing liabilities, which are made up of interest bearing deposits, federal funds purchased, securities sold under agreements to repurchase, and other borrowed funds. Interest expense is affected by volume, composition of interest bearing liabilities, and the related rates paid on those liabilities. Total interest expense was $12.0 million for 2013, a decrease of $6.3 million or 34.3% compared to $18.3 million for 2012. The decrease in interest expense is attributed to lower interest on deposits and long-term borrowings. Both rate declines and lower volume contributed to the decrease in interest
expense for each of these items. For deposits, substantially all of the decrease in interest expense was related to time deposits. The Company has continued to aggressively reprice higher-rate maturing time deposits downward to lower market rates or to allow them to mature without renewal. For long-term borrowings, the decrease in interest expense reflects two events that occurred during the fourth quarter of 2012: a $50.0 million principal repayment of borrowed funds which drove down the average balance for 2013 and the repricing of $23.2 million of 6.60% fixed rate subordinated debt to a floating interest rate of three-month LIBOR plus 132 basis points. The interest rate in effect at year-end 2013 for this portion of outstanding debt was 1.56%.
Net Interest Income
Net interest income is the most significant component of the Company’s operating earnings. Net interest income is the excess of the interest income earned on earning assets over the interest paid for funds to support those assets. The two most common metrics used to analyze net interest income are net interest spread and net interest margin. Net interest spread represents the difference between the taxable equivalent yields on earning assets and the rates paid on interest bearing liabilities. Net interest margin represents the percentage of taxable equivalent net interest income to average earning assets. Net interest margin will exceed net interest spread because of the existence of noninterest bearing sources of funds, principally demand deposits and shareholders’ equity, which are also available to fund earning assets. Changes in net interest income and margin result from the interaction between the volume and composition of earning assets, their related yields, and the associated cost and composition of the interest bearing liabilities. Accordingly, portfolio size, composition, and the related yields earned and the average rates paid have a significant impact on net interest spread and margin. The table following this discussion represents the major components of interest earning assets and interest bearing liabilities on a tax equivalent basis. To compare the tax-exempt asset yields to taxable yields, amounts in the table are adjusted to pretax equivalents based on the marginal corporate Federal tax rate of 35%.
Tax equivalent net interest income was $56.4 million for 2013, an increase of $1.7 million or 3.1% compared to $54.7 million for 2012. Net interest margin was 3.40%, an increase of 22 basis points from 3.18% for the prior year. The increase in net interest margin was driven by a 27 basis point increase in the net interest spread, which was 3.23% for 2013 compared to 2.96% for 2012.
The Company actively monitors and proactively manages the rate sensitive components of both its assets and liabilities in a continuously changing and difficult market environment. Competition in the Company’s market areas continues to be intense, and while longer term interest rates shifted upward during the last half of 2013, they remain low by historical measures. The Federal Reserve has kept its short-term federal funds target rate at near zero percent since mid-December 2008 and has indicated that it expects to maintain that rate at an exceptionally low level while unemployment rates remain above 6.5%. Yields on the 5-year, 10-year, and 30-year Treasury securities are up 102 basis points, 127 basis points, and 102 basis points at year-end 2013, respectively, compared to a year earlier. Yields on the 3-month and 6-month Treasuries are relatively unchanged.
Similar to the short-term federal funds target rate, the prime interest rate has not changed since December 2008. The Company uses the prime interest rate as part of its pricing model primarily on variable rate commercial real estate loans. The prime interest rate can have a significant impact on the Company’s interest income on loans that reprice based on changes to this rate. The Company’s variable interest rate loans contain provisions that limit the amount of increase or decrease in the interest rate during the life of a loan. This will limit the increase or decrease in interest income on loans that have interest rates tied to the prime interest rate. For 2013, the average yield earned on loans was 5.4%, which exceeded the prime interest rate of 3.25% at year-end. Predicting the movement of future interest rates is uncertain.
During 2013, the average rate for two of the Company’s most significant components of net interest income, loans and time deposits, both declined. The average rate earned on the Company’s loan portfolio for 2013 declined 11 basis points to 5.4% and the average rate paid on time deposits decreased 42 basis points to 1.0% compared to 2012. The Company expects its net interest margin to trend modestly upward in the near term, primarily from a decrease in its cost of funds, according to internal modeling using expectations about future market interest rates, the maturity structure of the Company’s earning assets and liabilities, and other factors. Future results, however, could be significantly different than expectations.
Distribution of Assets, Liabilities and Shareholders’ Equity: Interest Rates and Interest Differential
1Income and yield stated at a fully tax equivalent basis using the marginal corporate Federal tax rate of 35%.
2Loan balances include principal balances on nonaccrual loans.
3Loan fees included in interest income amounted to $1.3 million, $1.1 million, and $912 thousand for 2013, 2012, and 2011, respectively.
The following table is an analysis of the change in net interest income.
Analysis of Changes in Net Interest Income (tax equivalent basis)
1The changes which are not solely due to rate or volume are allocated on a percentage basis using the absolute values of rate and volume variances as a basis for allocation.
2Income stated at fully tax equivalent basis using the marginal corporate Federal tax rate of 35%.
Provision for Loan Losses
The Company recorded a credit to the provision for loan losses in the amount of $2.6 million for 2013 compared to a charge of $2.8 million for 2012. The allowance for loan losses as a percentage of outstanding loans (net of unearned income) was 2.06% at December 31, 2013 compared to 2.43% at year-end 2012. The decrease in the provision for loan losses is attributed to improving trends in the credit quality of the loan portfolio and a lower level of loans outstanding. Further information about improvements in the Company’s overall credit quality is included under the captions “Allowance for Loan Losses” and “Nonperforming Loans” that follows.
Net charge-offs were $1.3 million and $6.6 million for 2013 and 2012, respectively. This represents a decrease of $5.3 million or 80.8%. Net charge-offs were .13% of average loans outstanding for 2013 compared to .64% for the prior year.
Noninterest Income
The components of noninterest income are as follows for the periods indicated:
The more significant items impacting noninterest income are included below.
●
The decrease in allotment processing fees is attributed primarily to volume declines, due in part to reductions in military troop levels and deployments. The Company expects the rate of decrease from its allotment fees to slow or modestly increase beginning mid-2014 from an anticipated pickup in volume, resulting from a large competing vendor that is exiting this line of business in the coming year.
●
The increase in other service charges, commissions, and fees is attributed to higher interchange fees and loan servicing of $301 thousand or 12.8% and $90 thousand or 23.2%, respectively. The increase in interchange fees is due to higher debit card transaction volumes. Loan servicing income is up due to a $27.9 million or 16.2% growth in the mortgage loan servicing portfolio.
●
Data processing income began to decrease sharply during 2011 as a result of the initial termination of the Company’s depository services contract with the Commonwealth of Kentucky (“Commonwealth”). Fees from the Commonwealth continued to decline over an additional one-year transition period as the contract wound down and ultimately terminated in June 2012. These fee reductions have been partially offset by decreases in related noninterest expenses spread over multiple line items categories.
●
Investment securities include a $57 thousand loss for 2013 attributed to a single municipal bond where the issuer participated in the Build America Bond (“BAB”) program. BAB is a federal government program whereby the U.S. Treasury pays a direct subsidy to the issuer to support interest costs of qualified bonds. Federal budget sequestration events during 2013 reduced the subsidy to the issuer, triggering an extraordinary redemption feature related to these bonds. This bond had a carrying value in excess of its par value due to the unamortized premium. The issuer redeemed the bond at par value, which resulted in the loss. Given the current interest rate environment, the Company expects another bond issue related to the BAB program to be called during the first quarter of 2014, resulting in a loss of approximately $156 related to unamortized premiums. The net gain recorded in the prior year is attributed to normal asset/liability management strategies, as the Company periodically sells investment securities to lock in gains, increase yield, restructure expected future cash flows, and/or enhance its capital position.
●
The decrease in net gains on the sale of mortgage loans is due to lower origination and refinancing activity. The volume of loans sold in 2013 decreased $34.7 million or 41.0% compared to 2012. Mortgage refinancing and home purchases rose sharply during 2012 fueled by interest rate declines. Those rates have since increased which has reduced customer demand.
●
Income from company-owned life insurance decreased primarily because the prior year includes a nonrecurring gain in the amount of $529 thousand related to death benefit proceeds. Lower crediting rates represent the remaining decrease.
●
Other income for 2013 includes a net loss of $306 thousand related to the Company’s equity interest in two low income tax credit partnerships. For 2012, the loss was $226 thousand.
Noninterest Expense
The components of noninterest expense are as follows for the periods indicated:
The more significant items impacting noninterest expenses are included below.
●
The increase in salaries and employee benefits was driven by a $996 thousand or 20.5% net increase in benefit expenses, mainly from higher claims related to the Company’s self-funded health insurance plan. Claims for 2013 were unusually high in comparison to recent years. The Company had 519 full time equivalent employees at year-end 2013, virtually unchanged from 518 a year earlier.
●
Data processing and communication expenses mainly decreased due to cost savings related to an agreement the Company announced during the first quarter of 2012 to reduce its debit card processing expenses and to cost reductions associated with the termination of the Company’s depository services contract with the Commonwealth as previously discussed.
●
Amortization of intangible assets declined as a result of actuarial determined reductions related to core deposit and customer relationship intangible assets arising from previous business acquisitions. Intangible assets are scheduled to fully amortize by 2015.
●
Deposit insurance expense decreased during 2013 primarily as a result of the improved risk rating by the FDIC at the Company’s largest bank subsidiary. The better rating reduced the assessment rate used in determining the amount payable for deposit insurance.
●
The increase in other real estate expenses was driven by higher impairment charges of $1.8 million or 46.8%. Total impairment charges for 2013 were $5.5 million, which includes $2.0 million related to a single residential real estate development project that had a carrying value of $2.9 million at year-end 2013.
●
The decrease in legal expenses relates primarily to problem loan activity in the normal course of business. Also, the prior year includes nonrecurring expenses of $122 thousand related to registering the Company’s Series A preferred shares that were sold by the U.S. Treasury to third party investors.
Income Taxes
Income tax expense was $4.4 million for 2013, an increase of $1.5 million or 52.4% compared to $2.9 million for 2012. The effective income tax rates were 24.8% and 19.3% for 2013 and 2012, respectively. The increase in income tax expense and the effective tax rate for 2013 is attributed primarily to a combination of lower tax credits and the relative amount of tax-free income to total income. Tax credits that have been utilized by the Company over a number of years related to Qualified Zone Academy Bonds were fully exhausted during 2012. In addition, the taxable portion of total revenues has increased more in proportion to the nontaxable revenues.
FINANCIAL CONDITION
The size of the Company’s balance sheet was relatively unchanged at year-end 2013, with total assets up .1% compared to the prior year. The overall financial condition of the Company, however, continued to improve. Total nonperforming assets have declined in five consecutive quarters and are at the lowest level since the third quarter of 2009. Credit quality metrics and net interest margin improved in 2013, and banking regulators have recognized improvements by removing (during 2013) or reducing (in early 2014) enforcement actions at two of the Company’s subsidiary banks. Regulatory capital levels remain significantly above the “well-capitalized” threshold. Quality loan demand, however, remains weak. Absent regulatory approval to repay a portion of its preferred shares, preferred dividend payments will increase as a result of the rate resetting from 5% to 9% during the first quarter of 2014.
Total assets were $1.8 billion at December 31, 2013, representing a .1% increase from year-end 2012. Cash and cash equivalents, OREO, and loans (net of unearned income) decreased $27.6 million or 28.8%, $14.7 million or 28.0%, and $5.1 million or .5%, respectively. Investment securities increased $39.7 million or 6.9%. Deposits and total liabilities were unchanged at $1.4 billion and $1.6 billion, respectively; shareholders’ equity increased $2.0 million or 1.2%.
Temporary Investments
Temporary investments consist of interest bearing deposits in other banks and federal funds sold and securities purchased under agreements to resell. The Company uses these funds in the management of liquidity and interest rate sensitivity or as a short-term holding prior to subsequent movement into other investments with higher yields or for other purposes. At December 31, 2013, temporary investments were $45.3 million, a decrease of $23.1 million or 33.7% compared to $68.4 million at year-end 2012.
Investment Securities
The investment securities portfolio is comprised primarily of residential mortgage-backed securities, tax-exempt securities of states and political subdivisions, and debt securities issued by U.S. government-sponsored agencies. Substantially all of the Company’s investment securities are designated as available for sale. Total investment securities had a carrying amount of $614 million at year-end 2013, an increase of $39.7 million or 6.9% compared to $574 million at year-end 2012. Proceeds received from maturing or called investment securities not needed to fund higher-earning loans are either reinvested in similar investments or used to manage liquidity, such as for deposit outflows or other payment obligations. The Company periodically sells investment securities in response to its overall asset/liability management strategy to lock in gains, increase yield, restructure expected future cash flows, and/or enhance its capital position.
The increase in investment securities was driven by net purchases of $64.8 million, partially offset by a decrease in the unrealized gain on available for sale securities in the amount of $20.1 million, which resulted in an overall net unrealized loss of $5.6 million at year-end. Net premium amortization was $5.0 million for 2013 compared to $5.3 million for 2012. The decrease in the value of the available for sale securities portfolio is attributed to a general shift downward in bond prices, primarily for the longer term maturity periods. Bond prices fell sharply during the second quarter of 2013 and remained relatively stable during the third quarter, then further falling at year-end. The initial decrease in bond prices occurred primarily as a result of the market’s response to changing perceptions about monetary tightening by the Federal Reserve through its level and timing of bond purchasing activity. The resulting higher interest rates also increased volatility, which further reduced prices. During the fourth quarter, the Federal Reserve announced that it would begin paring back its bond purchasing activity beginning in 2014. This action, combined with a more positive economic outlook, resulted in lower bond prices for the quarter. As market interest rates increase, the value of fixed rate investments decreases.
At year-end 2013, investment securities include $5.9 million amortized cost amounts of single-issuer trust preferred capital securities of a U.S. based global financial services firm with an estimated fair value of $4.8 million. The investment continues to perform according to contractual terms and is rated as investment grade by major rating agencies. The issuer of the securities announced in the first quarter of 2013 that it had passed stringent regulatory stress testing and received regulatory approval to both increase per share common dividend payments and increase its equity repurchase program. The Company does not intend to sell its investment in these securities, nor does the Company believe it is likely that it will be required to sell these securities prior to their anticipated recovery. The Company believes these securities are not impaired due to reasons of credit quality or other factors, but rather the
unrealized loss is primarily attributed to general uncertainties in both international and domestic economies and continuing market volatility. The Company believes that it will collect all amounts due according to the contractual terms of these securities and that the fair values of these securities will continue to recover as they approach their maturity dates.
The Company attributes the unrealized losses in other sectors of the investment securities portfolio to changes in market interest rates and volatility, and thus identifies them as temporary. As discussed further above, market interest rates rose sharply during the last half of 2013, particularly for the longer dated maturity periods. Investment securities with unrealized losses at December 31, 2013 are performing according to their contractual terms, and the Company does not expect to incur a loss on these securities unless they are sold prior to maturity. The Company does not have the intent to sell these securities nor does it believe it is likely that it will be required to sell these securities prior to their anticipated recovery. The Company does not consider any of the securities to be impaired due to reasons of credit quality or other factors. All investment securities in the Company’s portfolio are currently performing.
Funds made available from sold, matured, or called bonds are redirected to fund higher yielding loan growth, reinvested to purchase additional investment securities, or otherwise employed to improve the composition of the balance sheet and liquidity. The purchase of nontaxable obligations of states and political subdivisions is one of the primary means of managing the Company’s tax position. The impact of the alternative minimum tax related to the Company’s ability to acquire tax-free obligations at an attractive yield is routinely monitored. The Company does not have direct exposure to the subprime mortgage market. The Company does not originate subprime mortgages nor has it invested in bonds that are secured by such mortgages.
The following table summarizes the carrying values of investment securities on December 31, 2013, 2012, and 2011. The investment securities are divided into available for sale and held to maturity securities. Available for sale securities are carried at estimated fair value and held to maturity securities are carried at amortized cost. Corporate debt securities consist primarily of debt issued by a large global financial services firm. Mutual funds and equity securities are attributed to the Company’s captive insurance subsidiary.
The following table presents an analysis of the contractual maturity and tax equivalent weighted average interest rates of investment securities at December 31, 2013. Available for sale securities are stated at estimated fair value and held to maturity securities are stated at amortized cost. Mortgage-backed securities are included in maturity categories based on their stated maturity dates. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations. Mutual funds and equity securities are attributed to the Company’s captive insurance subsidiary. These investments have no stated maturity date and are not included in the maturity schedule that follows.
Available for Sale
Held to Maturity
The calculation of the weighted average interest rates for each category is based on the weighted average costs of the securities. The weighted average tax rates on exempt state and political subdivisions are computed based on the marginal corporate Federal tax rate of 35%.
Loans
Loans, net of unearned income, were $1.0 billion at December 31, 2013, a decrease of $5.1 million or .5% compared to year-end 2012. While the Company continues its efforts to strengthen customer relationships and business development initiatives, high quality loan demand remains soft. The Company continues a measured and cautious lending strategy while it reduces high levels of nonperforming assets in an improving, but slow growing economy.
The composition of the loan portfolio, net of unearned income, is summarized in the table that follows. Loans outstanding were negatively impacted during the fourth quarter of 2013 by the payoff of four credit relationships totaling $14.1 million in the aggregate secured by similar commercial real estate properties. Based on economic forecasts and other available information, the Company expects minor improvement in the local and regional economy during 2014. An improving economy, particularly where the labor force participation rates increase, could slow the rate of decline experienced in outstanding loan balances in recent years or result in incremental loan growth.
On an average basis, loans represented 60.6% of earning assets for 2013, an increase of 50 basis points compared to 60.1% for 2012. As loan demand changes, available funds are reallocated between temporary investments or investment securities, which typically involve a decrease in credit risk and result in lower yields. The Company does not have direct exposure to the subprime mortgage market. The Company does not originate subprime mortgages nor has it invested in bonds that are secured by such mortgages. Subprime mortgage lending is defined by the Company generally as lending to a borrower that would not qualify for a mortgage loan at prevailing market rates or whereby the underwriting decision is based on limited or no documentation of the ability to repay.
The following table presents the amount of commercial, financial, and agricultural loans and loans secured by real estate outstanding at December 31, 2013 which, based on remaining scheduled repayments of principal, are due in the periods indicated.
Loan Maturities
The table below presents the amount of commercial, financial, and agricultural loans and loans secured by real estate outstanding at December 31, 2013 that are due after one year, classified according to sensitivity to changes in interest rates.
Interest Sensitivity
Asset Quality
The Company’s loan portfolio is subject to varying degrees of credit risk. Credit risk is mitigated by diversification within the portfolio, limiting exposure to any single customer or industry, rigorous lending policies and underwriting criteria, and collateral requirements. The Company maintains policies and procedures to ensure that the granting of credit is done in a sound and consistent manner. This includes policies on a company-wide basis that require certain minimum standards to be maintained by its subsidiary banks. However, the policies also permit the subsidiary companies authority to adopt standards that are no less stringent than those included in the company-wide policies. Credit decisions are made at the subsidiary bank level under guidelines established by policy. The Company’s internal audit department performs loan reviews at each subsidiary bank during the year. This review evaluates loan administration, credit quality, documentation, compliance with Company loan standards, and the adequacy of the allowance for loan losses on a consolidated and subsidiary basis.
The provision for loan losses represents charges or credits made to earnings to maintain an allowance for loan losses at a level considered adequate to provide for probable incurred credit losses at the balance sheet date. The allowance for loan losses is a
valuation allowance increased by the provision for loan losses and decreased by net charge-offs. Loan losses are charged against the allowance when management believes the uncollectibility of a loan is confirmed. Subsequent recoveries, if any, are credited to the allowance.
The allowance for loan losses and related provision for loan losses generally fluctuate as the relative level of nonperforming and impaired loans vary, but other factors impact the amount of the allowance. The Company estimates the adequacy of the allowance using a risk-rated methodology based on the Company’s past loan loss experience, known and inherent risks in the loan portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral securing loans, composition of the loan portfolio, current economic conditions, and other relevant factors. This evaluation is inherently subjective as it requires significant judgment and the use of estimates that may be susceptible to change.
The allowance for loan losses consists of specific and general components. The specific component relates to loans that are individually classified as impaired. The general component covers non-impaired loans and is based on historical loss experience adjusted for current risk factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. Actual loan losses could differ significantly from the amounts estimated by management.
The Company’s risk-rated methodology includes segregating non-impaired watch list and past due loans from the general portfolio and allocating a loss percentage to these loans depending on their status. For example, watch list loans, which may be identified by the internal loan review risk-rating process or by regulatory examiner classification, are assigned a certain loss percentage while loans past due 30 days or more are assigned a different loss percentage. Each of these percentages considers past experience as well as current factors. The remainder of the general loan portfolio is segregated into portfolio segments having similar risk characteristics identified as follows: real estate loans, commercial loans, and consumer loans. Each of these portfolio segments is assigned a loss percentage based on their respective rolling historical loss rates, adjusted for qualitative risk factors. During the third quarter of 2013, the Company lengthened the look-back period it uses to determine historical loss rates to the previous 16 quarters from 12 quarters. The change in the look-back period is the result of the Company’s ongoing monitoring and evaluation of the adequacy of its allowance for loan losses. The longer look-back period better reflects the Company’s loss estimates based on current market conditions. Lengthening the look-back period resulted in a $320 thousand increase in the allowance for loan losses.
The qualitative risk factors used in the methodology are consistent with the guidance in the most recent Interagency Policy Statement on the Allowance for Loan Losses issued. Each factor is supported by a detailed analysis performed at each subsidiary bank and is both measureable and supportable. Some factors include a minimum allocation in some instances where loss levels are extremely low and it is determined to be prudent from a safety and soundness perspective. Qualitative risk factors that are used in the methodology include the following for each loan portfolio segment:
●
Delinquency trends
●
Trends in net charge-offs
●
Trends in loan volume
●
Lending philosophy risk
●
Management experience risk
●
Concentration of credit risk
●
Economic conditions risk
A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired. 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.
Although the overall economy continued improving during 2013, recovery from the 2007-2009 recession and related financial crisis remains slow. The economic decline from these events resulted in significant deterioration in the Company’s credit quality and collateral values, primarily in residential real estate lending. While many economic measures have yet to rebound to their pre-recession levels, the overall trend is upward, albeit slow. Foreclosure rates continue to improve throughout much of Kentucky, as are the sales of residential real estate both in terms of volume and average sales prices. However, the 8.0% unemployment rate in Kentucky remains higher than the 6.7% national average; although the rate in the Central Kentucky region is generally below the state wide rate. The Kentucky unemployment rate rose to a high of 8.5% during 2013, influenced by U.S. federal government sequestration cuts impacting the defense sector and other government related industries. Economic growth remains slow, with current GDP growth forecasts for the U.S. and Kentucky at 2.5% and 2.0%, respectively, for 2014. The national and Kentucky unemployment rates each are forecasted to improve to around 6.5% for 2014.
The overall improvement in the credit quality of the loan portfolio has resulted in the lowest level of nonperforming assets since the third quarter of 2009. Nonperforming loans have decreased $57.4 million or 53.2% since peaking at $108 million for the first quarter of 2010. Over half of the nonperforming loans at year-end 2013 are made up of accruing restructured loans. Despite these improvements, the level of nonperforming assets remains elevated. High levels of nonperforming assets generally result in loan charge-offs, provisions for loan losses, and impairment charges on repossessed real estate. The Company expects the lingering effects of the recent recession to continue hindering its efforts to improve asset quality in the short term, which could result in further deterioration. The impact on asset quality in future periods, however, cannot be predicted with a high degree of certainty. The Company works with its loan customers on an individual case-by-case basis in order to maximize loan repayments on its challenged credits and typically does not restructure those that are past due.
Impaired loans are those in which the Company does not expect to receive full payment under the contractual terms. Impaired loans are measured at the present value of expected future cash flows discounted at the loan’s effective interest rate, at the loan’s observable market price, or at the fair value of the collateral taking into consideration estimated costs to sell if the loan is collateral dependent. Collateral values are updated in accordance with policy guidelines by obtaining independent third party appraisals and monitoring sales activity of similar properties in our market area.
At year-end 2013, the Company had $4.1 million in specific reserves related to impaired loans. Of this total, $1.5 million or 37.6% is attributed to a group of loans to a single creditor totaling $8.3 million secured by a combination of a real estate development and residential real estate. These collateral dependent loans are classified as performing restructured loans at year-end 2013.
The Company recorded a credit to the provision for loan losses of $2.6 million for 2013, a decrease of $5.4 million compared to a charge of $2.8 million for 2012. The decrease in the provision for loan losses is attributed mainly to the improvement in the credit quality of the loan portfolio and a decrease in loan balances outstanding. Historical loss rates, adjusted for current risk factors, have improved as lower recent charge-off activity has replaced the higher levels that had been included in the early part of the Company’s look-back period used in its allowance for loan losses methodology. The decrease in historical loss rates and charge-off activity relate primarily to stabilization in the value of real estate, which serves as collateral for nearly 90% of the Company’s loan portfolio. The rapid declines in real estate values experienced beginning in 2008 and continuing through 2011 have leveled off, and the allowance for loan losses reflects this improvement.
Net charge-offs were $1.3 million for 2013, a decrease of $5.3 million or 80.8% compared to 2012. Net charge-offs have declined in each of the last two years and are well below the $14.2 million peak recorded in the early part of the post-recession period of 2009. The amount of net charge-offs for 2013 represent the lowest point since 2006. Gross charge-offs and recoveries by loan category are detailed in the table that follows. Net charge-offs as a percentage of average loans were .13% for 2013, a decrease of 51 basis points compared to .64% for 2012. The allowance for loan losses as a percentage of outstanding loans (net of unearned income) was 2.06% and 2.43% at year-end 2013 and 2012, respectively. As a percentage of nonperforming loans, the allowance for loan losses was 40.7% and 45.4% at year-end 2013 and 2012, respectively.
The relatively low amount of the allowance for loan losses as a percentage of nonperforming loans is due mainly to the makeup of nonperforming loans, where performing restructured loans account for 52.0% of total nonperforming loans outstanding at year-end 2013. The allowance attributed to credits that are restructured with lower interest rates generally represents the difference in the present value of future cash flows calculated at the loan’s original effective interest rate and the new lower rate. This typically results in a reserve for loan losses that is less severe than for other loans that are collateral dependent.
Many of the nonaccrual loans outstanding at year-end 2013 have previously been charged-down. These charge-offs have occurred mainly as a result of the Company’s ongoing effort to appropriately value the collateral securing these loans through timely appraisals and evaluating the overall financial condition of the borrower. The allowance for loan losses as a percentage of nonaccrual loans was 86.3% and 89.2% at year-end 2013 and 2012, respectively.
The table below summarizes the loan loss experience for the past five years.
Allowance For Loan Losses
The following table presents an estimate of the allocation of the allowance for loan losses by type for the dates indicated. Although specific allocations exist, the entire allowance is available to absorb losses in any particular category.
Additional information concerning the Company’s asset quality is presented under the caption “Nonperforming Assets” which follows and “Investment Securities” beginning on page 49.
Nonperforming Assets
The Company’s nonperforming assets consist of nonperforming loans, OREO, and other foreclosed assets. Nonperforming loans include nonaccrual loans, restructured loans, and loans 90 days or more past due and still accruing interest. Nonaccrual loans are considered to be an indicator of potential future losses. The accrual of interest on loans is discontinued when it is determined that the collection of interest or principal is doubtful, or when a default of interest or principal has existed for 90 days or more, unless such loan is well secured and in the process of collection. Restructured loans occur when a lender, because of economic or legal reasons related to a borrower’s financial difficulty, grants a concession to the borrower that it would not otherwise consider. Restructured loans typically include a reduction of the stated interest rate or an extension of the maturity date. The Company gives careful consideration to identifying which of its challenged credits merit a restructuring of terms that it believes will result in maximum loan repayments and mitigate possible losses. Cash flow projections are carefully scrutinized prior to restructuring any credits; past due credits are typically not granted concessions.
Nonperforming assets were $88.4 million at year-end 2013, a decrease of $18.1 million or 17.0% compared to $106 million at year-end 2012. Nonperforming assets are at the lowest level since peaking at $135 million in the first quarter of 2010. Nonperforming assets increased sharply during 2009 and remain elevated mainly as a result of ongoing weaknesses in the overall economy, which continues to strain the Company and many of its customers.
Nonperforming assets by category are presented in the table below for the dates indicated.
Additional details related to nonperforming loans were as follows at year-end 2013 and 2012:
Nonperforming Loans
The most significant components of nonperforming loans include nonaccrual and restructured loans. Activity during 2013 related to these two components was as follows:
The Company gives careful consideration to identifying which of its challenged credits merit a restructuring of terms that it believes will result in maximum loan repayments and mitigate possible losses. From time to time the Company may modify a customer’s loan, but such modifications may or may not meet the criteria for classification as a restructured troubled debt. Modifications that do not meet the criteria of a troubled debt include:
●
repricing a loan to a current market rate of interest to a borrower with good credit and adequate collateral value in order to retain the customer;
●
changing the payment frequency from monthly to quarterly, semi-annually, or annually where the loan is performing, the borrower has good credit and adequate collateral value and the Company believes valid reasons exist for the change; or
●
extending the interest only payment period of a performing loan where the borrower has good credit and adequate collateral value in instances where a project may still be in a phase of development or leasing-up, and where the Company believes completion will occur in the near future, or such extension is otherwise in the Company’s best interest.
As modifications are made, management evaluates whether the modification meets the criteria to be classified as a troubled debt. These criteria include two components:
1.
The bank makes a concession on the loan terms that it would not otherwise consider, and
2. The borrower is experiencing financial difficulty.
The Company’s loan policy provides guidance to lending personnel regarding restructured loans to ensure those that are troubled debt are properly identified. Additional attention is given to restructured loans through the oversight of the Chief Credit Officer at the Parent Company to ensure that modifications meeting criteria for restructured loans are identified and properly reported.
The table below sets forth on an aggregate basis at December 31, 2013, the types of non-troubled debt restructurings by loan type, number of loans, average loan balance and modification type:
In each of the loan modifications identified in the table, management of the applicable bank determined the loan was not in troubled condition due to the financial status of the borrower and collateral.
The Company’s subsidiary banks have not engaged in loan splitting. Loan splitting is a practice that may occur in work-out situations whereby a loan is divided into two parts - a performing part and a nonperforming part. This benefits a lender by potentially replacing one impaired loan by one smaller good loan and one smaller bad loan. Overall charge-offs and reserve amounts are potentially reduced and the effects of adverse loan classifications may be diminished.
The Company’s comprehensive risk-grading and loan review program includes a review of loans to assess risk and assign a grade to those loans, a review of delinquencies, and an assessment of loans for needed charge-offs or placement on nonaccrual status. The Company had loans in the amount of $79.0 million and $104 million at year-end 2013 and year-end 2012, respectively, which were performing but considered potential problem loans and are not included in the nonperforming loan totals in the tables above. These loans, however, are considered in establishing an appropriate allowance for loan losses. The balance outstanding for potential problem credits is mainly a result of ongoing weaknesses in the overall economy that continue to strain many of the Company’s customers. Potential problem loans include a variety of borrowers and are secured primarily by various types of real estate including commercial, construction properties, and residential real estate developments. The $25.0 million or 24.1% decrease since year-end in the level of potential problem loans is attributed primarily to an overall improvement in credit quality similar to that of the overall portfolio. At December 31, 2013, the five largest potential problem credits were $16.7 million in the aggregate compared to $18.2 million at year-end 2012 and secured by various types of real estate including commercial, construction properties, and residential real estate development.
Potential problem loans are identified on the Company’s watch list and consist of loans that require close monitoring by management. Credits may be considered as a potential problem loan for reasons that are temporary or correctable, such as for a deficiency in loan documentation or absence of current financial statements of the borrower. Potential problem loans may also include credits where adverse circumstances are identified that may affect the borrower’s ability to comply with the contractual terms of the loan. Other factors which might indicate the existence of a potential problem loan include the delinquency of a scheduled loan payment, deterioration in a borrower’s financial condition identified in a review of periodic financial statements, a decrease in the value of the collateral securing the loan, or a change in the economic environment in which the borrower operates. Certain loans on the Company’s watch list are also considered impaired and specific allowances related to these loans were established in accordance with the appropriate accounting guidance.
Other real estate owned includes real estate properties acquired by the Company through, or in lieu of, actual loan foreclosures. At year-end 2013, OREO was $37.8 million, a decrease of $14.7 million or 28.0% compared to $52.6 million at year-end 2012.
OREO activity for 2013 was as follows:
The reduction in OREO was driven by property sales and impairment charges of $15.4 million and $5.5 million, respectively, which more than offset new repossession activity. Seven larger-balance properties with a carrying value of $7.6 million in the aggregate were sold during 2013. This includes four real estate development projects totaling $4.1 million and three commercial real estate properties totaling $3.5 million. Impairment charges include $2.0 million attributed to a single residential real estate development project which ended the year with a carrying value of $2.9 million, which represents the projects appraised value less estimated selling costs. The Company’s three largest OREO properties at year-end 2013 consist of one residential real estate development project with a carrying value of $2.9 million, one commercial real estate development project of $2.9 million, and one commercial rental real estate property of $2.8 million.
Deposits
The Company’s primary source of funding for its lending and investment activities results from its customer deposits, which consist of noninterest and interest bearing demand, savings, and time deposits. A summary of the Company’s deposits is presented in the table that follows. The decrease in time deposits is a result of the Company’s overall liquidity position and of its strategy to lower
funding costs, mainly by allowing higher-rate certificates of deposit to roll off or reprice at significantly lower interest rates. Many of those balances have been rolled into other types of interest bearing accounts or noninterest bearing demand accounts by the customer. As rates have decreased throughout the deposit portfolio, many customers have opted to transfer funds from maturing time deposits or investments from other sources into short-term demand or savings accounts. The Company has not sought out or accepted brokered deposits in the past nor does it have plans to do so in the future.
A summary of the Company’s deposits is as follows for the dates indicated:
A summary of average balances for deposits by type and the related weighted average rates paid is as follows for the periods presented:
Maturities of time deposits of $100,000 or more outstanding at December 31, 2013 are summarized as follows:
Short-term Borrowings
Short-term borrowings include funding sources with an original maturity of one year or less. The Company’s short-term borrowings consist of federal funds purchased and securities sold under agreements to repurchase, which are generally on an overnight basis. A summary of short-term borrowings is as follows:
Long-term Borrowings
Long-term borrowings include funding sources with an original maturity greater than one year. The Company’s long-term borrowings are comprised of securities sold under agreements to repurchase, FHLB advances, and subordinated notes payable to unconsolidated trusts. Long-term securities sold under agreements to repurchase primarily represent obligations related to the Company’s balance sheet leverage transaction that originated in 2007. In this transaction, the Company borrowed $200 million through multiple fixed rate repurchase agreements and used the proceeds to purchase fixed rate Government National Mortgage Association (“GNMA”) bonds that are pledged as collateral. The Company is required to secure the borrowed funds with GNMA bonds valued at 106% of the outstanding principal balance of the borrowings. Principal payments have reduced the outstanding balance of the obligation to $100 million at year-end 2013, with a weighted average interest rate of 3.95%. These borrowings are putable quarterly and mature in November 2017.
The Company has $754 thousand of other long-term repurchase agreements outstanding at year-end 2013 made in the ordinary course of business with commercial customers. These borrowings have a weighted average fixed rate of 1.17% with portions maturing during 2015 and 2016.
FHLB advances to the Company’s subsidiary banks are secured by restricted holdings of FHLB stock that participating banks are required to own as well as certain mortgage loans as required by the FHLB. Such advances are made pursuant to several different credit programs which have their own interest rates and range of maturities. Interest rates on FHLB advances are fixed and range between 2.99% and 6.90%, with a weighted average rate of 4.14%. Remaining maturities of FHLB advances extend over multiple time periods through 2020, with a weighted average remaining term of 2.9 years. FHLB advances are generally used to increase the Company’s lending activities and to aid the efforts of asset and liability management by utilizing various repayment options offered by the FHLB. Long-term advances from the FHLB totaled $27.1 million and $29.3 million at December 31, 2013 and 2012, respectively. This represents a decrease of $2.2 million or 7.4% and is attributed to scheduled repayment activity.
In 2005 and 2007, the Company completed three private offerings of trust preferred securities through separate Delaware statutory trusts (the “Trusts”) sponsored by the Company in the aggregate amount of $47.5 million. The combined $25.0 million proceeds from the first two trusts (“Trusts I and II”) established in 2005 were used to fund the acquisition of Citizens Bancorp. Proceeds from the third trust (“Trust III”) were used primarily to acquire Company shares through a tender offer during 2007. The Company owns all of the common securities of each of the three Trusts.
The Trusts used the proceeds from the sale of preferred securities, plus capital of $1.5 million contributed by the Company to establish the trusts, to purchase the Company’s subordinated notes in amounts and bearing terms that parallel the amounts and terms of the respective preferred securities. Amounts and general terms related to the Trusts at year-end 2013 are summarized in the table below.
The subordinated notes of Trusts I and II became redeemable in whole or in part, without penalty, at the Company’s option during 2010. The subordinated notes of Trust III became redeemable in whole or in part, without penalty, at the Company’s option during 2012. The subordinated notes are junior in right of payment of all present and future senior indebtedness of the Company. The weighted average interest rate in effect as of the last determination date in 2013 and 2012 was 1.71% and 1.77%, respectively.
Contractual Obligations
The Company’s contractual obligations to make future payments as of December 31, 2013 are as follows:
Long-term FHLB debt represents FHLB advances pursuant to several different credit programs. Long-term FHLB debt, subordinated notes payable, and securities sold under agreements to repurchase are more fully described under the caption “Long-term Borrowings” above and in Note 8 of the Company’s 2013 audited consolidated financial statements. Payments for borrowings in the table above do not include interest. Postretirement benefit obligations are actuarially determined and estimated based on various assumptions with payouts projected over the next ten years. Estimates can vary significantly each year due to changes in significant assumptions. Operating leases include standard business equipment used in the Company’s day-to-day business as well as the lease of certain branch sites. Operating lease terms generally range from one to five years, with the ability to extend certain branch site leases at the Company’s option. Payments related to leases are based on actual payments specified in the contracts. Employment agreements represent annual minimum base salary amounts payable by the Company to five employees. One of these agreements is with the Company’s Chief Executive Officer and includes aggregate payments of $385 thousand annually for a remaining term of four years, as amended. The other agreements are with key officers of the Company’s subsidiaries.
Guarantees
During 2007, the Parent Company entered into a guarantee agreement whereby it agreed to become unconditionally and irrevocably the guarantor of the obligations of three of its subsidiary banks in connection with the $200 million balance sheet leverage transaction. Principal payments by the bank subsidiaries have reduced the outstanding balance of the obligation to $100 million at year-end 2013, with the remaining portion maturing in 2017. The outstanding borrowings are required to be secured by GNMA bonds valued at 106% of the outstanding borrowings, although the banks typically maintain an amount in excess of the required minimum. Should any of the subsidiary banks default on its borrowings under the agreement, the GNMA bonds securing the borrowings would be liquidated to satisfy amounts due. If the value of the GNMA bonds fall below the obligation under the contract, the Parent Company is obligated to cover any such shortfall in absence of the subsidiary banks’ ability to do so. The Parent Company believes its subsidiary banks are fully capable of fulfilling their obligations under the borrowing arrangement and that the Parent Company will not be required to make any payments under the guarantee agreement.
Effects of Inflation
The majority of the Company’s assets and liabilities are monetary in nature. Therefore, the Company differs greatly from most commercial and industrial companies that have significant investments in nonmonetary assets, such as fixed assets and inventories. However, inflation does have an important impact on the growth of assets in the banking industry and on the resulting need to increase equity capital at higher than normal rates in order to maintain an appropriate equity to assets ratio. Inflation also affects other noninterest expense, which tends to rise during periods of general inflation.
Market Risk Management
Market risk is the risk of loss arising from adverse changes in market prices and rates. The Company’s market risk is comprised primarily of interest rate risk created by its core banking activities of extending loans and receiving deposits. The Company’s success is largely dependent upon its ability to manage this risk. Interest rate risk is defined as the exposure of the Company’s net interest income to adverse movements in interest rates. Although the Company manages other risks, such as credit and liquidity risk, management considers interest rate risk to be its most significant risk, which could potentially have the largest and a material effect on the Company’s financial condition and results of operations. A sudden and substantial change in interest rates may adversely impact the Company’s earnings to the extent that the interest rates earned on assets and paid on liabilities do not change at the same speed, to the same extent, or on the same basis. Other events that could have an adverse impact on the Company’s performance include changes in general economic and financial conditions, general movements in market interest rates, and changes in consumer preferences. The Company’s primary purpose in managing interest rate risk is to effectively invest the Company’s capital and to manage and preserve the value created by its core banking business.
Management believes the most significant impact on financial and operating results is the Company’s ability to react to changes in interest rates. Management seeks to maintain an essentially balanced position between interest sensitive assets and liabilities in order to protect against the effects of wide interest rate fluctuations.
The Parent Company and each of its subsidiary banks has a Corporate Asset and Liability Management Committee (“ALCO”) which monitors the composition of the balance sheet to ensure comprehensive management of interest rate risk and liquidity. The Parent Company ALCO also provides guidance and support to each ALCO of the Company’s subsidiary banks and is responsible for monitoring risks on a company-wide basis. The Parent Company ALCO has established minimum standards in its asset and liability management policy that each subsidiary bank must adopt. However, the subsidiary banks are permitted to deviate from these standards so long as the deviation is no less stringent than that of the Corporate policy.
The Company uses a simulation model as a tool to monitor and evaluate interest rate risk exposure. The model is designed to measure the sensitivity of net interest income and net income to changing interest rates over future periods. Forecasting net interest income and its sensitivity to changes in interest rates requires the Company to make assumptions about the volume and characteristics of many attributes, including assumptions relating to the replacement of maturing earning assets and liabilities. Other assumptions include, but are not limited to, projected prepayments, projected new volume, and the predicted relationship between changes in market interest rates and changes in customer account balances. These effects are combined with the Company’s estimate of the most likely rate environment to produce a forecast for the next twelve months. The forecasted results are then compared to the effect of a gradual 200 basis point increase and decrease in market interest rates on the Company’s net interest income and net income. Because assumptions are inherently uncertain, the model cannot precisely estimate net interest income and net income or the effect of interest rate changes on net interest income and net income. Actual results could differ significantly from simulated results.
At December 31, 2013, the model indicated that if rates were to gradually increase by 200 basis points over the next twelve months, then net interest income (TE) and net income would increase .05% and .04%, respectively, compared to forecasted results. The model indicated that if rates were to gradually decrease by 200 basis points over the next twelve months, then net interest income (TE) and net income would decrease 1.24% and 3.07%, respectively, compared to forecasted results.
In the current relatively low interest rate environment, it is not practical or possible to reduce certain deposit rates by the same magnitude as rates on earning assets. The average rate paid on many of the Company’s deposits is below 2%. This situation magnifies the model’s predicted results when modeling a decrease in interest rates, as earning assets with higher yields have more of an opportunity to reprice at lower rates than lower-rate deposits.
LIQUIDITY
Liquidity measures the ability to meet current and future cash flow needs as they become due. For financial institutions, liquidity reflects the capacity to meet loan demand, to accommodate possible outflows in deposits, and to react and capitalize on interest rate market opportunities. A financial institution’s ability to meet its current financial obligations is dependent upon the structure of its balance sheet, its ability to liquidate assets, and its access to alternative sources of funds. The Company’s goal is to meet its near-term funding needs by maintaining a level of liquid funds through its asset/liability management. For the longer term, the liquidity position is managed by balancing the maturity structure of the balance sheet. This process allows for an orderly flow of funds over an extended period of time. The Company’s ALCOs, both at the bank subsidiary and consolidated level, meet regularly and monitor the composition of the balance sheet to ensure comprehensive management of interest rate risk and liquidity.
The Company's objective as it relates to liquidity is to ensure that its subsidiary banks have funds available to meet deposit withdrawals and credit demands without unduly penalizing profitability. In order to maintain a proper level of liquidity, the subsidiary banks have several sources of funds available on a daily basis. For assets, those sources of funds include liquid assets that are readily marketable or that can be pledged, or which mature in the near future. These assets primarily include cash and due from banks, federal funds sold, and cash flow generated by the repayment of principal and interest on loans and investment securities. For liabilities, sources of funds primarily include the subsidiary banks' core deposits, FHLB and other borrowings, and federal funds purchased and securities sold under agreements to repurchase. While maturities and scheduled amortization of loans and investment securities are generally a predictable source of funds, deposit outflows and mortgage prepayments are influenced significantly by general interest rates, economic conditions, and competition in our local markets.
The Company uses a liquidity ratio metric to help measure its ability to meet its cash flow needs. This ratio is monitored by ALCO at both the bank and consolidated level. The liquidity ratio is based on current and projected levels of sources and uses of funds. This measure is useful in analyzing cash needs and formulating strategies to achieve desired results. For example, a low liquidity ratio could indicate that the Company’s ability to fund loans might become more difficult. A high liquidity ratio could indicate that the Company may have a disproportionate amount of funds in low yielding assets, which is more likely to occur during periods of sluggish loan demand or economic difficulties. The Company’s liquidity position, as measured by its liquidity ratio, was higher at year-end 2013 compared to year-end 2012 and is within its ALCO guidelines. The Company’s liquidity ratio remains elevated mainly as a result of its overall net funding position and weak, quality loan demand. As loans have paid down, payments have been reinvested more into investments securities or other temporary investments. The Company also continues a cautious lending strategy while continuing efforts to reduce its level of nonperforming assets in a slow growing economic environment.
As of December 31, 2013, the Company had $228 million of additional borrowing capacity under various FHLB, federal funds, and other agreements. However, there is no guarantee that these sources of funds will continue to be available to the Company, or that current borrowings can be refinanced upon maturity, although the Company is not aware of any events or uncertainties that are likely to cause a decrease in the Company’s liquidity from these sources. The Company’s borrowing capacity increased $36.2 million or 18.8% since year-end 2012, primarily as a result of additional borrowings available from the FHLB. The additional borrowing capacity is primarily attributed to improving credit metrics at two of the Company’s subsidiary banks. During the third quarter of 2013, the FHLB updated the collateral pledging method at one of these banks to blanket lien status from possession (delivery) status. Blanket lien status is the least restrictive collateral arrangement used by the FHLB. This status is generally assigned to lower risk institutions that pledge loan collateral related to their borrowings. All of the Company’s subsidiary banks qualify for the blanket lien pledging method at year-end 2013.
Liquidity at the Parent Company level is primarily affected by the receipt of dividends from its subsidiary banks, cash balances maintained, and borrowings from nonaffiliated sources. Payment of dividends by the Company’s subsidiary banks is subject to certain regulatory restrictions as set forth in national and state banking laws and regulations. In addition, United Bank and Citizens Northern each must obtain regulatory approval to declare or pay dividends to the Parent Company as a result of increased capital required in connection with prior regulatory exams. Capital ratios at each of the Company’s four subsidiary banks exceed regulatory established “well-capitalized” status at December 31, 2013 under the prompt corrective action regulatory framework. See Note 17 “Regulatory Matters” of the Company’s 2013 audited consolidated financial statements for further information regarding the restrictions on dividend payments and increased capital required at certain of the Company’s bank subsidiaries as outlined in prior regulatory agreements.
The Parent Company’s primary uses of cash include the payment of dividends to its preferred shareholders, injecting capital into subsidiaries, paying interest expense on borrowings, and payments for general operating expenses. Due to an agreement with its regulators, the Parent Company must obtain regulatory approval prior to making dividend payments on its preferred and common stock and interest payments on its trust preferred borrowings. While regulatory agencies have so far granted approval to all of the Company’s requests to make dividend payments on its preferred stock and interest payments on its trust preferred securities, the Company has not (based on the assessment by Company management of both the Company’s capital position and the earnings of its subsidiaries) sought regulatory approval to pay dividend on its common stock since the fourth quarter of 2009. Moreover, the Company will not pay a dividend on its common stock in any future quarter until the regulator’s assessment of the earnings of the Company’s subsidiaries, and the Company’s assessment of its capital position, both yield the conclusion that the payment of a common stock dividend is warranted. Reference is made to Note 17 “Regulatory Matters” of the Company’s 2013 audited consolidated financial statements, Item 1A “Risk Factors” of this Form 10-K, and the heading “Capital Resources” below for additional information on the Company’s restrictions and requirements related to the payment of interest and dividends.
The Parent Company had cash balances of $36.5 million at year-end 2013, an increase of $11.7 million or 47.2% compared to $24.8 million at year-end 2012. Significant cash receipts of the Parent Company during 2013 include dividends from banks subsidiaries in the amount of $14.5 million and management fees from subsidiaries of $3.7 million. Significant cash payments by the Parent Company for 2013 include $2.3 million for salaries, payroll taxes, and employee benefits, $1.5 million for the payment of dividends on outstanding preferred stock, and $866 thousand for interest on trust preferred borrowings.
Liquid assets consist of cash, cash equivalents, and available for sale investment securities. At December 31, 2013, consolidated liquid assets were $681 million, an increase of $12.1 million or 1.8% from year-end 2012. The increase in liquid assets was driven by a $39.7 million or 6.9% increase in available for sale investment securities, which offset a decrease in cash and cash equivalents of $27.6 million or 28.8%. Liquid assets remain elevated mainly as a result of the Company’s overall net funding position and soft, quality loan demand. The overall funding position of the Company changes as loan demand, deposit levels, and other sources and uses of funds fluctuate.
Net cash provided by operating activities was $24.0 million for 2013, a decrease of $4.4 million or 15.4% from $28.4 million for 2012. Net cash used in investing activities was $53.3 million for 2013 compared to a net cash inflow of $63.2 million for 2012. The $116 million difference compared to a year ago relates mainly to investment securities and loan activity. For investment securities, the Company had net cash outflows of $64.8 million for 2013 compared with net inflows of $21.3 million for 2012. Net cash outflow for investment securities in 2013 was driven by net purchase activity, which correlates to the increase in investment securities in the annual comparison. Since deposit levels were relatively unchanged for the year and quality loan demand remains weak, available funds have generally been reinvested more into investment securities. The Company had net principal collections related to loans of $5.5 million for 2013, a decrease of $24.3 million or 81.4% compared to 2012. Net principal collections on loans have declined to the lowest level since 2009 as the balance between new loan originations and repayment activity has narrowed.
Net cash provided by financing activities was $1.7 million for 2013 compared to net cash outflow in the prior year of $90.0 million. For 2013, the primary activity was made up by net cash proceeds from borrowing activity of $3.6 million, partially offset by dividend payments of $1.5 million on preferred stock. For 2012, cash outflows were driven by net principle repayments on debt of $64.3 million and a reduction in outstanding deposits of $24.3 million.
Information relating to commitments to extend credit is disclosed in Note 14 of the Company’s 2013 audited consolidated financial statements. These transactions are entered into in the ordinary course of providing traditional banking services and are considered in managing the Company’s liquidity position. The Company does not expect these commitments to significantly affect the liquidity position in future periods. The Company has not entered into any contracts for financial derivative instruments such as futures, swaps, options, or similar instruments.
CAPITAL RESOURCES
Shareholders’ equity was $170 million at December 31, 2013 up $2.0 million or 1.2% compared to $168 million at year-end 2012. Net income increased shareholders’ equity by $13.4 million, but was partially offset by a decline in other comprehensive income in the amount of $10.1 million. Other comprehensive income declined as a result of a decrease in the after-tax unrealized gain on available for sale investment securities in the amount $13.0 million attributed to an overall increase in market interest rates. This was partially offset by an improvement of $3.0 million in the after-tax amount related to the Company’s liability for its postretirement medical benefits plan. The improvement was primarily the result of favorable interest rates impacting the year-end actuarial valuation of the plan. Since the discount rate used in determining the obligation under the plan increased to 4.9% from 4.0%, the present value decreased.
On January 9, 2009, the Company issued 30 thousand shares of Series A, no par value cumulative perpetual preferred stock. The Series A preferred shares pay a cumulative cash dividend quarterly at 5% per annum during the first five years the preferred shares are outstanding, resetting to 9% during the first quarter of 2014. The Company’s goal is to repay a portion of the preferred shares during 2014, using internally generated cash flows for the potential repurchase. Redemption of the preferred shares is subject to approval by the Company’s banking regulators. The amount of outstanding preferred shares redeemed, if any, will be determined by the overall progress made under current regulatory agreements, the level of funds available, and both near and long term projections of liquidity and operating needs. The Parent Company is under no directive by its regulators to raise any additional capital.
At December 31, 2013 and 2012, the Company’s tangible capital ratio was 9.35% and 9.23%, respectively. The tangible capital ratio is defined as tangible equity as a percentage of tangible assets. Tangible common equity to tangible assets, which further excludes outstanding preferred stock, was 7.70% at year-end 2013, up 11 basis points compared to 7.59% at year-end 2012.
Consistent with the objective of operating a sound financial organization, the Company’s goal is to maintain capital ratios well above the regulatory minimum requirements. The Company's capital ratios as of December 31, 2013 and the regulatory minimums were as follows:
1Tier 1 Risk-based and Total Risk-based Capital ratios are computed by dividing Tier 1 or Total Capital, as defined by regulation, by a risk-weighted sum of the assets, with the risk weighting determined by general standards established by regulation. The safest assets (e.g., government obligations) are assigned a weighting of 0% with riskier assets receiving higher ratings (e.g., ordinary commercial loans are assigned a weighting of 100%).
2Tier 1 Leverage ratio is computed by dividing Tier 1 Capital by total quarterly average assets, as defined by regulation.
In July 2013, banking regulators issued final rules to bring U.S. banking organization into compliance with the Basel III capital framework effective in 2015. The Company has completed a pro forma analysis of its capital ratios under the new capital framework. This analysis indicates the Company remains well-capitalized under the new rules, including meeting the effective minimum capital
ratios with a fully phased-in capital conservation buffer. For further information, see discussion in Part I, Item 1 under the caption “Capital” beginning on page 15 of this Form 10-K.
The table below represents an analysis of dividend payout ratios and equity to asset ratios for the previous five years.
N/M-Not meaningful.
Primarily due to the regulatory actions during 2009 at certain of the Company’s subsidiary banks as discussed further below, the Federal Reserve Bank of St. Louis (“FRB St. Louis”) and the Kentucky Department of Financial Institutions (“KDFI”) proposed the Parent Company enter into a Memorandum of Understanding (“Memorandum”). The Company’s board approved entry into the Memorandum at a regular board meeting during the fourth quarter of 2009. Pursuant to the Memorandum, the Parent Company agreed that it would develop an acceptable capital plan to ensure that the consolidated organization remains well-capitalized and each of its subsidiary banks meet the capital requirements imposed by their regulator as summarized below.
The Company also agreed to reduce its common stock dividend in the fourth quarter of 2009 from $.25 per share down to $.10 per share and not make interest payments on the Company’s trust preferred securities or dividends on its common or preferred stock without prior approval from the FRB St. Louis and the KDFI. Representatives of the FRB St. Louis and the KDFI have indicated that any such approval for the payment of dividends will be predicated on a demonstration of adequate, normalized earnings on the part of the Company’s subsidiaries sufficient to support quarterly payments on the Company’s trust preferred securities and quarterly dividends on the Company’s common and preferred stock. While both regulatory agencies have granted approval of all subsequent quarterly Company requests to make interest payments on its trust preferred securities and dividends on its preferred stock, the Company has not (based on the assessment by Company management of both the Company’s capital position and the earnings of its subsidiaries) sought regulatory approval for the payment of common stock dividends since the fourth quarter of 2009. Moreover, the Company will not pay any such dividends on its common stock in any subsequent quarter until the regulator’s assessment of the earnings of the Company’s subsidiaries, and the Company’s assessment of its capital position, both yield the conclusion that the payment of a Company common stock dividend is warranted.
Additionally, under the Memorandum, the Parent Company agreed to:
●
utilize its financial and managerial resources to assist its subsidiary banks in addressing weaknesses identified at their most recent examinations and achieving and maintaining compliance with any regulatory supervisory actions respecting the subsidiary banks;
●
not pay any new salaries, bonuses, management fees or make any other payments to insiders without prior approval of the FRB St. Louis and the KDFI;
●
not incur additional debt or purchase or redeem any stock without the prior written approval of the FRB St. Louis and the KDFI;
●
submit to the FRB St. Louis and the KDFI an acceptable plan detailing the source and timing of funds for meeting the Company’s debt service requirements and other parent company expenses; and
●
within thirty days of the end of each calendar quarter submit to the FRB St. Louis and the KDFI parent company financial statements along with a status report on compliance with the provisions of the Memorandum.
Subsidiary Banks
The Company’s subsidiary banks are subject to capital-based regulatory requirements which place banks in one of five categories based upon their capital levels and other supervisory criteria. These five categories are: (1) well-capitalized, (2) adequately
capitalized, (3) undercapitalized, (4) significantly undercapitalized, and (5) critically undercapitalized. To be well-capitalized, a bank must have a Tier 1 Leverage ratio of at least 5% and a Total Risk-based Capital ratio of at least 10%. As of December 31, 2013, the Company’s four subsidiary banks had the following capital ratios for regulatory purposes:
Two of the Company’s subsidiary banks, due to their recent regulatory agreements, were required at year-end 2013 to maintain capital ratios in excess of the well-capitalized level under the prompt corrective action framework. The capital levels and other requirements for these two banks related to their regulatory agreement are discussed below. The Memorandum entered into during 2009 between Farmers Bank and its primarily regulator was terminated during the first quarter 2013 as a result of satisfactory compliance.
United Bank. In November of 2009, the FDIC, the KDFI, and United Bank entered into a Cease and Desist Order (“C&D”) primarily as a result of its level of nonperforming assets. The C&D was terminated in December 2011 coincident with the issuance of a Consent Order (“Consent Order”) entered into between the parties. The Consent Order is substantially the same as the C&D, with the primary exception being that United Bank must achieve and maintain a Tier 1 Leverage ratio of 9.0% and a Total Risk-based Capital ratio of 13.0% no later than March 31, 2012. At December 31, 2013, United Bank had a Tier 1 Leverage ratio of 9.67% and a Total Risk-based Capital ratio of 16.33%.
Subsequent to year-end 2013, the Company received written notification from the FDIC and the KDFI that the formal Consent Order entered into in 2011 was terminated and replaced with a stepped-down enforcement action in the form of an informal Memorandum. While many of the same provisions carried over to the Memorandum, replacing the Consent Order represents important progress for the Company.
The terms of the Memorandum, significantly all of which were included in the prior Consent Order, requires United Bank to:
●
continue to formulate, adopt and submit to the FDIC and the KDFI for review and comment a written plan of action to lessen the bank's risk position in each asset which was classified "Substandard" or "Doubtful" in the most recent or any subsequent examination or visitation, and which aggregated $1,000,000 or more. Such plan shall include:
a)
the dollar levels to which the bank will strive to reduce each line of credit within 6 and 12 months from the effective date of the Memorandum; and
b)
provisions for the submission of monthly written progress reports to the bank's board of directors for review and notation in the board of director's minutes.
●
within 10 days from the date of the Memorandum, the bank shall eliminate from its books, by collection, charge-off or other proper entries, all assets or portions of assets classified "Loss" in the most recent or any subsequent examination that have not been previously charged off or collected.
●
while the Memorandum is in effect, the bank shall not extend, directly or indirectly, any additional credit to, or for the benefit of, any borrower who is already obligated in any manner to the bank on any extensions of credit (including any portion thereof) that has been charged off the books of the bank or classified "Loss" in the most recent examination, or any subsequent examination or visitation, so long as such credit remains uncollected.
●
while the Memorandum is in effect, the bank shall not extend, directly or indirectly, any additional credit to, or for the benefit of, any borrower whose loan or other credit has been classified "Substandard", or "Doubtful", or is listed for Special Mention in the most recent examination, or any subsequent examination or visitation, and is uncollected unless the bank's board of directors has adopted, prior to such extension of credit, a detailed written statement giving the reasons why such extension of credit is in the best interest of the bank.
●
while the Memorandum is in effect, the bank shall continue its practice of having procedures for managing the bank's sensitivity to interest rate risk. The procedures shall comply with the Joint Agency Statement of Policy on Interest Rate Risk (June 26, 1996), and the Joint Supervisory Statement on Investment Securities and End-user Derivative Activities (April 23, 1998). The bank shall also implement within 60 days of the Memorandum the recommendations to enhance the bank's interest rate risk management policy and practices set forth in the most recent examination.
●
while the Memorandum remains in effect, the bank shall continue its practice of adopting, implementing, and adhering to a written profit plan and a comprehensive budget for all categories of income and expense for calendar year 2014 and each succeeding year. The plans shall contain formal goals and strategies, consistent with sound banking practices, to reduce discretionary expenses and to improve the bank's overall earnings, and contain a description of the operating assumptions that form the basis for major projected income and expense components. The written profit plan shall address, at a minimum:
a)
an identification of the major areas in, and means by which, the board will seek to improve the bank's operating performance;
b)
realistic and comprehensive budgets;
c)
a budget review process to monitor the income and expenses of the bank to compare actual figures with budgetary projections;
d)
a description of the operating assumptions that form the basis for, and adequately support, major projected income and expense components; and
e)
periodic salary review.
Copies of the plans and budgets required by this provision shall be submitted to the FDIC and the KDFI.
●
while the Memorandum is in effect, the bank shall maintain Tier 1 Capital and Total Risk-Based Capital at a level equal to or exceeding 9.0% and 13.0% of the bank's total assets, calculated in accordance with Part 325 of the FDIC Rules and Regulations. If such ratio is less than the aforementioned minimums as of each quarter end, while the Memorandum is in effect, the bank shall, within 30 days of such dates, present to the FDIC and the KDFI a plan for the restoration of these capital ratios.
●
while the Memorandum is in effect, the bank shall not declare or pay any dividends without the prior written consent of the FDIC and the KDFI.
●
within 30 days following each calendar quarter after the date of the Memorandum, progress reports covering each of the provisions of the Memorandum shall be submitted to the FDIC and the KDFI, until notification by the supervisory authorities that the reports need no longer be submitted. The board shall review all reports prior to submission and note their considerations in the minutes.
Following is a summary of the activity during 2013 of substandard loans that meet the reporting requirements included in the Consent Order.
Substandard Loans
At December 31, 2013, United Bank had ten credit relationships with an aggregate outstanding balance of $28.7 million that meet the risk identification criteria established in the Consent Order. The aggregate amount of substandard loans meeting the reporting criteria exceeded the target level established by United Bank due to the anticipated sale of collateral and related paydown that did not occur prior to year end. Target levels are established based on projections of individual substandard loan amounts and will fluctuate depending on the actual amount of newly classified loans, principal reductions, or repossession activity.
Citizens Northern. The FDIC and the KDFI entered into a Memorandum with Citizens Northern on September 8, 2010. That Memorandum was terminated July 7, 2013 upon the issuance of an updated Memorandum. The updated Memorandum is substantially the same as the replaced Memorandum, including the requirement to obtain regulatory approval prior to declaring or paying a dividend, but raised the required minimum Tier I Leverage to 9.0% from 8.0%. At year-end 2013, Citizens Northern had a Tier I Leverage ratio of 9.67% and a Total Risk-based Capital ratio of 14.82%.
Under the Memorandum, Citizens Northern agreed to:
●
have and retain qualified management, with particular emphasis on its loan administration and collection needs. Every member of management shall have the qualifications and experience commensurate with his or her duties and responsibilities. The qualifications of management shall be assessed on management’s ability to:
a)
Affect reasonable improvements to the condition of the institution, including improvements in asset quality and earnings;
b)
Comply with applicable laws, rules, regulations, and regulatory policies; and
c)
Comply with the requirements of this Memorandum;
●
within 60 days from the date of this Memorandum, to formulate, adopt and submit to the Regional Director and the Commissioner for review and comment a written plan of action to lessen the risk position in each asset which was classified “Substandard” in the most recent examination, and which aggregated $250,000 or more. Such plan shall include:
a)
dollar levels to which it will strive to reduce each line of credit within six and twelve months from the effective date of this Memorandum; and
b)
provisions for the submission of monthly written progress reports to its board of directors for review and notation in the board of director’s minutes;
●
not extend any additional credit to, or for the benefit of, any borrower who is already obligated in any manner on any extension of credit (including any portion thereof) that:
a)
has been charged off or classified “Loss” in the most recent examination or in any subsequent review by consultants or by a regulatory body so long as such credit remains uncollected; or
b)
has been classified “Substandard” or “Doubtful” in the most recent examination, on the bank’s internal watch list, or in any subsequent review by its consultants, and is uncollected, unless the board of directors
or loan committee has adopted, prior to such extension of credit, a detailed written statement giving reasons why such extension of credit is in the best interest of the bank. A copy of the statement, including a thorough financial analysis gauging the borrower’s financial condition and overall ability to service the existing and new debt, shall be placed in the appropriate loan file and shall be incorporated in the minutes of the applicable loan committee;
●
within 60 days from the date of this Memorandum, take all steps necessary to correct the credit underwriting and administration weaknesses listed in the most recent examination. Corrective actions will include a revision of procedures for assessing borrower repayment capacity. The revised procedures will include obtaining and evaluating current financial information; considering delinquent property taxes; and incorporating material changes to the balance sheet accounts such as account receivables, inventories, fixed assets, and accounts payable into cash flow analyses for commercial borrowers;
●
within 30 days from the date of this Memorandum, revise its Allowance for Loan and Lease Losses (“ALLL”) methodology consistent with the comments in the most recent examination. Ensure that when assessing impairment under Accounting Standards Codification Topic 310 using the fair value of collateral method, assessments are based on current valuations of the pledged collateral;
(Company Note: The ALLL methodology is structurally sound. The comments referred to in the most recent examination pertain to documentation exceptions for two impaired credit relationships consisting of eight real estate properties with an aggregate outstanding balance of $1.7 million. Documentation supporting certain of these properties was stale as of the examination date. However, appraisals received subsequent to the examination date confirm that the estimated discount applied to the stale appraisals resulted in an allowance that was adequate. Additional procedures for adhering to and monitoring compliance over the ALLL have been revisited and refined to assure that the ALLL is fully documented and adequately supported in a timely fashion).
●
prior to submission or publication of all Reports of Condition and income required by the FDIC after the effective date of this Memorandum, the board of directors shall review the adequacy of the ALLL, shall provide an adequate allowance, and shall report such allowance on the Reports of Condition and income. The minutes of the board meeting at which such review is undertaken shall indicate the results of the review, the amount of increase in the allowance recommended, if any, and the basis for determination of the amount of the allowance provided;
●
within 60 days from the date of this Memorandum, formulate and implement a written Profit Plan. The Profit Plan shall be consistent with the loan, investment and funds management policies. This Plan shall be submitted to the Regional Director and Commissioner for review and comment, and shall address, at a minimum, goals and strategies for improving and sustaining earnings including:
a)
an identification of the major areas in, and means by which, the board will seek to improve the operating performance;
b) realistic and comprehensive budgets;
c)
a budget review process to monitor the income and expenses to compare actual figures with budgetary projections;
d)
a description of the operating assumptions that form the basis for, and adequately support, major projected income and expense components; and
e) periodic salary review;
●
within 30 days from the date of this Memorandum, take all steps necessary to correct the violations scheduled in the most recent examination. In addition, adopt procedures to assure future compliance with all applicable laws, rules and regulations;
●
while this Memorandum is in effect, maintain Tier I capital at a level equal to or exceeding 9.0% of the total assets which shall be calculated in accordance with Part 325 of the FDIC Rules and Regulations. If such ratio is less than 9.0% as of March 31, June 30, September 30 or December 31 of each calendar year, while this Memorandum is in effect, within 30 days of such dates, present to the Regional Director and Commissioner a plan for the augmentation of the capital accounts or other measures to bring the ratio to 9.0%;
●
while this Memorandum is in effect, written consent of the Regional Director and the Commissioner is required to declare or pay any dividends; and
●
within 30 days following each calendar quarter after the date of this Memorandum, progress reports covering each of the provisions of this Memorandum shall be submitted to the Regional Director and Commissioner until notification by the supervisory authorities that the reports need no longer be submitted. The board of directors shall review all reports prior to submission and note their consideration in the minutes.
Following is a summary of the activity during 2013 of substandard loans that meet the reporting requirements included in the Memorandum.
Substandard Loans
At December 31, 2013, Citizens Northern had ten credit relationships with an aggregate outstanding balance of $9.2 million that meet the risk identification criteria established in the Memorandum. There was no related target level established at year-end 2013.
At the Parent Company and at each of its bank subsidiaries, the Company believes it is adequately addressing all issues of the regulatory agreements to which it is subject and is in compliance with those agreements as of December 31, 2013. However, only the respective regulatory agencies can determine if compliance with the applicable regulatory agreements have been met. Regulators continue to monitor the Company’s progress and compliance with the agreements through periodic on-site examinations, regular communications, and quarterly data analysis. The results of these examinations and communications show satisfactory progress toward meeting the requirements included in the regulatory agreements.
The Parent Company maintains cash available to fund a certain amount of additional injections of capital to its bank subsidiaries if required by its regulators. If needed, further amounts in excess of available cash may be funded by future public or private sales of securities, although the Parent Company is currently under no directive by its regulators to raise any additional capital.
Share Buy Back Program
At various times, the Company’s Board of Directors has authorized the purchase of shares of the Company’s outstanding common stock. No stated expiration dates have been established under any of the previous authorizations. There are 84,971 shares that may still be purchased under the various authorizations. However, as discussed under the caption “Capital Resources” above, the Company must be granted permission by the FRB St. Louis and the KDFI before it can repurchase or redeem any of its outstanding common or preferred stock as a result of its regulatory agreement.
Shareholder Information
As of February 18, 2014, the Company had 2,919 shareholders of record, which includes individual participants in securities positions listings.
Common Stock Price
The Company’s common stock is traded on the NASDAQ Stock Market LLC exchange in the Global Select Market tier, with sales prices reported under the symbol: FFKT. The table below lists the high and low sales prices of the Company’s common stock for 2013 and 2012.
The closing price per share of the Company’s common stock on December 31, 2013, the last trading day of the Company’s fiscal year, was $21.75. There have been no dividends declared on the Company’s common stock since 2009.
Recently Issued But Not Yet Effective Accounting Standards
In February 2013, The Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2013-04, Liabilities (Topic 405) - Obligations Resulting From Joint and Several Liability Arrangements for Which the Total Amount of the Obligation Is Fixed at the Reporting Date. This ASU establishes guidance for the recognition, measurement, and disclosure of obligations arising from joint and several liability arrangements for which the total amount under the arrangement is fixed at the reporting date (for example, debt arrangements, other contractual obligations, settled litigation, and judicial rulings). Under joint and several liability, the total amount of an obligation is enforceable against any and all parties to the arrangement. Each obligor is considered primarily responsible for the entire obligation.
Under the new guidance, the amount to be recognized is equal to the sum of (1) the amount that the entity agreed to pay based on its arrangement with co-obligors, and (2) any additional amount expected to be paid on behalf of the co-obligors using a “best estimate.” In addition, disclosure is required of the nature and amount of each covered obligation, including the nature of any recourse provisions which may allow recovery from other entities. This ASU does not apply to certain obligations where specific accounting guidance already exists under accounting principles generally accepted in the U.S., such as for contingencies, guarantees, compensation-retirement benefits, and income taxes.
The amendments in ASU No. 2013-04 are effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. The amendments should be applied retrospectively to all prior periods presented for those obligations resulting from joint and several liability arrangements within the ASU's scope that exist at the beginning of an entity’s fiscal year of adoption. The Company does not expect there to be a material impact on its consolidated financial position or results of operations upon adoption.
In January 2014, the FASB issued ASU 2014-04, Receivables - Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans Upon Foreclosure. The ASU clarifies that an in-substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additional disclosures about foreclosed residential real estate property are also required.
The amendments are effective for annual periods, and interim reporting periods within those annual periods, beginning after December 15, 2014. The amendments may be adopted using either a modified retrospective transition method or a prospective transition method. Early adoption is permitted. The Company does not expect there to be a material impact on its consolidated financial position or results of operations upon adoption.
2012 Compared to 2011
The Company reported net income of $12.1 million or $1.37 per common share in 2012 compared to $2.7 million or $.11 per common share for 2011. This represents an increase of $9.4 million or $1.26 per common share. The increase in net income for 2012 was primarily due to a decrease in the provision for loan losses of $10.7 million or 79.4% and noninterest expenses of $2.7 million or 4.3%, partially offset by an increase in income tax expense of $3.6 million. Net interest income decreased $715 thousand or 1.3%.
For 2012, the decrease in net interest income of $715 thousand or 1.3% from 2011 was due to a decrease in interest income of $7.1 million or 9.1%, partially offset by lower interest expense of $6.4 million or 26.0%. The decrease in interest income was mainly related to lower interest on loans of $5.8 million or 9.5%, which decreased as a result of lower average balances outstanding and a low interest rate environment. The decrease in interest expense was primarily related to lower interest expense on deposits of $5.2 million or 36.2%, which decreased mainly from the Company’s continuing efforts to reduce higher-rate time deposits. Interest expense also decreased to a lesser extent due to a lower average balance outstanding of long-term debt, resulting from scheduled principal repayments. Net interest margin was 3.18% for 2012, an increase of nine basis points from 3.09% for 2011. Net interest spread was 2.96%, up 12 basis points compared to 2.84%.
The provision for loan losses for 2012 was $2.8 million, a decrease of $10.7 million or 79.4% compared to $13.5 million for 2011. The decrease in the provision for loan losses was attributed to an overall improvement in the credit quality of the loan portfolio and a decrease in loan balances outstanding. Nonperforming loans, loans past due 30-89 days, and watch list loans all decreased during 2012. Historical loss rates, adjusted for current risk factors, also improved as lower recent charge-off activity replaced the higher levels that spiked upward starting in 2009. The high charge-offs from that period began to roll out of the three-year look-back period the Company used when evaluating its allowance for loan losses.
Nonperforming loans decreased $25.0 million or 31.7% in 2012. The allowance for loan losses was $24.4 million at year-end 2012 and $28.3 million at year-end 2011. As a percentage of loans net of unearned income, the allowance for loan losses decreased 21 basis points to 2.43% compared to 2.64%.
Noninterest income for 2012 was $24.7 million, an increase of $263 thousand or 1.1% compared to $24.4 million for 2011. The increase in noninterest income was driven by higher net gains on the sale of mortgage loans of $936 thousand or 95.3% and income from company-owned life insurance of $585 thousand or 62.3%. The increase in net gains on the sale of mortgage loans was attributable to an increase in the volume of loans sold of $43.6 million or 106%. The interest rate environment during 2012 declined beyond the already low levels that existed during 2011, which led to a spike in home refinancing and purchasing activity during 2012. The increase in income from company-owned life insurance was mainly the result of a $529 thousand gain related to death benefit proceeds received during 2012. There was no similar transaction in 2011.
The more significant components of noninterest income that decreased were data processing income by $550 thousand or 69.4% and service charges and fees on deposits by $493 thousand or 5.7%. The decrease in data processing income was driven by a decrease in fees related to the winding down of the depository services contract with the Commonwealth. The decrease in service charges and fees on deposits was driven by a decline in fees from overdraft/insufficient funds related to lower transaction volume.
Total noninterest expenses were $59.8 million for 2012, a decrease of $2.7 million or 4.3% compared to $62.5 million for 2011. The decrease in noninterest expenses was made up primarily by a $2.1 million or 28.9% decrease in expenses associated with repossessed real estate, a $514 thousand decrease related to a deposit fraud loss recorded in the prior year (net of a $186 thousand recovery), a $365 thousand or 7.9% decrease in data processing and communications expense, and a $258 thousand or 8.8% decrease in deposit insurance expense. Partially offsetting these noninterest expense decreases was an increase in salaries and employee benefits of $1.2 million or 4.5%.
The $2.1 million decrease in expenses related to repossessed real estate is mainly due to a $1.7 million or 30.9% decline in impairment charges. The $514 thousand deposit fraud loss relates to a transaction on a deposit account involving one of the Company’s customers that occurred during the first quarter of 2011. Data processing and communications expenses decreased $365 thousand mainly as a result of cost savings related to the winding down of the Company’s contract with the Commonwealth as well as an agreement the Company announced during the first quarter to reduce its debit card processing expenses during 2012 and 2013.
The $258 thousand decrease in deposit insurance expense is mainly attributed to changes in the FDIC’s assessment base and rate structure that went into effect during the second quarter of 2011. Salaries and employee benefits increased $1.2 million in the comparison mainly as a result of a larger workforce, including additions in credit administration and nonperforming asset management positions in early 2012, higher postretirement benefits expenses, and modest annual employee pay increases.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The information required by this item is incorporated by reference to Part II, Item 7 under the caption “Market Risk Management” beginning on page 63 of this Form 10-K.
Item 8.
Item 8. Financial Statements and Supplementary Data
MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL REPORTING
The management of Farmers Capital Bank Corporation has the responsibility for preparing the accompanying consolidated financial statements and for their integrity and objectivity. The statements were prepared in accordance with accounting principles generally accepted in the United States of America. The consolidated financial statements include amounts that are based on management’s best estimates and judgments. Management also prepared other information in the annual report and is responsible for its accuracy and consistency with the financial statements.
The Company’s 2013 consolidated financial statements have been audited by BKD, LLP (“BKD”) independent accountants. Management has made available to BKD all financial records and related data, as well as the minutes of Boards of Directors’ meetings. Management believes that all representations made to BKD during the audit were valid and appropriate.
Lloyd C. Hillard, Jr.
C. Douglas Carpenter
President and Chief Executive Officer
Executive Vice President, Secretary, and Chief Financial Officer
March 6, 2014
Report of Independent Registered Public Accounting Firm
Audit Committee, Board of Directors
and Stockholders
Farmers Capital Bank Corporation
Frankfort, Kentucky
We have audited Farmers Capital Bank Corporation’s (Company) internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying management report on internal control over financial reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company, (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of the Company and our report dated March 6, 2014, expressed an unqualified opinion thereon.
Louisville, Kentucky
March 6, 2014
Report of Independent Registered Public Accounting Firm
Audit Committee, Board of Directors
and Stockholders
Farmers Capital Bank Corporation
Frankfort, Kentucky
We have audited the accompanying consolidated balance sheets of Farmers Capital Bank Corporation (Company) as of December 31, 2013 and 2012, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity and cash flows for each of the years in the two-year period ended December 31, 2013. The Company’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. Our audits included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management and 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 the Company as of December 31, 2013 and 2012, and the results of its operations and its cash flows for each of the years in the two-year period ended December 31, 2013, in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 6, 2014, expressed an unqualified opinion on the effectiveness of the Company's internal control over financial reporting.
Louisville, Kentucky
March 6, 2014
Report of Independent Registered Public Accounting Firm
Board of Directors and Shareholders
Farmers Capital Bank Corporation
Frankfort, Kentucky
We have audited the accompanying consolidated statements of income, comprehensive income, changes in shareholders’ equity, and cash flows of Farmers Capital Bank Corporation for the year ended December 31, 2011. Farmers Capital Bank Corporation’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. 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 consolidated financial statements referred to above of Farmers Capital Bank Corporation present fairly, in all material respects, the results of its operations and its cash flows for the year ended December 31, 2011, in conformity with U.S. generally accepted accounting principles.
Crowe Horwath LLP
Louisville, Kentucky
March 6, 2012
Consolidated Balance Sheets
See accompanying notes to consolidated financial statements.
Consolidated Statements of Income
See accompanying notes to consolidated financial statements.
Consolidated Statements of Comprehensive Income
See accompanying notes to consolidated financial statements.
Consolidated Statements of Changes in Shareholders’ Equity
See accompanying notes to consolidated financial statements.
Consolidated Statements of Cash Flows
See accompanying notes to consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Summary of Significant Accounting Policies
The accounting and reporting policies of Farmers Capital Bank Corporation and subsidiaries conform to accounting principles generally accepted in the United States of America (“U.S. GAAP”) and general practices applicable to the banking industry. Significant accounting policies are summarized below.
Principles of Consolidation and Nature of Operations
The consolidated financial statements include the accounts of Farmers Capital Bank Corporation (the “Company” or “Parent Company”), a bank holding company, and its bank and nonbank subsidiaries. Bank subsidiaries include Farmers Bank & Capital Trust Company (“Farmers Bank”) in Frankfort, KY, United Bank & Trust Company (“United Bank”) in Versailles, KY, First Citizens Bank (“First Citizens”) in Elizabethtown, KY, and Citizens Bank of Northern Kentucky, Inc. (“Citizens Northern”) in Newport, KY.
Farmers Bank’s significant subsidiaries include EG Properties, Inc., Leasing One Corporation (“Leasing One”), and Farmers Capital Insurance Corporation (“Farmers Insurance”). EG Properties, Inc. is involved in real estate management and liquidation for certain repossessed properties of Farmers Bank. Leasing One is a commercial leasing company in Frankfort, KY, and Farmers Insurance is an insurance agency in Frankfort, KY. United Bank has one wholly-owned subsidiary, EGT Properties, Inc. EGT Properties, Inc. is involved in real estate management and liquidation for certain repossessed properties of United Bank. First Citizens has one wholly-owned subsidiary, HBJ Properties, LLC. HBJ Properties, LLC is involved in real estate management and liquidation for certain repossessed properties of First Citizens. Citizens Northern has one wholly-owned subsidiary, ENKY Properties, Inc. ENKY Properties, Inc. is involved in real estate management and liquidation for certain repossessed properties of Citizens Northern.
The Company has three active nonbank subsidiaries, FCB Services, Inc. (“FCB Services”), FFKT Insurance Services, Inc. (“FFKT Insurance”), and EKT Properties, Inc. (“EKT”). FCB Services is a data processing subsidiary located in Frankfort, KY that provides services to the Company’s banks as well as unaffiliated entities. FFKT Insurance is a captive property and casualty insurance company insuring primarily deductible exposures and uncovered liability related to properties of the Company. EKT was formed to manage and liquidate certain real estate properties repossessed by the Company. The Company has three subsidiaries organized as Delaware statutory trusts that are not consolidated into its financial statements. These trusts were formed for the purpose of issuing trust preferred securities. All significant intercompany transactions and balances are eliminated in consolidation.
The Company provides financial services at its 36 locations in 23 communities throughout Central and Northern Kentucky to individual, business, agriculture, government, and educational customers. Its primary deposit products are checking, savings, and term certificate accounts. Its primary lending products are residential mortgage, commercial lending, and consumer installment loans. Substantially all loans and leases are secured by specific items of collateral including business assets, consumer assets, and commercial and residential real estate. Commercial loans and leases are expected to be repaid from cash flow from operations of businesses. Other services include, but are not limited to, cash management services, issuing letters of credit, safe deposit box rental, and providing funds transfer services. Other financial instruments, which potentially represent concentrations of credit risk, include deposit accounts in other financial institutions and federal funds sold.
Use of Estimates
The preparation of financial statements in conformity with U.S. GAAP 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. Estimates used in the preparation of the financial statements are based on various factors including the current interest rate environment and the general strength of the local economy. Changes in the overall interest rate environment can significantly affect the Company’s net interest income and the value of its recorded assets and liabilities. Actual results could differ from those estimates used in the preparation of the financial statements. The allowance for loan losses,
carrying value of other real estate owned, actuarial assumptions used to calculate postretirement benefits, and the fair values of financial instruments are estimates that are particularly subject to change.
Reclassifications
Certain amounts in the accompanying consolidated financial statements presented for prior years have been reclassified to conform to the 2013 presentation. These reclassifications do not affect net income or total shareholders’ equity as previously reported.
Segment Information
The Company provides a broad range of financial services to individuals, corporations, and others through its 36 banking locations throughout Central and Northern Kentucky. These services primarily include the activities of lending, receiving deposits, providing cash management services, safe deposit box rental, and trust activities. While the chief decision-makers monitor the revenue streams of the various products and services, operations are managed and financial performance is evaluated on a Company-wide basis. Operating segments are aggregated into one as operating results for all segments are similar. Accordingly, all of the financial service operations are considered by management to be aggregated in one reportable segment.
Cash Flows
For purposes of reporting cash flows, cash and cash equivalents include the following: cash on hand, deposits from other financial institutions that have an initial maturity of less than 90 days when acquired by the Company, federal funds sold, and securities purchased under agreements to resell. Generally, federal funds sold and securities purchased under agreements to resell are purchased and sold for one-day periods. Net cash flows are reported for loan, deposit, and short-term borrowing transactions.
Investment Securities
Investments in debt and equity securities are classified into three categories. Securities that management has the positive intent and ability to hold until maturity are classified as held to maturity. Securities that are bought and held specifically for the purpose of selling them in the near term are classified as trading securities. The Company had no securities classified as trading during 2013, 2012, or 2011. All other securities are classified as available for sale. Securities are designated as available for sale if they might be sold before maturity. Securities classified as available for sale are carried at estimated fair value. Unrealized holding gains and losses for available for sale securities are reported net of deferred income taxes in other comprehensive income. Investments classified as held to maturity are carried at amortized cost. Amortized cost basis for investment securities includes adjustments made to the cost for previous other-than-temporary impairment (“OTTI”) recognized in earnings, amortization, accretion, and collection of cash.
Interest income includes amortization and accretion of purchase premiums or discounts. Premiums and discounts on securities are amortized using the interest method over the expected life of the securities without anticipating prepayments, except for mortgage backed securities where prepayments are anticipated. Realized gains and losses on the sales of securities are recorded on the trade date and computed on the basis of specific identification of the adjusted cost of each security and are included in noninterest income.
The Company evaluates investment securities for OTTI at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. A decline in the market value of investment securities below cost that is deemed other-than-temporary results in a charge to earnings and the establishment of a new cost basis for the security. Substantially all of the Company’s investment securities are debt securities. In estimating OTTI for debt securities, management considers each of the following: (1) the length of time and extent to which fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether market decline was affected by macroeconomic conditions, and (4) whether the Company has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery in fair value. The assessment of whether an OTTI charge exists involves a high degree of subjectivity and judgment and is based on the information available to the Company at a point in time.
Investment securities classified as available for sale or held-to-maturity are generally evaluated for OTTI under Financial Accounting Standard Board (“FASB”) Accounting Standards CodificationTM (“ASC”) Topic 320, “Investments-Debt and Equity Securities.” In determining OTTI under ASC Topic 320 the Company considers many factors, including those enumerated above. When OTTI occurs, the amount of the OTTI recognized in earnings depends on whether the Company intends to sell the security or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis. If the Company intends to sell or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, OTTI is recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. If the Company does not intend to sell the security and it is not more likely than not that it will be required to sell the security before recovery of its amortized cost basis, OTTI is separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the total OTTI related to other factors is recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less OTTI recognized in earnings becomes the new amortized cost basis of the investment.
Federal Home Loan Bank and Federal Reserve Bank Stock
Federal Home Loan Bank (“FHLB”) and Federal Reserve Bank stock is carried at cost on the consolidated balance sheets under the caption “Other assets.” These stocks are classified as restricted securities and periodically evaluated for impairment based on ultimate recovery of par value. Both cash and stock dividends are reported as income. The amount outstanding at December 31, 2013 and 2012 was $9.5 million.
Loans and Interest Income
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their unpaid principal amount outstanding adjusted for any charge-offs and deferred fees or costs on originated loans. Interest income on loans is recognized using the interest method based on loan principal amounts outstanding during the period. Interest income also includes amortization and accretion of any premiums or discounts over the expected life of acquired loans at the time of purchase or business acquisition. Loan origination fees, net of certain direct origination costs, are deferred and amortized as yield adjustments over the contractual term of the loans.
The Company disaggregates certain disclosure information related to loans, the related allowance for loan losses, and credit quality measures by either portfolio segment or by loan class. The Company segregates its loan portfolio segments based on similar risk characteristics as follows: real estate loans, commercial loans, and consumer loans. Portfolio segments are further disaggregated into classes for certain required disclosures as follows:
Portfolio Segment
Class
Real estate loans
Real estate mortgage - construction and land development
Real estate mortgage - residential
Real estate mortgage - farmland and other commercial enterprises
Commercial loans
Commercial and industrial
Depository institutions
Agriculture production and other loans to farmers
States and political subdivisions
Leases
Other
Consumer loans
Secured
Unsecured
Loan disclosures include presenting certain disaggregated information based on recorded investment. The recorded investment in a loan includes its principal amount outstanding adjusted for certain items that include net deferred loan costs or fees, unamortized premiums or discounts, charge offs, and accrued interest. The Company had a total of $492 thousand and $574 thousand of net deferred loan costs at year-end 2013 and 2012, respectively, included in the carrying
amount of loans on the balance sheet, which represents .05% and .06% of average loans outstanding for 2013 and 2012. The amount of net deferred loans costs are not material and are omitted from the computation of the recorded investment included in Note 3 that follows. Similarly, accrued interest receivable on loans was $3.4 million and $3.7 million at year-end 2013 and 2012, respectively, or .3% and .4% of average loans outstanding and has also been omitted from certain information presented in Note 3.
The Company has a loan policy in place that is amended and approved from time to time as needed to reflect current economic conditions and product offerings in its markets. The policy establishes written procedures concerning areas such as the lending authorities of loan officers, committee review and approval of certain credit requests, underwriting criteria, policy exceptions, appraisal requirements, and loan review. Credit is extended to borrowers based primarily on their ability to repay as demonstrated by income and cash flow analysis.
Loans secured by real estate make up the largest segment of the Company’s loan portfolio. If a borrower fails to repay a loan secured by real estate, the Company may liquidate the collateral in order to satisfy the amount owed. Determining the value of real estate is a key component to the lending process for real estate backed loans. If the fair value of real estate (less estimated cost to sell) securing a collateral dependent loan declines below the outstanding loan amount, the Company will write down the carrying value of the loan and thereby incur a loss. The Company uses independent third party state certified or licensed appraisers in accordance with its loan policy to mitigate risk when underwriting real estate loans. Cash flow analysis of the borrower, loan to value limits as adopted by loan policy, and other customary underwriting standards are also in place which are designed to maximize credit quality and mitigate risks associated with real estate lending.
Commercial loans are made to businesses and are secured mainly by assets such as inventory, accounts receivable, machinery, fixtures and equipment, or other business assets. Commercial lending involves significant risk, as loan repayments are more dependent on the successful operation or management of the business and its cash flows. Consumer lending includes loans to individuals mainly for personal autos, boats, or a variety of other personal uses and may be secured or unsecured. Loan repayment associated with consumer loans is highly dependent upon the borrower’s continuing financial stability, which is heavily influenced by local unemployment rates. The Company mitigates its risk exposure to each of its loan segments by analyzing the borrower’s repayment capacity, imposing restrictions on the amount it will loan compared to estimated collateral values, limiting the payback periods, and following other customary underwriting practices as adopted in its loan policy.
The accrual of interest on loans is discontinued when it is determined that the collection of interest or principal is doubtful, or when a default of interest or principal has existed for 90 days or more, unless such loan is well secured and in the process of collection. Past due status is based on the contractual terms of the loan. Interest accrued but not received for a loan placed on nonaccrual status is reversed against interest income. Cash payments received on nonaccrual loans generally are applied to principal until qualifying for return to accrual status. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. The Company’s policy for placing a loan on nonaccrual status or subsequently returning a loan to accrual status does not differ based on its portfolio class or segment.
Commercial and real estate loans delinquent in excess of 120 days and consumer loans delinquent in excess of 180 days are charged off, unless the collateral securing the debt is of such value that any loss appears to be unlikely. In all cases, loans are charged off at an earlier date if classified as loss under its loan grading process or as a result of regulatory examination. The Company’s charge-off policy for impaired loans does not differ from the charge-off policy for loans outside the definition of impaired.
Loans Held for Sale
The Company’s operations include a limited amount of mortgage banking. Mortgage banking activities include the origination of fixed-rate residential mortgage loans for sale to various third-party investors. Mortgage loans originated and intended for sale in the secondary market, principally under programs with the Federal Home Loan Mortgage Corporation, the Federal National Mortgage Association, and other commercial lending institutions are carried at the lower of cost or estimated fair value determined in the aggregate and included in net loans on the balance sheet until sold.
These loans are sold with the related servicing rights either retained or released by the Company depending on the economic conditions present at the time of origination. Mortgage loans held for sale included in net loans totaled $4.1 million and $2.5 million at December 31, 2013 and December 31, 2012, respectively. Mortgage banking revenues, including origination fees, servicing fees, net gains on sales of mortgage loans, and other fee income were 1.6%, 2.4%, and 1.28% of the Company’s total revenue for the years ended December 31, 2013, 2012, and 2011, respectively.
Provision and Allowance for Loan Losses
The provision for loan losses represents charges or credits made to earnings to maintain an allowance for loan losses at a level considered adequate to provide for probable incurred credit losses at the balance sheet date. The allowance for loan losses is a valuation allowance increased by the provision for loan losses and decreased by net charge-offs. Loan losses are charged against the allowance when management believes the uncollectibility of a loan is confirmed. Subsequent recoveries, if any, are credited to the allowance.
The Company estimates the adequacy of the allowance using a risk-rated methodology which is based on the Company’s past loan loss experience, known and inherent risks in the loan portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral securing loans, composition of the loan portfolio, current economic conditions, and other relevant factors. This evaluation is inherently subjective as it requires significant judgment and the use of estimates that may be susceptible to change.
The allowance for loan losses consists of specific and general components. The specific component relates to loans that are individually classified as impaired. The general component covers non-impaired loans and is based on historical loss experience adjusted for current risk factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. Actual loan losses could differ significantly from the amounts estimated by management.
The Company’s risk-rated methodology includes segregating non-impaired watch list and past due loans from the general portfolio and allocating a loss percentage to these loans depending on their status. For example, watch list loans, which may be identified by the internal loan review risk-rating process or by regulatory examiner classification, are assigned a certain loss percentage while loans past due 30 days or more are assigned a different loss percentage. Each of these percentages considers past experience as well as current factors. The remainder of the general loan portfolio is segregated into portfolio segments having similar risk characteristics identified as follows: real estate loans, commercial loans, and consumer loans. Each of these portfolio segments is assigned a loss percentage based on their respective rolling historical loss rates, adjusted for qualitative risk factors. During the third quarter of 2013, the Company lengthened the look-back period it uses to determine historical loss rates to the previous 16 quarters from 12 quarters. The change in the look-back period is the result of the Company’s ongoing monitoring and evaluation of the adequacy of its allowance for loan losses. The longer look-back period better reflects the Company’s loss estimates based on current market conditions. Lengthening the look-back period resulted in a $320 thousand increase in the allowance for loan losses.
The qualitative risk factors used in the methodology are consistent with the guidance in the most recent Interagency Policy Statement on the Allowance for Loan Losses issued. Each factor is supported by a detailed analysis performed at each subsidiary bank and is both measureable and supportable. Some factors include a minimum allocation in some instances where loss levels are extremely low and it is determined to be prudent from a safety and soundness perspective. Qualitative risk factors that are used in the methodology include the following for each loan portfolio segment:
●
Delinquency trends
●
Trends in net charge-offs
●
Trends in loan volume
●
Lending philosophy risk
●
Management experience risk
●
Concentration of credit risk
●
Economic conditions risk
A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired. 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.
The Company accounts for impaired loans in accordance with ASC Topic 310, “Receivables.” ASC Topic 310 requires that impaired loans be measured at the present value of expected future cash flows, discounted at the loan’s effective interest rate, at the loan’s observable market price, or at the fair value of the collateral if the loan is collateral dependent. Impaired loans may also be classified as nonaccrual. In many circumstances, however, the Company continues to accrue interest on an impaired loan. Cash receipts on accruing impaired loans are applied to the recorded investment in the loan, including any accrued interest receivable. Cash payments received on nonaccrual impaired loans generally are applied to principal until qualifying for return to accrual status. Loans that are part of a large group of smaller-balance homogeneous loans, such as residential mortgage, consumer, and smaller-balance commercial loans, are collectively evaluated for impairment. Troubled debt restructurings are measured at the present value of estimated future cash flows using the loan’s effective interest rate at inception, or at the fair value of collateral. The Company determines the amount of reserve for troubled debt restructurings that subsequently default in accordance with its accounting policy for the allowance for loan losses.
Mortgage Servicing Rights
Mortgage servicing rights are recognized in other assets on the Company’s consolidated balance sheet at their initial fair value on loans sold with servicing retained. Fair value is based on market prices for comparable mortgage servicing contracts when available, or alternatively, is based on a valuation model that calculates the present value of estimated future net servicing income. Mortgage servicing rights are subsequently measured using the amortization method in which the mortgage servicing right is expensed in proportion to, and over the period of, the estimated future net servicing income of the underlying loans. Impairment is evaluated based on the fair value of the rights, grouping the underlying loans by interest rates. Impairment of a grouping is reported as a valuation allowance. Capitalized mortgage servicing rights were $785 thousand and $795 thousand at December 31, 2013 and 2012, respectively. No impairment of the asset was determined to exist on either of these dates. Mortgage loans serviced for others totaled $200 million and $172 million at December 31, 2013 and 2012, respectively. Mortgage loans serviced for others are not included in the Company’s balance sheets.
Fair Value of Financial Instruments
Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in Note 18. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates.
Loan Commitments and Related Financial Instruments
Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit, which are issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.
Intangible Assets
Intangible assets consist of core deposit and customer relationship intangible assets arising from business acquisitions. Intangible assets are initially measured at fair value and then amortized on an accelerated method over their estimated
useful lives, which range between seven and 10 years. Such assets are evaluated for impairment whenever events or changes in circumstances indicate the carrying value may not be recoverable.
Other Real Estate Owned
Other real estate owned (“OREO”) and held for sale in the accompanying consolidated balance sheets includes properties acquired by the Company through, or in lieu of, actual loan foreclosures. OREO is initially carried at fair value less estimated costs to sell. Fair value of assets is generally based on third party appraisals of the property that includes comparable sales data. If the carrying amount exceeds fair value less estimated costs to sell, an impairment loss is recorded through expense. These assets are subsequently accounted for at the lower of carrying amount or fair value less estimated costs to sell. Operating costs after acquisition are expensed.
Income Taxes
Income tax expense is the total of current year income tax due or refundable and the change in deferred tax assets and liabilities, except for the deferred tax assets and liabilities related to business combinations or components of other comprehensive income. Deferred income tax assets and liabilities result from temporary differences between the tax basis of assets and liabilities and their reported amounts in the consolidated financial statements that will result in taxable or deductible amounts in future years. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in years in which those temporary differences are expected to be recovered or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through income tax expense. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.
A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.
The Company files a consolidated federal income tax return with its subsidiaries. Federal income tax expense or benefit has been allocated to subsidiaries on a separate return basis. The Company’s policy is to record the accrual of interest and/or penalties relative to income tax matters, if any, in income tax expense.
Premises and Equipment
Premises, equipment, and leasehold improvements are stated at cost less accumulated depreciation and amortization. Depreciation is computed primarily on the straight-line method over the estimated useful lives generally ranging from two to seven years for furniture and equipment and generally ten to 40 years for buildings and related components. Leasehold improvements are amortized over the shorter of the estimated useful lives or terms of the related leases on the straight-line method. Maintenance, repairs, and minor improvements are charged to operating expenses as incurred and major improvements are capitalized. The cost of assets sold or retired and the related accumulated depreciation are removed from the accounts and any resulting gain or loss is included in noninterest income. Land is carried at cost.
Company-owned Life Insurance
The Company has purchased life insurance policies on certain key employees with their knowledge and written consent. Company-owned life insurance is recorded on the consolidated balance sheet at its cash surrender value, which is the amount that can be realized under the insurance contract at the balance sheet date. The related change in cash surrender value and proceeds received under the policies are reported on the consolidated statements of income under the caption “Income from company-owned life insurance.”
Related Party Transactions
In the ordinary course of business, the Company offers loan and deposit products to its directors, executive officers, and principal shareholders - including affiliated companies of which they are principal owners (“Related Parties”). These products are offered on substantially the same terms as those prevailing at the time for comparable transactions with unrelated parties, and these receivables and deposits are included in loans and deposits in the Company’s consolidated balance sheets. Additional information related to these transactions can be found in Note 3 and Note 6.
The Company makes payments to Related Parties in the normal course of business for various services, primarily related to legal fees. For example, certain directors of the Parent Company and its subsidiary banks are partners in law firms that act as counsel to the Company. The following table represents the amount and type of payments to Related Parties, other than director fees, for the periods indicated:
Retirement Plans
The Company maintains a 401(k) salary savings plan and records expense based on the amount of its matching contributions of employee deferrals. The Company also has a nonqualified supplemental retirement plan for certain key employees that it acquired in connection with the Citizens Northern acquisition. Supplemental retirement plan expense allocates the benefits over years of service.
Net Income Per Common Share
Basic net income per common share is determined by dividing net income available to common shareholders by the weighted average total number of common shares issued and outstanding. Net income available to common shareholders represents net income adjusted for preferred stock dividends including dividends declared, accretion of discounts on preferred stock issuances, and cumulative dividends related to the current dividend period that have not been declared as of the end of the period.
Diluted net income per common share is determined by dividing net income available to common shareholders by the total weighted average number of common shares issued and outstanding plus amounts representing the dilutive effect of stock options outstanding and outstanding warrants. The effects of stock options and outstanding warrants are excluded from the computation of diluted earnings per common share in periods in which the effect would be antidilutive. Dilutive potential common shares are calculated using the treasury stock method.
Net income per common share computations were as follows for the years ended December 31, 2013, 2012, and 2011.
Stock options for 22,049, 24,049, and 24,049 shares of common stock were not included in the determination of diluted net income per common share for 2013, 2012, and 2011, respectively, because they were antidilutive. There were 223,992 potential common shares associated with a warrant issued to the U.S. Treasury that were excluded from the computation of diluted net income per common share for 2011 because they were antidilutive. The Company repurchased the warrant from the Treasury during the third quarter of 2012.
Comprehensive Income
Comprehensive income is defined as the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. For the Company this includes net income, the after tax effect of changes in the net unrealized gains and losses on available for sale investment securities, and the after tax changes to the funded status of postretirement benefit plans.
Dividend Restrictions
Banking regulations require maintaining certain capital levels which limit the amount of dividends paid to the Company by its bank subsidiaries. In addition, the Parent Company and two of its subsidiary banks must obtain regulatory approval to pay dividends as a result of agreements entered into related to recent examinations. Refer to Note 17 for additional information.
Restrictions on Cash
The Company is required to maintain funds in cash and/or on deposit with the Federal Reserve Bank in accordance with reserve requirements specified by the Federal Reserve Board of Governors. The required reserve was $19.9 million and $17.0 million at December 31, 2013 and 2012, respectively.
Equity
Outstanding common shares purchased by the Company are retired. When common shares are purchased, the Company allocates a portion of the purchase price of the common shares that are retired to each of the following balance sheet line items: common stock, capital surplus, and retained earnings. The Company did not purchase any of its outstanding common shares during 2013 or 2012.
Trust Assets
Assets of the Company’s trust departments, other than cash on deposit at subsidiary banks, are not included in the accompanying financial statements because they are not assets of the Company.
Transfers of Financial Assets
Transfers of financial assets are accounted for as sales when control over the assets has been relinquished. Control over transferred assets is deemed to be surrendered when the assets have been isolated from the Company, the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
Long-term Assets
Premises and equipment, core deposit and other intangible assets, and other long-term assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at fair value.
Stock-Based Compensation
The Company recognizes compensation cost for its Employee Stock Purchase Plan (“ESPP”) and for stock options granted based on the fair value of these awards at the date of grant. A Black-Scholes model is utilized to estimate the fair value of ESPP and stock option awards. Compensation cost is recognized over the required service period, generally defined as the vesting period, on a straight-line basis. There have been no stock options granted by the Company since 2004, and all outstanding options are vested.
The ESPP was approved by the Company’s shareholders in 2004. The purpose of the ESPP is to provide a means by which eligible employees may purchase, at a discount, shares of the Company’s common stock through payroll withholding. The purchase price of the shares is equal to 85% of their fair market value on specified dates as defined in the plan. The ESPP was effective beginning July 1, 2004. There were 8,893, 23,368, and 34,769 shares issued under the plan during 2013, 2012, and 2011, respectively. Compensation expense related to the ESPP included in the accompanying statements of income was $36 thousand, $36 thousand, and $42 thousand in 2013, 2012, and 2011, respectively.
Following are the weighted average assumptions used and estimated fair market value for the ESPP, which is considered a compensatory plan under ASC Topic 718, “Compensation-Stock Compensation.”
Adoption of New Accounting Standards
Effective January 1, 2013, the Company adopted Accounting Standards Update (“ASU”) 2013-02, Comprehensive Income (Topic 220) - Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. This ASU requires additional disclosure about the changes in the components of accumulated other comprehensive income, including amounts reclassified and amounts due to current period other comprehensive income. The following table presents changes in accumulated other comprehensive income by component, net of tax, for the period indicated.
The following table presents amounts reclassified out of accumulated other comprehensive income by component for the period indicated. Line items in the statement of income affected by the reclassification are also presented.
2. Investment Securities
The following tables summarize the amortized cost and estimated fair values of the securities portfolio at December 31, 2013 and 2012 and the corresponding amounts of gross unrealized gains and losses. The summary is divided into available for sale and held to maturity securities.
At year-end 2013 and 2012, the Company held no investment securities of any single issuer, other than the U.S. Government and its agencies, in an amount greater than 10% of shareholders’ equity.
The amortized cost and estimated fair value of the securities portfolio at December 31, 2013, by contractual maturity, are detailed below. The summary is divided into available for sale and held to maturity securities. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Mutual funds and equity securities in the available for sale portfolio at December 31, 2013 consist of investments by the Company’s captive insurance subsidiary. These securities have no stated maturity and are not included in the maturity schedule that follows.
Mortgage-backed securities are stated separately due to the nature of payment and prepayment characteristics of these securities, as principal is not due at a single date.
Gross realized gains and losses on the sale of available for sale investment securities were as follows for the year indicated.
Investment securities with a carrying value of $277 million and $285 million at December 31, 2013 and 2012 were pledged to secure public and trust deposits, repurchase agreements, and for other purposes.
Investment securities with unrealized losses at year-end 2013 and 2012 not recognized in income are presented in the tables below. The tables segregate investment securities that have been in a continuous unrealized loss position for less than twelve months from those that have been in a continuous unrealized loss position for twelve months or more. The table also includes the fair value of the related securities.
Unrealized losses included in the tables above have not been recognized in income since they have been identified as temporary. The Company evaluates investment securities for other-than-temporary impairment at least quarterly, and more frequently when economic or market conditions warrant. Many factors are considered, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was effected by macroeconomic conditions, and (4) whether the Company has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an OTTI charge exists involves a high degree of subjectivity and judgment and is based on the information available to the Company at a point in time.
At December 31, 2013, the Company’s investment securities portfolio had gross unrealized losses of $12.9 million, an increase of $11.6 million compared to year-end 2012. Of the total gross unrealized losses at December 31, 2013, $3.6 million or 28.0% relates to investments that have been in a continuous loss position for 12 months or more. Unrealized losses on corporate debt securities and mortgage-backed securities each make up $1.0 million of the total unrealized loss on investment securities in a continuous loss position of 12 months or more.
Corporate debt securities in the Company’s investment securities portfolio at December 31, 2013 include single-issuer trust preferred capital securities with a carrying value of $4.8 million. These securities were issued by a national and global financial services firm and were purchased by the Company during 2007. The securities are currently performing and continue to be rated as investment grade by major rating agencies. The issuer of the securities announced in the first quarter of 2013 that it had passed stringent regulatory stress testing and received regulatory approval to both increase per share common dividend payments and increase its equity repurchase program. The Company does not intend to sell these
securities nor does it believe it is likely that it will be required to sell these securities prior to their anticipated recovery. The Company believes these securities are not impared due to reasons of credit quality or other factors, but rather the unrealized loss is primarily attributed to continuing uncertainties in both international and domestic economies and market volatility. The Company believes that it will collect all amounts due according to the contractual terms of these securities and that the fair values of these securities will recover as they approach their maturity dates.
The Company attributes the unrealized losses in other sectors of its investment securities portfolio to changes in market interest rates and volatility. Market interest rates rose sharply during the second and fourth quarters of 2013 as measured by the yields on Treasury bonds, particularly for the longer dated maturity periods. Investment securities with unrealized losses at December 31, 2013 are performing according to their contractual terms, and the Company does not expect to incur a loss on these securities unless they are sold prior to maturity. The Company does not have the intent to sell these securities nor does it believe it is likely that it will be required to sell these securities prior to their anticipated recovery. The Company does not consider any of the securities to be impaired due to reasons of credit quality or other factors.
3. Loans and Allowance for Loan Losses
Major classifications of loans are summarized in the following table.
Loans with a carrying value of $484 million and $466 million at December 31, 2013 and December 31, 2012, respectively, were pledged to secure borrowings and lines of credit. Such borrowings primarily include FHLB advances and short-term borrowing arrangements with the Federal Reserve.
Loans to directors, executive officers, and principal shareholders of the Parent Company and its subsidiaries (including loans to affiliated companies of which they are principal owners) and loans to members of the immediate family of such persons were $18.1 million at December 31, 2013. Such loans were made in the normal course of business on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other customers and did not involve more than the normal risk of collectability. An analysis of the activity with respect to these loans is presented in the table below.
Activity in the allowance for loan losses by portfolio segment was as follows for each of the three years in the period ended December 31, 2013:
The following tables present individually impaired loans by class of loans for the dates indicated.
The following tables present the balance of the allowance for loan losses and the recorded investment in loans by portfolio segment based on impairment method as of December 31, 2013 and 2012.
The following tables present the recorded investment in nonperforming loans by class of loans as of December 31, 2013 and 2012.
The Company has allocated $2.7 million and $2.9 million of specific reserves to customers whose loan terms have been modified in troubled debt restructurings and that are in compliance with those terms as of December 31, 2013 and 2012, respectively. The Company had no commitments to lend additional amounts to customers with outstanding loans that are classified as troubled debt restructurings at December 31, 2013 and 2012.
During 2013, the Company had eight credits that were modified as troubled debt restructurings. Seven of these credits with an aggregate recorded investment of $338 thousand represent debt by borrowers discharged under Chapter 7 bankruptcy. The borrower in each case did not reaffirm their debt, and the release of personal liability by the court is deemed a concession. However, each borrower continues to make payments under the original terms of the loan agreement. The remaining restructuring consists of a credit secured by commercial real estate whereby the maturity date was extended 48 months.
During 2012, the Company had three credits that were modified as troubled debt restructurings. One restructuring includes a commercial real estate credit whereby the stated interest rate was reduced to 5.0% from 7.25% and repayment terms that include an initial six month interest only component. One restructuring includes a residential real estate credit
whereby the stated interest rate was reduced to 4.125% from 6.0% and the due date extended by three months. The remaining restructured credit represents a secured consumer loans in which the maturity date was extended.
The following table presents loans by class modified as troubled debt restructurings that occurred during the years ended December 31, 2013 and 2012.
The troubled debt restructurings identified above increased the allowance for loan losses by $37 thousand and $442 thousand for 2013 and 2012, respectively. There were no charge-offs related to loans restructured in 2013 or 2012.
The Company had one restructured credit in 2013 for which there was a payment default within twelve months following the modification. This credit is secured by residential real estate with an outstanding balance of $15 thousand at year-end 2013. No charge-offs have been recorded for this credit.
The Company had one restructured credit in 2012 for which there was a payment default within twelve months following the modification. This credit had an outstanding balance of $72 thousand at December 31, 2012 and is secured by residential real estate. This credit had a specific reserve allocation of $5 thousand at year-end 2012. There were no charge-offs recorded during 2012 related to this credit.
The tables below present an age analysis of past due loans 30 days or more by class of loans as of the dates indicated. Past due loans that are also classified as nonaccrual are included in their respective past due category.
The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends and conditions. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis includes large-balance loans and non-homogeneous loans, such as commercial real estate and certain residential real estate loans. Loan rating grades, as described further below, are assigned based on a continuous process. The amount and adequacy of the allowance for loan loss is determined on a quarterly basis. The Company uses the following definitions for its risk ratings:
Special Mention. Loans classified as special mention have a potential weakness that deserves management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the borrower’s
repayment ability, weaken the collateral or inadequately protect the Company’s credit position at some future date. These credits pose elevated risk, but their weaknesses do not yet justify a substandard classification.
Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.
Doubtful. Loans classified as doubtful have all the weaknesses inherent of those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
Loans not meeting the criteria above which are analyzed individually as part of the above described process are considered to be pass rated loans, which are considered to have a low risk of loss. Based on the most recent analysis performed, the risk category of loans by class of loans is as follows for the dates indicated. Each of the following tables excludes immaterial amounts attributed to accrued interest receivable.
The Company considers the performance of the loan portfolio and its impact on the allowance for loan losses. For consumer loan classes, the Company also evaluates credit quality based on the aging status of the loan, which was previously presented, and by payment activity. The following table presents the consumer loans outstanding based on payment activity as of December 31, 2013 and 2012.
4. Other Real Estate Owned
OREO was as follows as of the date indicated:
OREO activity for 2013 and 2012 was as follows:
5. Premises and Equipment
Premises and equipment consist of the following.
Depreciation and amortization of premises and equipment was $3.4 million, $3.4 million, and $3.5 million for 2013, 2012, and 2011, respectively.
6. Deposit Liabilities
Major classifications of deposits are summarized as follows for the dates indicated:
At December 31, 2013, the scheduled maturities of time deposits were as follows:
Time deposits of $100 thousand or more at December 31, 2013 and 2012 were $156 million and $181 million, respectively. Interest expense on time deposits of $100 thousand or more was $1.8 million, $2.9 million, and $4.5 million for 2013, 2012, and 2011, respectively.
During 2010, the Federal Deposit Insurance Corporation (“FDIC”) permanently raised its standard maximum insurance amount per depositor from $100 thousand to $250 thousand. At December 31, 2013 and 2012, the Company had $30.4 million and $32.2 million, respectively, of time deposits outstanding in amounts of $250 thousand or more.
Deposits from directors, executive officers, and principal shareholders of the Parent Company and its subsidiaries (including deposits from affiliated companies of which they are principal owners) and deposits from members of the immediate family of such persons were $19.0 million and $19.1 million at December 31, 2013 and 2012, respectively. Such deposits were accepted in the normal course of business on substantially the same terms as those prevailing at the time for comparable transactions with other customers.
7. Federal Funds Purchased and Other Short-term Borrowings
Federal funds purchased and other short-term borrowings represent borrowings with an original maturity of less than one year. All of the Company’s short-term borrowings are made up of federal funds purchased and securities sold under agreements to repurchase, which represent borrowings that generally mature one business day following the date of the transaction. Information on federal funds purchased and other short-term borrowings is as follows:
8. Securities Sold Under Agreements to Repurchase and Other Long-term Borrowings
Long-term securities sold under agreements to repurchase and other borrowings represent borrowings with an original maturity of one year or more. The table below displays a summary of the ending balance and average rate for borrowed funds on the dates indicated.
Long-term FHLB advances are made pursuant to several different credit programs, which have their own interest rates and range of maturities. At December 31, 2013, interest rates on all FHLB advances are fixed and range between 2.99% and 6.90%, averaging 4.14%, over a remaining maturity period of up to seven years. At December 31, 2012, interest rates on FHLB advances ranged between 2.60% and 6.90%, averaging 4.04%, over a remaining maturity period of up to eight years. Long-term FHLB borrowings of $26.0 million and $28.0 million at year-end 2013 and 2012, respectively, were putable quarterly. None of the long-term FHLB advances are convertible to a floating interest rate.
For FHLB advances, the subsidiary banks pledge FHLB stock and fully disbursed, otherwise unencumbered, 1-4 family first mortgage loans as collateral for these advances as required by the FHLB. Based on this collateral and the Company’s holdings of FHLB stock, the Company is eligible to borrow up to an additional $101 million from the FHLB at year-end 2013.
During 2005, the Company completed two private offerings of trust preferred securities through two separate Delaware statutory trusts sponsored by the Company. Farmers Capital Bank Trust I (“Trust I”) sold $10.0 million of preferred securities and Farmers Capital Bank Trust II (“Trust II”) sold $15.0 million of preferred securities. The proceeds from the offerings were used to fund the cash portion of the acquisition of Citizens Bancorp, Inc., the former parent company of Citizens Northern. The trust preferred securities mature September 30, 2035 and can now be redeemed at any time by the Trust at par.
Farmers Capital Bank Trust III (“Trust III”), a Delaware statutory trust sponsored by the Company, was formed during 2007 for the purpose of financing the cost of acquiring Company shares under a share repurchase program. Trust III sold $22.5 million of trust preferred securities to the public with an initial fixed rate of 6.60% through October 2012, thereafter
at a variable rate of interest, reset quarterly, equal to the 3-month LIBOR plus a predetermined spread of 132 basis points). The trust preferred securities mature on November 1, 2037 and can now be redeemed at any time by the Trust at par. Trust I, Trust II, and Trust III are hereafter collectively referred to as the “Trusts.”
The Trusts used the proceeds from the sale of preferred securities, plus capital contributed to establish the trusts, to purchase the Company’s subordinated notes in amounts and bearing terms that parallel the amounts and terms of the respective preferred securities. The subordinated notes to Trust I and Trust II mature in 2035 and in 2037 for Trust III, and bear a floating interest rate (current three-month LIBOR plus 150 basis points in the case of the notes held by Trust I, current three-month LIBOR plus 165 basis points in the case of the notes held by Trust II, and current three-month LIBOR plus 132 basis points in the case of the notes held by Trust III). Interest on the notes is payable quarterly. Interest payments to the Trusts and distributions to preferred shareholders by the Trusts may be deferred for 20 consecutive quarterly periods.
The subordinated notes are redeemable in whole or in part, without penalty, at the Company’s option. The notes are junior in right of payment of all present and future senior indebtedness. At December 31, 2013 and 2012 the balance of the subordinated notes payable to Trust I, Trust II, and Trust III was $10.3 million, $15.5 million, and $23.2 million, respectively. The interest rates in effect as of the last determination date for 2013 were 1.75%, 1.90%, and 1.56% for Trust I, Trust II, and Trust III, respectively. For 2012 these rates were 1.81%, 1.96%, and 1.63% for Trust I Trust II, and Trust III, respectively.
The Company is not considered the primary beneficiary of the Trusts; therefore the Trusts are not consolidated into its financial statements. Accordingly, the Company does not report the securities issued by the Trusts as liabilities, but instead reports as liabilities the subordinated notes issued by the Company and held by the Trusts. The Company, which owns all of the common securities of the Trusts, accounts for its investment in each of the Trusts as other assets. The Company records interest expense on the corresponding notes issued to the Trusts on its statements of income.
The subordinated notes, net of the Company’s investment in the Trusts, may be included in Tier 1 capital (with certain limitations applicable) under current regulatory capital guidelines and interpretations. The net amount of subordinated notes in excess of the limit may be included in Tier 2 capital, subject to restrictions. At year-end 2013 and 2012, the Company’s Tier 1 capital included $47.5 million, which represents the full amount of the subordinated notes net of the Company’s investment in the Trusts.
During 2007, the Company entered into a balance sheet leverage transaction whereby it borrowed $200 million in multiple fixed rate term repurchase agreements with an initial weighted average cost of 3.95% and invested the proceeds in Government National Mortgage Association (“GNMA”) bonds, which were pledged as collateral. The Company is required to secure the borrowed funds by GNMA bonds valued at 106% of the outstanding principal balance. The borrowings have an outstanding balance of $100 million at December 31, 2013, are putable on a quarterly basis, and mature in November 2017. The repurchase agreements are held by each of the Company’s three subsidiary banks that are participating in the transaction and are guaranteed by the Parent Company. The Company has $754 thousand of other long-term repurchase agreements outstanding at December 31, 2013 made in the ordinary course of business with commercial customers. The average interest rate on these fixed rate borrowings is 1.17%.
Maturities of long-term borrowings at December 31, 2013 are as follows:
9. Income Taxes
The components of income tax expense are as follows:
An analysis of the difference between the effective income tax rates and the statutory federal income tax rate follows.
The tax effects of the significant temporary differences that comprise deferred tax assets and liabilities at December 31, 2013 and 2012 are as follows:
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not the Company will realize the benefits of these deductible differences at December 31, 2013.
The Internal Revenue Code grants preferential treatment to the interest income derived from debt issued by states and political subdivisions in that it is not subject to Federal taxation. As a financial institution, the Company is not allowed a tax deduction for a pro rata portion of the interest expense incurred to purchase debt with tax-free attributes. The amount of disallowed interest expense is determined by the total amount of debt issued during the calendar year by the issuer and dependent upon the issuer being considered a qualified small issuer. Debt purchased by a financial institution that meets the requirements to be designated a “qualified tax exempt obligation” has a lower interest expense disallowance than debt that does not meet the “qualified tax exempt obligation” designation. As part of the normal due diligence for a loan with tax-free attributes, the Company relies on the attestation of the borrower, legal counsel for the borrower, and the legal counsel for the Company concerning the representations of the borrower for their debt. During the fourth quarter of 2010, the Company became aware that the qualified status of the debt issued by a customer was being reviewed by the Internal Revenue Service (“IRS”). The customer had previously made representations that their debt was qualified.
During the first quarter of 2011, the Company became aware that this customer had received verbal notification of the IRS’s intent to issue an adverse ruling regarding the qualified status of the financing. At that time, the Company had a potential accumulated tax liability of $402 thousand at risk related to the determination for the tax years 2007 through 2010. Under ASC Topic 740, “Income Taxes,” the Company is required to recognize a tax position when it is more likely than not that the position would be sustained in a tax examination, with the tax examination being presumed to occur. Additionally, ASC Topic 740 indicates that a subsequent change in facts and circumstances should be recognized in the period in which the change occurs. As such, the Company recorded an accrual of $449 thousand including the $402 thousand accumulated tax liability and interest of $47 thousand in the first quarter of 2011. The amount of this tax liability has been reduced by $371 thousand since the initial recording of the liability due to the statute of limitations expiring on a portion of the potential tax payment.
The original loan contract contains provisions that the customer will indemnify the Company for any penalties, taxes or interest thereon for which the Company becomes liable as a result of a determination of taxability. The Company intends to exercise its rights under the contract; however, due to the contingent nature of the indemnification provisions, the Company will not record the effects of the indemnification until it is realized.
A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:
The $66 thousand at year-end 2013 represents the amount of unrecognized tax benefits that, if recognized, would favorably affect the effective income tax rate in future periods. The Company does not expect the total amount of unrecognized tax benefits to significantly increase or decrease in the next twelve months.
The Company’s policy is to record the accrual of interest or penalties relative to unrecognized tax benefits, if any, in its income tax expense accounts. The total amount of interest recorded in the income tax expense (benefit) line item of the income statement for the year ended December 31, 2011 was $32 thousand. This interest amount was reduced by $9 thousand during 2012 and $11 thousand during 2013 due to the statute of limitations expiring on a portion of the potential
tax payment. The amount accrued for interest at December 31, 2013 and 2012 was $12 thousand and $23 thousand, respectively. No penalties were accrued or recorded during any year in the three years ended December 31, 2013.
The Company files U.S. federal and various state income tax returns. The Company is no longer subject to income tax examinations by taxing authorities for the years before 2010.
10. Retirement Plans
The Company maintains a salary savings plan that covers substantially all of its employees. The Company matches voluntary tax deferred employee contributions at 50% of eligible deferrals up to a maximum of 6% of the participants’ compensation. The Company may, at the discretion of its Board, contribute an additional amount based upon a percentage of covered employees’ salaries. The Company did not make a discretionary contribution during 2013, 2012, or 2011. Discretionary contributions are allocated among participants in the ratio that each participant’s compensation bears to all participants’ compensation. Eligible employees are presented with various investment alternatives related to the salary savings plan. Those alternatives include various stock and bond mutual funds ranging from traditional growth funds to more stable income funds as well as an option to invest in bank certificates of deposits. Company shares are not an available investment alternative in the salary savings plan. The total retirement plan expense for 2013, 2012, and 2011 was $528 thousand, $485 thousand, and $470 thousand, respectively.
In connection with its acquisition of Citizens Northern, the Company acquired nonqualified supplemental retirement plans for certain key employees. Benefits provided under these plans are unfunded, and payments to plan participants are made by the Company.
The following schedules set forth a reconciliation of the changes in the supplemental retirement plans’ benefit obligation and funded status for the years ended December 31, 2013 and 2012.
The following table provides disclosure of the net periodic benefit cost as of December 31 for the years indicated.
The following table presents estimated future benefit payments in the period indicated.
Amounts recognized in accumulated other comprehensive income as of December 31, 2013 and 2012 are as follows:
The estimated cost that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next fiscal year is as follows:
11. Common Stock Options
During 1997, the Company’s Board of Directors approved a nonqualified stock option plan (the “Plan”), subsequently approved by the Company’s shareholders, that has provided for the granting of stock options to key employees and officers of the Company. The Plan provides for the granting of options to purchase up to 450,000 shares of the Company’s common stock at a price equal to the fair value of the Company’s common stock on the date the option is granted. The options expire after ten years from the grant date and must be held for a minimum of one year before they can be exercised. Forfeited options are available for the granting of additional stock options under the Plan. Options forfeited from the initial grant in 1997 were used to grant options during 2000 and 2004. Total options granted were 450,000, 54,000, and 40,049 in the years 1997, 2000, and 2004, respectively. Unexercised options granted during 1997 and 2000 have expired. All outstanding options granted under the Plan are vested. At December 31, 2013, there were 54,172 options available for future grants under the Plan.
A summary of the activity in the Company’s Plan for 2013 is presented below.
Options outstanding at year-end 2013 have a remaining contractual life of .83 years. Aggregate options outstanding and exercisable at December 31, 2013 had no intrinsic value since the exercise price was in excess of the market price of the
Company’s stock. There were no options exercised or granted in any year in the three-year periods ending December 31, 2013, nor were there any modifications or cash paid to settle stock option awards during those periods.
12. Postretirement Medical Benefits
Prior to 2003, the Company provided lifetime medical and dental benefits upon retirement for certain employees meeting the eligibility requirements as of December 31, 1989 (“Plan 1”). During 2003, the Company implemented an additional postretirement health insurance program (“Plan 2”). Under Plan 2, any employee meeting the service requirement of 20 years of full time service to the Company and is at least age 55 years of age upon retirement is eligible to continue their health insurance coverage. Under both plans, retirees not yet eligible for Medicare have coverage identical to the coverage offered to active employees. Under both plans, Medicare-eligible retirees are provided with a Medicare Advantage plan. The Company pays 100% of the cost of Plan 1. The Company and the retirees each pay 50% of the cost under Plan 2. Both plans are unfunded.
The following schedules set forth a reconciliation of the changes to the benefit obligation and funded status of the plans for the years ended December 31, 2013 and 2012.
The following table provides disclosure of the net periodic benefit cost as of December 31 for the years indicated.
Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. For measurement purposes, the rate of increase in pre-Medicare medical care claims costs was 8% and 7% for 2014 and 2015, respectively, then grading down by .5% annually to 5% for 2019 and thereafter. For dental claims cost, it was 5% for 2014 and thereafter. A 1% change in the assumed health care cost trend rates would have the following incremental effects:
The following table presents estimated future benefit payments in the period indicated.
Amounts recognized in accumulated other comprehensive income as of December 31, 2013 and 2012 are as follows:
The estimated costs that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next fiscal year are as follows:
13. Leases
The Company leases certain branch sites and banking equipment under various operating leases. Branch site leases have renewal options of varying lengths and terms. The following table presents estimated future minimum rental commitments under these leases for the period indicated.
Rent expense was $399 thousand, $424 thousand, and $451 thousand for 2013, 2012, and 2011, respectively.
14. Financial Instruments With Off-Balance Sheet Risk
The Company 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. The financial instruments include commitments to extend credit in the form of unused lines of credit and standby letters of credit.
These financial 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 amounts of these instruments reflect the extent of involvement the Company has in particular classes of financial instruments.
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 and may require the payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. Total commitments to extend credit were $140 million and $129 million at December 31, 2013 and 2012, respectively. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained upon extension of credit, if deemed necessary by the Company, is based on management’s credit evaluation of the counter-party. Collateral held varies, but may include accounts receivable, marketable securities, inventory, premises and equipment, residential real estate, and income producing commercial properties.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Since many of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. The credit risk involved in issuing letters of credit is essentially the same as that received when extending credit to customers. The fair value of these instruments is not considered material for disclosure. The Company had $23.4 million and $24.4 million in irrevocable letters of credit outstanding at December 31, 2013 and 2012, respectively.
The contractual amount of financial instruments with off-balance sheet risk was as follows at year-end:
15. Concentration of Credit Risk
The Company’s bank subsidiaries actively engage in lending, primarily in their home counties around Central and Northern Kentucky and adjacent areas. Collateral is received to support these loans as deemed necessary. The more significant categories of collateral include cash on deposit with the Company’s banks, marketable securities, income producing properties, commercial real estate, home mortgages, and consumer durables. Loans outstanding, commitments to make loans, and letters of credit range across a large number of industries and individuals. The obligations are significantly diverse and reflect no material concentration in one or more areas, other than most of the Company’s loans are in Kentucky and secured by real estate and thus significantly affected by changes in the Kentucky economy.
16. Loss Contingencies
Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. As of December 31, 2013, there were various pending legal actions and proceedings against the Company arising from the normal course of business and in which claims for damages are asserted. It is the opinion of management, after discussion with legal counsel, that the disposition or ultimate resolution of such claims and legal actions will not have a material effect upon the consolidated financial statements of the Company.
17. Regulatory Matters
The Company and its subsidiary banks are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements will 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 banks must meet specific capital guidelines that involve quantitative measures of the banks’ assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Company and its subsidiary banks’ 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 Company and its subsidiary banks to maintain minimum amounts and ratios (set forth in the tables below) of Tier 1 and total capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital to average assets (as defined). As of December 31, 2013, the most recent notification from the FDIC categorized the banks as well-capitalized under the regulatory framework for prompt corrective action. To be categorized as well-capitalized, the banks must maintain minimum Tier 1 Risk-based, Total Risk-based, and Tier 1 Leverage ratios as set forth in the tables. There are no conditions or events since that notification that management believes have changed the institutions’ category. As noted below under the caption “Summary of Regulatory Agreements,” two of the Company’s subsidiary banks are required to maintain certain capital ratios that exceed the regulatory established well-capitalized status.
The regulatory capital amounts and ratios of the consolidated Company and its subsidiary banks are presented in the following tables for the dates indicated.
1Tier 1 Risk-based and Total Risk-based Capital ratios are computed by dividing a bank’s Tier 1 or Total Capital, as defined by regulation, by a risk-weighted sum of the bank’s assets, with the risk weighting determined by general standards established by regulation. The safest assets (e.g., government obligations) are assigned a weighting of 0% with riskier assets receiving higher ratings (e.g., ordinary commercial loans are assigned a weighting of 100%).
2See discussion below under the caption “Summary of Regulatory Agreements” for minimum capital ratios required as part of the bank’s regulatory agreement.
3Tier 1 Leverage ratio is computed by dividing a bank’s Tier 1 Capital by its total quarterly average assets, as defined by regulation.
Payment of dividends by the Company’s subsidiary banks is subject to certain regulatory restrictions as set forth in national and state banking laws and regulations. Generally, capital distributions are limited to undistributed net income for the current and prior two years, subject to the capital requirements as summarized above. Furthermore, at December 31, 2013, two of the Company’s subsidiary banks are required to obtain regulatory approval before declaring or paying a dividend to the Parent Company as a result of agreements entered into with their primary regulator. The payment of dividends by the Parent Company to its shareholders is also subject to approval as a result of its regulatory agreement.
Summary of Regulatory Agreements
Below is a summary of the regulatory agreements that the Parent Company and two of its subsidiary banks have entered into with their primary regulators. The agreement entered into during 2009 between Farmers Bank and its primary regulator was terminated in January 2013 as a result of satisfactory compliance.
Parent Company
Primarily due to regulatory actions during 2009 at certain of the Company’s subsidiary banks (further discussed below), the Federal Reserve Bank of St. Louis (“FRB St. Louis”) and the Kentucky Department of Financial Institutions (“KDFI”) proposed the Company enter into a Memorandum of Understanding (“Memorandum”). The Company’s board approved entry into the Memorandum at a regular board meeting during the fourth quarter of 2009. Pursuant to the Memorandum, the Company agreed that it would develop an acceptable capital plan to ensure that the consolidated organization remains well-capitalized and each of its subsidiary banks meet the capital requirements imposed by their regulator as summarized below.
The Company also agreed to reduce its common stock dividend in the fourth quarter of 2009 from $.25 per share down to $.10 per share and not make interest payments on the Company’s trust preferred securities or dividends on its common or preferred stock without prior approval from FRB St. Louis and the KDFI. Representatives of the FRB St. Louis and the KDFI have indicated that any such approval for the payment of dividends will be predicated on a demonstration of adequate, normalized earnings on the part of the Company’s subsidiaries sufficient to support quarterly payments on the Company’s trust preferred securities and quarterly dividends on the Company’s common and preferred stock. While both regulatory agencies have granted approval of all subsequent quarterly Company requests to make interest payments on its trust preferred securities and dividends on its preferred stock, the Company has not (based on the assessment by Company management of both the Company’s capital position and the earnings of its subsidiaries) sought regulatory approval for the payment of common stock dividends since the fourth quarter of 2009. Moreover, the Company will not pay any such dividends on its common stock in any subsequent quarter until the regulator’s assessment of the earnings of the Company’s subsidiaries, and the Company’s assessment of its capital position, both yield the conclusion that the payment of a Company common stock dividend is warranted.
Other components in the regulatory order for the parent company include requesting and receiving regulatory approval for the payment of new salaries/bonuses or other compensation to insiders; assisting its subsidiary banks in addressing weaknesses identified in their reports of examinations; providing periodic reports detailing how it will meet its debt service obligations; and providing progress reports with its compliance with the regulatory Memorandum.
United Bank
In November of 2009, the FDIC and the KDFI entered into a Cease and Desist Order (“C&D”) with United Bank primarily as a result of its level of nonperforming assets. The C&D was terminated in December 2011 coincident with the issuance of a Consent Order (“Consent Order”) entered into between the parties. The Consent Order is substantially the same as the C&D, with the primary exception being that United Bank must achieve and maintain a Tier 1 Leverage ratio of 9.0% and a Total Risk-based Capital ratio of 13.0% no later than March 31, 2012.
Other components in the regulatory order include stricter oversight and reporting to its regulators in terms of complying with the Consent Order. It also includes an increase in the level of reporting by management to its board of directors of its financial results, budgeting, and liquidity analysis, as well as restricting the bank from extending additional credit to borrowers with credits classified as substandard, doubtful or special mention in the report of examination. There is also a requirement to obtain written consent prior to declaring or paying a dividend and to develop a written contingency plan if the bank is unable to meet the capital levels established in the Consent Order.
During January 2014, the Company received written notification from the FDIC and KDFI that the formal Consent Order entered into during 2011 with United Bank had been terminated and replaced with a stepped-down enforcement action in
the form of an informal Memorandum. The informal Memorandum includes substantially the same provisions covered by the Consent Order.
Citizens Northern
The FDIC and the KDFI entered into a Memorandum with Citizens Northern in September 2010. The Memorandum was terminated July 7, 2013 upon the issuance of an updated Memorandum. The updated Memorandum contains many of the same provisions included in the terminated Memorandum, with a new requirement that Citizens Northern maintain a Tier 1 leverage ratio at or above 9.0%. In addition, the updated Memorandum requires having and retaining qualified management in the areas of loan administration and collection. It also requires Citizens Northern to address credit underwriting and administration weaknesses identified in the most recent examination of the bank by the FDIC and the KDFI.
Other parts of the regulatory order include the development and documentation of plans for reducing problem loans, providing progress reports on compliance with the Memorandum, and for the development and implementation of a written profit plan and strategic plans. It also restricts the bank from extending additional credit to borrowers with credits classified as substandard, doubtful or special mention in the report of examination.
Regulators continue to monitor the Company’s progress and compliance with the regulatory agreements through periodic on-site examinations, regular communications, and quarterly data analysis. At the Parent Company and at each of its bank subsidiaries, the Company believes it is adequately addressing all issues of the regulatory agreements to which it is subject. However, only the respective regulatory agencies can determine if compliance with the applicable regulatory agreements has been met. The Company believes that it and its subsidiary banks are in compliance with the requirements identified in the regulatory agreements as of December 31, 2013.
The Parent Company maintains cash available to fund a certain amount of additional injections of capital to its bank subsidiaries as determined by management or if required by its regulators. If needed, further amounts in excess of available cash may be funded by future public or private sales of securities, although the Parent Company is currently under no directive by its regulators to raise any additional capital.
18. Fair Value Measurements
ASC Topic 820, “Fair Value Measurements and Disclosures,” defines fair value, establishes a framework for measuring fair value, and sets forth disclosures about fair value measurements. ASC Topic 825, “Financial Instruments,” allows entities to choose to measure certain financial assets and liabilities at fair value. The Company has not elected the fair value option for any of its financial assets or liabilities.
ASC Topic 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. It also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. This Topic describes three levels of inputs that may be used to measure fair value:
Level 1:
Quoted prices for identical assets or liabilities in active markets that the entity has the ability to access at the measurement date.
Level 2:
Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3:
Significant unobservable inputs that reflect a reporting entity’s own assumptions supported by little or no market activity, about the assumptions that market participants would use in pricing the asset or liability.
Following is a description of the valuation method used for instruments measured at fair value on a recurring basis. For this disclosure, the Company only has available for sale investment securities that meet the requirement.
Available for sale investment securities
Valued primarily by independent third party pricing services under the market valuation approach that include, but are not limited to, the following inputs:
●
Mutual funds and equity securities are priced utilizing real-time data feeds from active market exchanges for identical securities and are considered Level 1 inputs.
●
Government-sponsored agency debt securities, obligations of states and political subdivisions, mortgage-backed securities, corporate bonds, and other similar investment securities are priced with available market information through processes using benchmark yields, matrix pricing, prepayment speeds, cash flows, live trading data, and market spreads sourced from new issues, dealer quotes, and trade prices, among others sources and are considered Level 2 inputs.
Available for sale investment securities are the Company’s only balance sheet item that meets the disclosure requirements for instruments measured at fair value on a recurring basis. Disclosures as of December 31, 2013 and 2012 are as follows:
The Company is required to measure and disclose certain other assets and liabilities at fair value on a nonrecurring basis in periods following their initial recognition. The Company’s disclosure about assets and liabilities measured at fair value on a nonrecurring basis consists of impaired loans and OREO. The carrying value of these assets are adjusted to fair value on a nonrecurring basis through impairment charges as described more fully below.
Impairment charges on collateral-dependent loans are recorded by either an increase to the provision for loan losses and related allowance or by direct loan charge-offs. The fair value of collateral-dependent impaired loans with specific allocations of the allowance for loan losses is measured based on recent appraisals of the underlying collateral. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the
income approach. Appraisers take absorption rates into consideration and adjustments are routinely made in the appraisal process to identify differences between the comparable sales and income data available. Such adjustments consist mainly of estimated costs to sell that are not included in certain appraisals or to update appraised collateral values as a result of market declines of similar properties for which a newer appraisal is available. These adjustments can be significant and typically result in a Level 3 classification of the inputs for determining fair value.
OREO includes properties acquired by the Company through, or in lieu of, actual loan foreclosures and is carried at fair value less estimated costs to sell. Fair value of OREO at acquisition is generally based on third party appraisals of the property that includes comparable sales data and is considered as Level 3 inputs. The carrying value of each OREO property is updated at least annually and more frequently when market conditions significantly impact the value of the property. If the carrying amount of the OREO exceeds fair value less estimated costs to sell, an impairment loss is recorded through noninterest expense.
The following table represents the carrying amount of assets measured at fair value on a nonrecurring basis and still held by the Company as of the dates indicated. The amounts in the table only represent assets whose carrying amount has been adjusted by impairment charges during the period in a manner as described above; therefore, these amounts will differ from the total amounts outstanding. Collateral-dependent impaired loan amounts in the tables below exclude restructured loans since they are measured based on present value techniques, which are outside the scope of the fair value reporting framework.
The following table presents impairment charges recorded in earnings on assets measured at fair value on a nonrecurring basis.
The following table presents quantitative information about unobservable inputs for assets measured on a nonrecurring basis using Level 3 measurements.
As previously discussed, the fair value of real estate securing collateral-dependent impaired loans and OREO are based on current third party appraisals. It is often necessary, however, for the Company to discount the appraisal amounts supporting its impaired loans and OREO. These discounts relate primarily to marketing and other holding costs that are not included in certain appraisals or to update values as a result of market declines of similar properties for which newer appraisals are available. Discounts also result from contracts to sell properties entered into during the period. The range of discounts is presented in the table above for 2013. The upper end of the range identified in the table above related to OREO is the result of a few outlier transactions of small dollar properties written down to the contracted sales price, which magnified the percentage. The weighted average column is more of an indicator of the discounts applied to the appraisals.
Fair Value of Financial Instruments
The table that follows represents the estimated fair values of the Company’s financial instruments made in accordance with the requirements of ASC Topic 825, “Financial Instruments.” ASC Topic 825 requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet for which it is practicable to estimate that value. The estimated fair value amounts have been determined by the Company using available market information and present value or other valuation techniques. These derived fair values are subjective in nature, involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. ASC Topic 825 excludes certain financial instruments and all nonfinancial instruments from the disclosure requirements. Accordingly, the aggregate fair value amounts presented are not intended to represent the underlying value of the Company.
The following methods and assumptions were used to estimate the fair value of each class of financial instruments not presented elsewhere for which it is practicable to estimate that value.
Cash and Cash Equivalents, Accrued Interest Receivable, and Accrued Interest Payable
The carrying amount is a reasonable estimate of fair value due to the relatively short time between the origination of the instrument and its expected realization or settlement.
Investment Securities Held to Maturity
Fair value is based on quoted market price, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities or with available market information through processes using benchmark yields, matrix pricing, prepayment speeds, cash flows, live trading data, and market spreads sourced from new issues, dealer quotes, and trade prices, among others sources.
Loans
The fair value of loans is estimated by discounting expected future cash flows using current discount rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Expected future cash flows are projected based on contractual cash flows adjusted for estimated prepayments.
Federal Home Loan Bank and Federal Reserve Bank Stock
It is not practical to determine the fair value of Federal Home Loan Bank and Federal Reserve Bank stock due to restrictions placed on its transferability.
Deposit Liabilities
The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date and fair value approximates carrying value. The fair value of fixed maturity certificates of deposit is estimated by discounting the expected future cash flows using the rates currently offered for certificates of deposit with similar remaining maturities.
Federal Funds Purchased and Other Short-term Borrowings
The carrying amount is the estimated fair value for these borrowings which reprice frequently in the near term.
Securities Sold Under Agreements to Repurchase, Subordinated Notes Payable, and Other Long-term Borrowings
The fair value of these borrowings is estimated by discounting the expected future cash flows using rates currently available for debt with similar terms and remaining maturities. For subordinated notes payable, the Company uses its best estimate to determine an appropriate discount rate since active markets for similar debt transactions are very limited.
Commitments to Extend Credit and Standby Letters of Credit
Pricing of these financial instruments is based on the credit quality and relationship, fees, interest rates, probability of funding, compensating balance, and other covenants or requirements. Loan commitments generally
have fixed expiration dates, variable interest rates and contain termination and other clauses that provide for relief from funding in the event there is a significant deterioration in the credit quality of the customer. Many loan commitments are expected to, and typically do, expire without being drawn upon. The rates and terms of the Company’s commitments to lend and standby letters of credit are competitive with others in the various markets in which the Company operates. There are no unamortized fees relating to these financial instruments, as such the carrying value and fair value are both zero.
The following table presents the estimated fair values of the Company’s financial instruments and the level within the fair value hierarchy in which the fair value measurements fall at December 31, 2013 and 2012. Information for available for sale investment securities is presented within this footnote in greater detail above.
19. Parent Company Financial Statements
Condensed Balance Sheets
Condensed Statements of Income and Comprehensive Income
Condensed Statements of Cash Flows
20. Quarterly Financial Data (Unaudited)
21. Intangible Assets
Acquired core deposit and customer relationship intangible assets were as follows as of December 31 for the years indicated.
Aggregate amortization expense of core deposit and customer relationship intangible assets was $540 thousand, $1.0 million, and $1.1 million for 2013, 2012, and 2011, respectively. Core deposit intangibles and customer relationship intangibles in the amount of $1.9 million and $1.3 million, respectively, recorded in connection with a prior business acquisition during 2006 have been removed from the gross carrying amount and accumulated amortization for 2013 due to being fully amortized. Core deposit and customer relationship intangible assets are scheduled to be fully amortized by 2015. Estimated expense over the remaining amortization period is as follows:
22. Preferred Stock and Warrant
On January 9, 2009, as part of the U.S. Department of Treasury’s (“Treasury”) Capital Purchase Program (“CPP”), the Company issued 30 thousand shares of Series A, no par value cumulative perpetual preferred stock to the Treasury for $30.0 million. The Company also issued a warrant to the Treasury as part of the CPP allowing it to purchase 223,992 shares of the Company’s common stock at an exercise price of $20.09. In June 2012, the Treasury conducted an auction in which it sold all of its investment in the Company’s Series A preferred stock to private investors. The Company received no proceeds as part of the transaction. In July 2012, the Company repurchased the warrant issued to the Treasury at a
mutually agreed upon price of $75 thousand. Upon settlement of the warrent repurchase, the Treasury has no remaining equity stake in the Company.
The Company accounted for the allocation of the proceeds received from the issuance of the preferred shares, net of transaction costs, on a pro rata basis between the Series A preferred stock and the warrant based on their relative fair values. The Company used the Black-Scholes model to estimate the fair value of the warrant. The fair value of the Series A preferred stock was estimated using a discounted cash flow methodology with a discount rate of 13%. The Company assigned $2.0 million and $28.0 million to the warrant and the Series A preferred stock, respectively. The resulting discount on the Series A preferred stock is being accreted up to the $30.0 million liquidation amount over the initial five year expected life of the Series A preferred stock. The discount accretion is being recorded as additional preferred stock dividends, resulting in an effective dividend rate of 6.56%.
The Series A preferred shares have a liquidation preference of $1 thousand per share (plus any accrued and unpaid dividends) and pay a cumulative cash dividend quarterly at 5% per annum during the first five years, resetting to 9% thereafter. The Company may not pay dividends on the preferred shares without prior approval from its banking regulators. So long as the preferred shares are outstanding, the Company may not declare or pay a dividend or other distribution on its common stock, and generally may not purchase, redeem or otherwise acquire any shares of its common stock, unless all accrued and unpaid dividends on the preferred shares for all past dividend periods are paid in full. Holders of the preferred shares generally have no voting rights. However, if the Company defers dividend payments on its Series A preferred shares for an aggregate of six quarterly dividend periods, the authorized number of directors of the Company will increase by two and the holders of the Series A preferred shares will have the right to elect directors to fill such director positions at the Company’s next annual meeting of stockholders or special meeting called for that purpose. The Company may redeem the preferred shares for 100% of the liquidation preference amount at any time, in whole or in part, subject to obtaining prior approval of its banking regulators.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
On September 14, 2011, the Audit Committee of the Registrant dismissed Crowe Horwath LLP (“Crowe”) and engaged BKD, LLP (“BKD”) as its independent accountants. Crowe’s service terminated at the completion of its audit and issuance of its related report on the Company’s financial statements filed on Form 10-K for the Company’s fiscal year ended December 31, 2011. The change in the Registrant's independent accountants was the result of a competitive bidding process involving several accounting firms.
In connection with the audits of the two fiscal years ended December 31, 2010, and the subsequent interim period through September 14, 2011, there were no disagreements with Crowe on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreement, if not resolved to the satisfaction of Crowe would have caused Crowe to make reference to the subject matter of the disagreements in connection with its reports. Crowe’s audit reports on the consolidated financial statements of the Company as of and for the years ended December 31, 2010 and 2009 contained no adverse opinion or disclaimer of opinion and was not qualified or modified as to uncertainty, audit scope or accounting principles.
None of the reportable events described under Item 304(a)(1)(v) of Regulation S-K occurred within the Company’s two most recent fiscal years and the subsequent interim period through September 14, 2011.
During the two most recent fiscal years, and any subsequent interim period prior to engaging BKD, neither the Company, nor anyone on its behalf, consulted BKD regarding (i) either: the application of accounting principles to a specified transaction, either completed or proposed; or the type of audit opinion that might be rendered on the Company's financial statements, and either a written report was provided to the Company or oral advice was provided that BKD concluded was an important factor considered by the Company in reaching a decision as to the accounting, auditing or financial reporting issue; or (ii) any matter that was either the subject of a disagreement (as defined in paragraph 304(a)(1)(iv) of Regulation S-K and the related instructions) or a reportable event (as described in paragraph 304(a)(1)(v) of Regulation S-K).
The Company requested that Crowe furnish it with a letter addressed to the Securities and Exchange Commission (“SEC”) stating whether it agrees with the above statements. A copy of Crowe’s letter to the SEC dated September 20, 2011 is attached as an exhibit to this report.
Item 9A.
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
As of the end of the period covered by this report, an evaluation was carried out under the supervision and with the participation of our management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based on their evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures and internal control over financial reporting are, to the best of their knowledge, effective to ensure that information required to be disclosed by the Company in reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.
The Company’s Chief Executive Officer and Chief Financial Officer have also concluded that there were no changes in the Company’s internal control over financial reporting or in other factors that occurred during the Company’s most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting or any corrective actions with regard to significant deficiencies and material weaknesses in internal control over financial reporting.
Management’s Report on Internal Control Over Financial Reporting
Management Responsibility. Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control system is designed to provide reasonable
assurance to the Company’s management and Board of Directors regarding the reliability of financial reporting and the presentation of published financial statements. However, all internal control systems, no matter how well designed, have inherent limitations.
General Description of Internal Control over Financial Reporting. Internal control over financial reporting refers to a process designed by, or under the supervision of, the Company’s Chief Executive Officer and Chief Financial Officer and effected by the Company’s Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:
●
Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of Company assets;
●
Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that Company’s receipts and expenditures are being made only in accordance with the authorization of Company’s management and members of the Company’s Board of Directors; and
●
Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisitions, uses or dispositions of Company assets that could have a material effect on the Company’s financial statements.
Inherent Limitations in Internal Control over Financial Reporting. Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented or overridden by collusion or other improper activities. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process, and it is possible to design into the process safeguards to reduce, though not eliminate, this risk.
Management’s Assessment of the Company’s Internal Control over Financial Reporting. Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2013. In making this assessment, the Company’s management used the criteria for effective internal control over financial reporting set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework (1992).
As a result of our assessment of the Company’s internal control over financial reporting, management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2013 to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.
BKD, LLP, the independent registered public accounting firm that audited the Company’s consolidated financial statements included in this Annual Report on Form 10-K, has also audited the effectiveness of the Company’s internal control over financial reporting as of December 31, 2013. The audit report on the effectiveness of the Company’s internal control over financial reporting is included in this Annual Report on page 77.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
Executive Officer1
Age
Positions and Offices With the Registrant
Years of Service With the Registrant
Lloyd C. Hillard, Jr.
President and Chief Executive Officer, Director2
R. Terry Bennett, Chairman of the Company’s board of directors, is considered an executive officer in name only for purposes of Regulation O.
Also a director of Farmers Bank, United Bank, First Citizens, Citizens Northern, FCB Services, Farmers Insurance (Chairman), FFKT Insurance, EGT Properties, EKT Properties, and an administrative trustee of Farmers Capital Bank Trust I, Farmers Capital Bank Trust II, and Farmers Capital Bank Trust III.
Includes years of service with the Company and its subsidiaries.
The Company has adopted a Code of Ethics that applies to the Company’s directors, officers, and employees, including the Company’s chief executive officer and chief financial officer. The Company makes available its Code of Ethics on its Internet website at www.farmerscapital.com.
Additional information required by Item 10 is hereby incorporated by reference from the Company's definitive proxy statement in connection with its annual meeting of shareholders scheduled for May 13, 2014, which will be filed with the Commission on or about April 1, 2014, pursuant to Regulation 14A.
Item 11.
Item 11. Executive Compensation
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
Item 14.
Item 14. Principal Accounting Fees and Services
The information required by Items 11 through 14 is hereby incorporated by reference from the Company's definitive proxy statement in connection with its annual meeting of shareholders scheduled for May 13, 2014, which will be filed with the Commission on or about April 1, 2014, pursuant to Regulation 14A.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules
(a)1.
Financial Statements
The following consolidated financial statements and report of independent registered public accounting firm of the Company is included in Part II, Item 8 on pages 76 through 129:
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Comprehensive Income
Consolidated Statements of Changes in Shareholders’ Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
(a)2.
Financial Statement Schedules
All schedules are omitted for the reason they are not required, or are not applicable, or the required information is disclosed elsewhere in the financial statements and related notes thereto.
(a)3.
Exhibits:
3.1
Second Amended and Restated Articles of Incorporation of Farmers Capital Bank Corporation (incorporated by reference to the Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2006 (File No. 000-14412)).
3.2
Articles of Amendment to Second Amended and Restated Articles of Incorporation of Farmers Capital Bank Corporation dated January 6, 2009 (incorporated by reference to the Current Report on Form 8-K dated January 13, 2009 (File No. 000-14412)).
3.3
Articles of Amendment to Second Amended and Restated Articles of Incorporation of Farmers Capital Bank Corporation dated November 16, 2009 (incorporated by reference to the Current Report on Form 8-K dated November 17, 2009 (File No. 000-14412)).
3.4
Amended and Restated Bylaws of Farmers Capital Bank Corporation (incorporated by reference to the Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2009 (File No. 000-14412)).
4.1*
Junior Subordinated Indenture, dated as of July 21, 2005, between Farmers Capital Bank Corporation and Wilmington Trust Company, as Trustee, relating to unsecured junior subordinated deferrable interest notes that mature in 2035.
4.2*
Amended and Restated Trust Agreement, dated as of July 21, 2005, among Farmers Capital Bank Corporation, as Depositor, Wilmington Trust Company, as Property and Delaware Trustee, the Administrative Trustees (as named therein), and the Holders (as defined therein).
4.3*
Guarantee Agreement, dated as of July 21, 2005, between Farmers Capital Bank Corporation, as Guarantor, and Wilmington Trust Company, as Guarantee Trustee.
4.4*
Junior Subordinated Indenture, dated as of July 26, 2005, between Farmers Capital Bank Corporation and Wilmington Trust Company, as Trustee, relating to unsecured junior subordinated deferrable interest notes that mature in 2035.
4.5*
Amended and Restated Trust Agreement, dated as of July 26, 2005, among Farmers Capital Bank Corporation, as Depositor, Wilmington Trust Company, as Property and Delaware Trustee, the Administrative Trustees (as named therein), and the Holders (as defined therein).
4.6*
Guarantee Agreement, dated as of July 26, 2005, between Farmers Capital Bank Corporation, as Guarantor, and Wilmington Trust Company, as Guarantee Trustee.
4.7*
Indenture, dated as of August 14, 2007 between Farmers Capital Bank Corporation, as Issuer, and Wilmington Trust Company, as Trustee, relating to fixed/floating rate junior subordinated debt due 2037.
4.8*
Amended and Restated Declaration of Trust, dated as of August 14, 2007, by Farmers Capital Bank Corporation, as Sponsor, Wilmington Trust Company, as Delaware and Institutional Trustee, the Administrative Trustees (as named therein), and the Holders (as defined therein).
4.9*
Guarantee Agreement, dated as of August 14, 2007, between Farmers Capital Bank Corporation, as Guarantor, and Wilmington Trust Company, as Guarantee Trustee.
4.10
Form of Certificate for Fixed Rate Cumulative Perpetual Preferred Stock, Series A (incorporated by reference to the Current Report on Form 8-K dated January 13, 2009 (File No. 000-14412)).
4.11
Letter Agreement, dated January 9, 2009, between Farmers Capital Bank Corporation and the United States Treasury, with respect to the issuance and sale of the Series A preferred stock and the Warrant, and Securities Purchase Agreement-Standard Terms attached thereto as Exhibit A (incorporated by reference to the Current Report on Form 8-K dated January 13, 2009 (File No. 000-14412)).
10.1
Employee Stock Purchase Plan of Farmers Capital Bank Corporation (incorporated by reference to Form S-8 effective June 24, 2004 (File No. 333-116801)).
10.2
Nonqualified Stock Option Plan of Farmers Capital Bank Corporation (incorporated by reference to Form S-8 effective September 8, 1998 (File No. 333-63037)).
10.3
Employment agreement dated December 10, 2012 between Farmers Capital Bank Corporation and Lloyd C. Hillard, Jr. (incorporated by reference to Exhibit 10.1 to Form 8-K/A filed December 26, 2012).
10.4
Amendment No. 1 to Employment agreement dated December 10, 2012 between Farmers Capital Bank Corporation and Lloyd C. Hillard, Jr. (incorporated by reference to Exhibit 10.1 to Form 8-K filed December 30, 2013).
10.5
Employment agreement dated December 17, 2013 between Farmers Capital Bank Corporation and Rickey D. Harp (incorporated by reference to Exhibit 10.1 to Form 8-K filed December 30, 2013).
16**
Letter re Change in Certifying Accountant
21**
Subsidiaries of the Registrant
23.1**
Consent of Independent Registered Public Accounting Firm (BKD, LLP)
23.2**
Consent of Independent Registered Public Accounting Firm (Crowe Horwath LLP)
31.1**
CEO Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2**
CFO Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32**
CEO and CFO Certifications Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
Interactive Data Files
*
Exhibit not included pursuant to Item 601(b)(4)(iii) and (v) of Regulation S-K. The Company will provide a copy of such exhibit to the Securities and Exchange Commission upon request.
**
Filed with this Annual Report on Form 10-K.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
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.
/s/ Lloyd C. Hillard, Jr.
President, Chief Executive Officer
March 6, 2014
Lloyd C. Hillard, Jr.
and Director (principal executive
officer of the Registrant)
/s/ R. Terry Bennett
Chairman
February 24, 2014
R. Terry Bennett
/s/ J. Barry Banker
Vice Chairman
February 26, 2014
J. Barry Banker
/s/ Michael J. Crawford
Director
February 25, 2014
Michael J. Crawford
/s/ John R. Farris
Director
February 25, 2014
John R. Farris
/s/ William C. Nash
Director
February 23, 2014
Dr. William C. Nash
/s/ David R. O’Bryan
Director
February 27, 2014
David R. O’Bryan
/s/ Fred N. Parker
Director
February 26, 2014
Fred N. Parker
/s/ David Y. Phelps
Director
February 28, 2014
David Y. Phelps
/s/ Marvin E. Strong, Jr.
Director
February 27, 2014
Marvin E. Strong, Jr.
/s/ Fred Sutterlin
Director
February 27, 2014
Fred Sutterlin
/s/ Shelley S. Sweeney
Director
February 22, 2014
Shelley S. Sweeney
/s/ Doug Carpenter
Executive Vice President, Secretary,
March 6, 2014
C. Douglas Carpenter
and Chief Financial Officer (principal financial and accounting officer)
INDEX OF EXHIBITS
Exhibit
Page
Letter re Change in Certifying Accountant
Subsidiaries of the Registrant
23.1
Consent of Independent Registered Public Accounting Firm
23.2
Consent of Independent Registered Public Accounting Firm
31.1
CEO Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
CFO Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
CEO and CFO Certifications Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002