ITEM 1. DESCRIPTION OF BUSINESS
Certain statements in this Annual Report on Form 10-K (excluding statements of fact or historical financial information) involve forward-looking information within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are subject to the "safe harbor" created by those sections. These forward-looking statements involve certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Such risks and uncertainties include, but are not limited to, the following factors: competitive pressure in the banking industry increases significantly; changes in the interest rate environment reduce margins; general economic conditions, either nationally or regionally, are less favorable than expected, resulting in, among other things, a deterioration in credit quality and an increase in the provision for possible loan losses; changes in the regulatory environment; changes in business conditions, particularly in Shasta County; volatility of rate sensitive deposits; operational risks including data processing system failures or fraud; asset/liability matching risks and liquidity risks; and changes in the securities markets. See also "Certain Additional Business Risks" on pages 25 through 26 herein, Year 2000 Compliance on pages 26 through 27, and other risk factors discussed elsewhere in this Report.
General
North Valley Bancorp (the "Company") is a bank holding company registered with and subject to regulation and supervision by the Board of Governors of the Federal Reserve System (the "Federal Reserve"). The Company was incorporated in 1980 in the State of California, and wholly owns its principal subsidiaries, North Valley Bank (the "Bank"), North Valley Trading Company (the "Trading Company"), which is inactive, and Bank Processing, Inc., a California corporation. The sole subsidiary of the Bank, which is inactive, is North Valley Basic Securities (the "Securities Company"). As used herein, the terms "North Valley Bancorp" or the "Company" include the subsidiaries of the Company and the term "Bank" includes the subsidiary of the Bank, unless the context requires otherwise.
At December 31, 1998, the Company had approximately 165 employees (which includes 142 full-time equivalent employees); the Company had total consolidated assets of $296,362,000; before consolidation the Bank had total assets of $295,861,000 and total deposits of $262,344,000; assets of the Trading Company were $2,000; assets of Bank Processing, Inc., were $357,000; and assets of the Securities Company were $1,000.
The Bank was organized in September, 1972, under the laws of the State of California, and commenced operations in February, 1973. The Bank is principally supervised and regulated by the California Superintendent of Banks and conducts a commercial and retail banking business, which includes accepting demand, savings, money market rate deposit accounts, and time deposits, and making commercial, real estate and consumer loans. It also offers installment note collections, issues cashier's checks and money orders, sells travelers' checks and provides safe deposit boxes and other customary banking services. As a federally insured bank, the Bank is also subject to regulation by the Federal Deposit Insurance Corporation ("FDIC") and deposits are insured by the FDIC up to the legal limits thereupon. The Bank does not offer trust services or international banking services and does not
plan to do so in the near future.
The Bank operates twelve banking offices in Shasta and Trinity Counties, for which it has received all of the requisite regulatory approvals. The headquarters office in Redding was opened in February, 1973. In October, 1973, the Bank opened its Weaverville Office; in October, 1974, its Hayfork Office; in January, 1978, its Anderson Office; and in September, 1979, its Enterprise Office (East Redding). On December 20, 1982, the Bank acquired the assets of two branches of the Bank of California: one located in Shasta Lake and the other in Redding, California. On June 1, 1985, the Bank opened its Westwood Village Office in south Redding. On November 27, 1995, the Bank opened a new branch located in Palo Cedro, California. During the year ended December 31, 1995, the Bank purchased, in the ordinary course of business, the Hayfork branch for $134,000 which the Bank had previously leased from a former Board member. In 1997, the Bank finished construction on its new site located in Shasta Lake, CA. The branch was relocated from its leased facility to its new building on October 14, 1997. The Bank opened two super-market branches in 1998 located in Cottonwood, CA, on January 20, 1998, and Redding, CA, on September 8, 1998. On May 11, 1998, the Bank opened a Business Banking Center in Redding, CA, to provide banking services to business and professional clients.
The Trading Company, incorporated under the laws of the State of California in 1984, formed a joint venture to explore trading opportunities in the Pacific Basin. The joint venture was terminated in July, 1986, and the Trading Company is now inactive. The Securities Company, formed to hold premises pursuant to Section 752 of the California Financial Code, is inactive. North Valley Consulting Services was established as a consulting service for depository institutions. In December, 1988, North Valley Consulting Services changed its name to Bank Processing, Inc. Bank Processing, Inc., was established as a bank processing service to provide data processing services to other depository institutions, pursuant to Section 225.25(b)(7) of Federal Reserve Regulation Y and Section 4(c)(8) of the Bank Holding Company Act of 1956, as amended ("BHCA").
Bank Processing, Inc., is utilizing "excess capacity" on their system to process other depository institutions' data, and is currently processing daily applications for the Bank and one other bank where entries are captured and files updated by the "Liberty Banking Package," which include: Demand Deposits (DDA), Savings Deposits (SAV), Central Information Files (CIF), Mortgage Loans (MLA), Installment Loans (ILA), Commercial Loans (CLA), Individual Retirement Accounts (IRA), and Financial Information Statement, i.e., General Ledger (FIS). The data processing activities do not involve providing hardware or software.
At December 31, 1998 Bank Processing, Inc., had cash of approximately $140,000.
On August 18, 1995, the Bank entered into an Agreement with Linsco Private Ledger ("LPL") to furnish brokerage services and standardized investment advice to Bank customers at an LPL office located at 1327 South Street, in the upstairs portion of North Valley Bank. All invest- ments recommended to Bank customers appear on an approved list or are specially approved by LPL's central office. The Bank shares in the fees and commissions paid to LPL on a pre-determined schedule.
The Company does not hold deposits of any one customer or group of customers where the loss of such deposits would have an effect on the Company. The Company's business is not seasonal.
Selected Statistical Data
The following tables present certain consolidated statistical information concerning the business of the Company. This information should be read in conjunction with the Consolidated Financial Statements and the notes thereto and Management's Discussion and Analysis or Plan of Operation and other information contained elsewhere herein. Averages are based on daily averages. Tax-equivalent adjustments (using a 31% tax rate for 1998, 30% for 1997, and 32% for 1996) have been made in calculating yields on tax-exempt securities.
AVERAGE BALANCES AND TAX-EQUIVALENT NET INTEREST MARGIN
AVERAGE AVERAGE INCOME(1)/ RATES (Dollars in thousands) BALANCE EXPENSE EARNED/ PAID ASSETS ================================
Federal funds sold $18,690 $ 990 5.30% Available for sale securities: U.S. Treasury securities 327 18 5.50% U.S. Agencies 5,162 323 6.26% Obligations of states and political subdivisions 4,918 384 7.80% Other investments 579 27 4.66% -------- --------- ---- Total available for sale securities 10,986 752 6.84% Held to maturity securities: U.S. Agencies 4,078 281 6.89% Obligations of states and political subdivisions 34,923 3,094 8.86% -------- --------- ---- Total held to maturity securities 39,001 3,375 8.65% FHLB 709 40 5.64% Cash held in trust 0 0 0.00% Trading account securities 1,094 58 5.30% Total loans (2)(3) 157,644 14,517 9.21% -------- --------- ----
Total interest earning assets/ interest income 228,124 19,732 8.65% ====
Nonearning assets 20,740 Less: Allowance for loan losses (1,502) TOTAL ASSETS $247,362 ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Interest bearing liabilities Deposits Transaction $ 40,022 $ 931 2.33% Savings & Money Market 44,392 1,325 2.98% Time 109,946 5,821 5.29% -------- --------- ---- Total interest bearing deposits/interest expense 194,360 8,077 4.16% ==== Non interest-bearing deposits 27,376 Other noninterest-bearing liabilities 2,928 ------- TOTAL LIABILITIES 224,664 Shareholders' equity 22,698 ------- Total Liabilities and and Stockholders' Equity $247,362 ========
Net Interest Income and Margin(4) $ 11,655 5.11% ========= ====
(1) Tax-equivalent basis (2) Loans on nonaccrual status have been included in the computation of average balances. (3) Includes loan fees of $302,000, $259,000, and $225,000, for 1998, 1997 and 1996, respectively. (4) Net interest margin is determined by dividing net interest income by total average interest earning assets.
RATE-VOLUME ANALYSIS OF CHANGES IN NET INTEREST INCOME
1996 versus 1995 -------------------------------- Total Average Average Increase (Dollars in thousands) Volume Rate (Decrease)
INTEREST INCOME Interest on Federal funds sold $ 50 $ (100) $ (50) Interest on available for sale securities: U.S. Treasury securities (482) 126 (356) U.S. Agencies 123 (2) 121 Obligations of states and political subdivisions 380 (1) 379 Other investments 8 5 13 ------- ------- ------- Total available for sale securities 29 128 157 Interest on held to maturity securities: U.S. Agencies (104) 32 (72) Obligations of states and political subdivisions (137) (99) (236) ------- ------- ------- Total held to maturity securities (241) (67) (308) Dividends on FHLB 4 5 9 Interest on trust Interest on trading account securities 47 (2) 45 Interest on total loans 1,845 (558) 1,287 ------- ------- ------- Total interest income 1,734 (594) 1,140 ------- ------- -------
INTEREST EXPENSE
Interest bearing liabilities Deposits Transaction 81 (17) 64 Savings & Money Market 8 69 77 Time 508 (131) 377 ------- ------- ------- Total interest expense 597 (79) 518 ------- ------- ------- Change in net interest income $ 1,137 $ (515) $ 622 ======= ======= =======
(1) The change in interest due to both rate and volume has been allocated to volume.
Investment Securities:
The Company accounts for investments in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities. The Company's policy with regard to investments is as follows:
Trading Securities are carried at fair value. Changes in fair value are included in other operating income. The Company did not have any securities classified as trading at December 31, 1998, 1997, and 1996.
Available for Sale Securities are carried at fair value and represent securities not classified as trading securities nor as held to maturity securities. Unrealized gains and losses resulting from changes in fair value are recorded, net of tax, as a separate component of stockholders' equity. Gains or losses on disposition are recorded in other operating income based on the net proceeds received and the carrying amount of the securities sold, using the specific identification method.
Held to Maturity Securities are carried at cost adjusted for amortization of premiums and accretion of discounts, which are recognized as adjustments to interest income. The Company's policy of carrying such investment securities at amortized cost is based upon its ability and management's intent to hold such securities to maturity.
Gross realized gains on sales of securities categorized as available for sale securities were $979,000, $250,000, and $31,000 in 1998, 1997 and 1996. There were no gross realized losses on sale of available for sale securities in 1998, 1997, or 1996.
The Bank's policy requires that management determine the appropriate classification of securities at the time of purchase. If management has the intent and the Company has the ability at the time of purchase to hold securities until maturity, they are classified as investments held to maturity, and carried at amortized historical cost. Securities to be held for indefinite periods of time and not intended to be held to maturity are classified as available for sale and carried at market value. Securities held for indefinite periods of time include securities that management intends to use as part of its asset/liability management strategy and that may be sold in response to changes in interest rates, resultant prepayment risk, and other related factors.
Scheduled maturities of held to maturity and available for sale securities (other than equity securities with an amortized cost of approximately $215,000 and a carrying value of approximately $187,000) at December 31, 1998, are shown below (in thousands). Expected maturities may differ from contractual maturities because borrowers may have the right to prepay with or without penalty.
The following table sets forth the maturities of investment securities at December 31, 1998, based on their amortized cost, and the weighted average yields of such securities. Tax-equivalent adjustments have been made in calculating yields on obligations of state and political subdivisions.
Loan Portfolio
The Company originates loans for business, consumer and real estate activities. Such loans are concentrated in Shasta and Trinity Counties and neighboring communities. Substantially all loans are collateralized. Generally real estate loans are secured by real property. Commercial and other loans are secured by bank deposits or business or personal assets. The Company's policy for requiring collateral is through analysis of the borrower, the borrower's industry and the economic environment in which the loan would be granted. The loans are expected to be repaid from cash flows or proceeds from the sale of selected assets of the borrower.
At December 31, 1998 and 1997, the Bank serviced real estate loans and loans guaranteed by the Small Business Administration which it had sold to the secondary market of approximately $78,568,000 and $88,640,000, respectively.
The Bank was contingently liable under letters of credit issued on behalf of its customers in the amount of $485,000 and $1,189,000 at December 31, 1998 and 1997, respectively. At December 31, 1998 commercial and consumer lines of credit, and real estate loans of approximately $23,975,000 and $2,191,000 respectively, were undisbursed. These instruments involve, to varying degrees, elements of credit and market risk in excess of the amounts recognized in the balance sheet. The contractual or notional amounts of these transactions express the extent of the Bank's involvement in these instruments and do not necessarily represent the actual amount subject to credit loss.
Maturity Distribution and Interest Rate Sensitivity of Loans
Impaired, Nonaccrual, Past Due, Restructured Loans, and Other Real Estate Owned
At December 31, 1998 and 1997, the recorded investment in loans for which impairment has been recognized was approximately $2,871,000 and $4,353,000. Of the 1998 balance approximately $2,269,000 has a related valuation allowance of $226,900. The remaining $602,000 did not require a valuation allowance. No significant impaired balances required a valuation allowance at December 31, 1997. For the years ended December 31, 1998, 1997 and 1996, the average recorded investment in loans for which impairment has been recognized was approximately $3,201,000, $3,455,000 and $2,244,000, respectively. During the portion of the year that the loans were impaired the Company recognized interest income of approximately $232,000, $153,000 and $203,000 for cash payments received in 1998, 1997 and 1996.
Loans on which the accrual of interest has been discontinued are designated as nonaccrual loans. Accrual of interest on loans is discontinued either when reasonable doubt exists as to the full and timely collection of interest or principal, or when a loan becomes contractually past due by 90 days or more with respect to interest or principal (except that when management believes a loan is well secured and in the process of collection, interest accruals are continued on loans deemed by management to be fully collectible). When a loan is placed on nonaccrual status, all interest previously accrued but not collected is reversed against current period interest income. Income on such loans is then recognized only to the extent that cash is received and where the future collection of principal is probable. Interest accruals are resumed on such loans when, in the judgment of management, the loans are estimated to be fully collectible as to both principal and interest.
If interest on nonaccrual loans had been accrued, such income would have approximated $132,000 in 1998, $32,000 in 1997, and $82,000 in 1996. Interest income of $33,000 in 1998, $28,000 in 1997, and $27,000 in 1996 was recorded when it was received on the nonaccrual loans.
Based on its review of impaired, past due and nonaccrual loans and other information known to management at the date of this Report, in addition to the nonperforming loans included in the above table, management has identified 3 loans in the aggregate principal amount of $347,000 about which it has serious doubts regarding the borrowers' ability to comply with present loan repayment terms, such that said loans might subsequently be classified as nonperforming.
At December 31, 1998, there were no commitments to lend additional funds to borrowers whose loans were classified as nonaccrual.
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The Bank maintains an allowance for possible loan losses (the "Allowance") to provide for possible loan losses in the loan portfolio. Additions to the Allowance are made by charges to operating expense in the form of a provision for possible loan losses. Loans are charged against the Allowance when management believes that the collectibility of the principal is unlikely, while any recoveries are credited to the Allowance.
The Company evaluates the adequacy of its Allowance by specific categories of loans rather than on an overall basis. In determining the adequacy of the Allowance, management considers such factors as the Bank's lending policies, historical loan loss experience, non-performing loans and problem credits, evaluations made by bank regulatory authorities, assessment of economic conditions, and other appropriate data in its attempt to identify the risks in the loan portfolio. While these factors are essentially judgmental, the management of the Company believes that its Allowance at December 31, 1998, was adequate against foreseeable losses in its loan portfolio at that time. The risk of nonpayment of loans is inherent in commercial banking, and, while management has procedures in place to identify loans with more than a normal risk of default, it is not always possible to identify all such potential problem credits. To some extent, the degree of perceived risk is taken into account in establishing the structure of, and interest
rates and security for, specific loans and various types of loans. The Bank also attempts to minimize its credit risk exposure by use of thorough loan application, approval and review procedures.
The Allowance totaled $1,902,000, or .95% of total loans outstanding at December 31, 1998. Based on management's evaluation of the current loan portfolio and economic trends during 1998, the Bank made a provision to its Allowance of $1,430,000 which was due primarily to the increase in loan volume and loans charged off during 1998. Management's continuing evaluation of the loan portfolio and assessment of current economic conditions will dictate future funding levels.
Certificates of Deposit
Maturities of time certificates of deposit of $100,000 or more outstanding at December 31, 1998 are summarized as follows (dollars in thousands):
$100,000 or More -Time Certificates of Deposit - ---------------------------------------------------------------------- Remaining maturities: Three months or less $ 6,952
Over three through six months 6,505
Over six through twelve months 4,421
Over twelve months 591 ------- TOTAL $18,469 =======
As of December 31, 1998, the Company did not have any brokered deposits. In general, it is the Company's policy not to accept brokered deposits.
Return on Equity and Assets:
The following table sets forth certain financial ratios for the Company:
December -------------------------- 1998 1997 1996 ---- ---- ---- Return on average equity (net income divided by average equity) 13.73% 19.67% 18.09%
Return on average assets (net income divided by average total assets) 1.46% 1.93% 1.66%
Equity to assets ratio (average equity divided by average total assets) 10.64% 9.80% 9.18%
Dividend payout ratio (dividends paid or declared divided by net income) 33.86% 24.96% 31.31%
Short Term Borrowings
At December 31, 1998, 1997, and 1996, the Bank did not have any short term borrowings outstanding.
SUPERVISION AND REGULATION
The Effect of Government Policy on Banking
The earnings and growth of the Company are affected not only by local market area factors and general economic conditions, but also by government monetary and fiscal policies. For example, the Board of Governors of the Federal Reserve System ("FRB") influences the supply of money through its open market operations in U.S. Government securities and adjustments to the discount rates applicable to borrowings by depository institutions and others. Such actions influence the growth of loans, investments and deposits and also affect interest rates charged on loans and paid on deposits. The nature and impact of future changes in such policies on the business and earnings of the Company cannot be predicted. Additionally, state and federal tax policies can impact banking organizations. Effective January 1, 1997, applicable California bank and corporation tax rates were reduced by 5% in order to keep California competitive with other western states.
As a consequence of the extensive regulation of commercial banking activities in the United States, the business of the Company is particularly susceptible to being affected by the enactment of federal and state legislation which may have the effect of increasing or decreasing the cost of doing business, modifying permissible activities or enhancing the competitive position of other financial institutions. Any change in applicable laws or regulations may have a material adverse effect on the business and prospects of the Company. In response to various business failures in the savings and loan industry and in the banking industry, in December 1991, Congress enacted, and the President signed into law, the Federal Deposit
Insurance Corporation Improvement Act of 1991 ("FDICIA"). FDICIA substantially revised the bank regulatory framework and deposit insurance funding provisions of the Federal Deposit Insurance Act and made revisions to several other federal banking statutes.
Regulation and Supervision of Bank Holding Companies
The Company is a bank holding company subject to the Bank Holding Company Act of 1956, as amended ("BHCA"). The Company reports to, registers with, and may be examined by, the FRB. The FRB also has the authority to examine the Company's subsidiaries. The costs of any examination by the FRB are payable by the Company.
The Company is also a bank holding company within the meaning of Section 3700 of the California Financial Code. As such, the Company and the Bank are subject to examination by, and may be required to file reports with, the California Commissioner of Financial Institutions (the "Commissioner").
The FRB has significant supervisory and regulatory authority over the Company and its affiliates. The FRB requires the Company to maintain certain levels of capital. See "Capital Standards." The FRB also has the authority to take enforcement action against any bank holding company that commits any unsafe or unsound practice, or violates certain laws, regulations or conditions imposed in writing by the FRB. See "Prompt Corrective Action and Other Enforcement Mechanisms."
Under the BHCA, a company generally must obtain the prior approval of the FRB before it exercises a controlling influence over a bank, or acquires directly or indirectly, more than 5% of the voting shares or substantially all of the assets of any bank or bank holding company. Thus, the Company is required to obtain the prior approval of the FRB before it acquires, merges or consolidates with any bank or bank holding company; any company seeking to acquire, merge or consolidate with the Company also would be required to obtain the approval of the FRB.
The Company is generally prohibited under the BHCA from acquiring ownership or control of more than 5% of the voting shares of any company that is not a bank or bank holding company and from engaging directly or indirectly in activities other than banking, managing banks, or providing services to affiliates of the holding company. A bank holding company, with the approval of the FRB, may engage, or acquire the voting shares of companies engaged, in activities that the FRB has determined to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. A bank holding company must demonstrate that the benefits to the public of the proposed activity will outweigh the possible adverse effects associated with such activity.
Pursuant to the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the "Interstate Banking and Branching Act"), a bank holding company became able to acquire banks in states other than its home state beginning September 29, 1995 without regard to the permissibility of such acquisitions under state law, but subject to any state requirement that the bank has been organized and operating for a minimum period of time, not to exceed five years, and the requirement that the bank holding company, prior to or following the proposed acquisition, controls no more than 10% of the total amount of deposits of insured depository institutions in the United States and no more than 30% of such deposits in that state (or such lesser or greater amount set by state law).
The Interstate Banking and Branching Act also authorizes banks to merge across states lines, therefore creating interstate branches, beginning June 1, 1997. Under such legislation, each state had the opportunity to "opt out" of this provision, thereby prohibiting interstate branching in such states, or to "opt in" at an earlier time, thereby allowing interstate branching within that state prior to June 1, 1997. Furthermore, a bank is now able to open new branches in a state in which it does not already have banking operations, if the laws of such state permit such de novo branching.
California "opted in" to the Interstate Banking and Branching Act provisions regarding interstate branching by enacting the Caldera, Weggeland, and Killea California Interstate Banking and Branching Act of 1995 ("IBBA"). Under the IBBA, (a) out-of-state banks that wish to establish a California branch office to conduct core banking business must first acquire an existing 5 year old California bank or industrial loan company by merger or purchase; (b) California state-chartered banks will be empowered to conduct various authorized branch-like activities on an agency basis through affiliated and unaffiliated insured depository institutions in California and other states and (c) the Commissioner will be authorized to approve an interstate acquisition or merger which would result in a deposit concentration exceeding 30% if the Commissioner finds that the transaction is consistent with public convenience and advantage. However, the IBBA prohibits a state bank chartered in a state other than California from entering California by purchasing a California branch office of a California bank or industrial loan company without purchasing the entire entity or by establishing a de novo California branch office. The legislation also contains extensive provisions governing intrastate and interstate (a) intra-industry sales, mergers and conversions between banks and between industrial loan companies and (b) inter-industry transactions involving banks, savings associations and industrial loan companies.
Proposals to change the laws and regulations governing the banking industry are frequently introduced in Congress, in the state legislatures and before the various bank regulatory agencies. For instance, there are proposals currently pending in Congress to reform the Glass-Steagall Act, to allow affiliations between banks and other firms, including insurance companies and securities firms.
The FRB generally prohibits a bank holding company from declaring or paying a cash dividend which would impose undue pressure on the capital of subsidiary banks or would be funded only through borrowing or other arrangements that might adversely affect a bank holding company's financial position. The FRB's policy is that a bank holding company should not continue its existing rate of cash dividends on its common stock unless its net income is sufficient to fully fund each dividend and its prospective rate of earnings retention appears consistent with its capital needs, asset quality and overall financial condition. See the section entitled "Restrictions on Dividends and Other Distributions" for additional restrictions.
Transactions between the Company and the Bank are subject to a number of other restrictions. FRB policies forbid the payment by bank subsidiaries of management fees which are unreasonable in amount or exceed the fair market value of the services rendered (or, if no market exists, actual costs plus a reasonable profit). Subject to certain limitations, depository institution subsidiaries of bank holding companies may extend credit to, invest in the securities of, purchase assets from, or issue a guarantee, acceptance, or letter of credit on behalf of, an affiliate, provided that the aggregate of such transactions with affiliates may not exceed 10% of the capital stock and surplus of the institution, and the aggregate of such transactions with all affiliates may not exceed 20% of the capital stock and surplus of such institution. The Company may only borrow from depository institution subsidiaries if the loan is secured by marketable obligations with a value of a designated amount in excess of the loan. Further, the Company may not sell a low-quality asset to a depository institution subsidiary.
The FRB has adopted comprehensive amendments to Regulation Y which became effective April 21, 1997, and are intended to improve the competitiveness of bank holding companies by, among other things: (i) expanding the list of permissible nonbanking activities in which well-run bank holding companies may engage without prior FRB approval, (ii) streamlining the procedures for well-run bank holding companies to obtain approval to engage in other nonbanking activities and (iii) eliminating most of the anti-tying restrictions imposed upon bank holding companies and their nonbank subsidiaries. Amended Regulation Y also provides for a streamlined and expedited review process for bank acquisition proposals submitted by "well-run" bank holding companies and eliminates certain duplicative reporting requirements when there has been a further change in bank control or in bank directors or officers after an earlier approved change.
In order for a bank holding company to qualify as "well-run," both it and the insured depository institutions that it controls must meet the "well-capitalized" and "well-managed" criteria set forth in Regulation Y.
The permissible nonbanking activities in which bank holding companies may engage include: (i) extending credit and servicing loans; (ii) real estate and personal property appraising; (iii) arranging commercial real estate equity financing; (iv) check-guaranty services; (v) collection agency services; (vi) credit bureau services; (vii) asset management, servicing and collection; (viii) acquiring debt in default; (ix) real estate settlement services; (x) leasing personal or real property; (xi) operating nonbank depository institutions; (xii) trust company functions; (xiii) financial and investment advisory activities; (xiv) riskless principal transactions; (xv) private placement services; (xvi) foreign exchange trading for a bank holding company's own account; (xvii) dealing and related activities in gold, silver, platinum and palladium; (xviii) employee benefits consulting; (xix) career counselling services; (xx) printing and selling checks; (xxi) insurance agency and underwriting services; (xxii) community development activities; (xxiii) data processing; and (xxiv) money order, savings bond and traveler's checks services. A bank holding company's provision of these services is subject to numerous qualifications, limitations and restrictions.
Bank Regulation and Supervision
The Bank is subject to regulation, supervision and regular examination by the California Department of Financial Institutions ("DFI") and the Federal Deposit Insurance Corporation (the "FDIC"). The regulations of these agencies affect most aspects of the Bank's business and prescribe permissible types of loans and investments, the amount of required reserves, requirements for branch offices, the permissible scope of the Bank's activities and various other requirements. While the Bank is not a member of the FRB, it is also subject to certain regulations of the FRB dealing primarily with check clearing activities, establishment of banking reserves, Truth-in-Lending (Regulation Z), Truth-in-Savings (Regulation DD), and Equal Credit Opportunity (Regulation B). The DFI was created pursuant to AB 3351, effective July 1, 1997, and combines the State Banking Department, the Department of Savings and Loan, and regulatory oversight over industrial loan companies and credit unions with the DFI. For the most part, the DFI has assumed the responsibilities and authorities held by the previous regulators.
The activities of the Bank are also regulated by state law. Under California law, the Bank is subject to various restrictions on, and requirements regarding, its operations and administration including the maintenance of branch offices and automated teller machines, capital and reserve requirements, deposits and borrowings, stockholder rights and duties, and investment and lending activities. Whenever it appears that the contributed capital of a California bank is impaired, the Commissioner shall order the bank to correct such impairment. If a bank is unable to correct the impairment, such bank is required to levy and
collect an assessment upon its common shares. If such assessment becomes delinquent, such common shares are to be sold by the bank.
California law permits a state chartered bank to invest in the stock and securities of other corporations, subject to a state chartered bank receiving either general authorization or, depending on the amount of the proposed investment, specific authorization from the Commissioner. FDICIA, however, imposed limitations on the activities and equity investments of state chartered, federally insured banks, such as the Bank. FDIC rules on investments prohibit a state Bank from acquiring an equity investment not permissible for a national bank and FDICIA generally prohibits a state bank from engaging in any activity that is not permissible for a national bank.
The OCC has adopted a regulation to revise and streamline its procedures with respect to corporate activities of national banks, effective December 31, 1996. These revised standards allow the OCC to approve, on a case-by-case basis, the entry of bank operating subsidiaries into a business incidental to banking, including activities in which the parent bank is not permitted to engage. Such a standard allows a national bank to conduct an activity approved for a bank holding company through a bank operating subsidiary such as acting as an investment or financial advisor, leasing personal property and providing financial advice to customers. In general, these revised standards will be available to well-capitalized or adequately capitalized national banks.
Capital Standards
The federal banking agencies have risk-based capital adequacy guidelines intended to provide a measure of capital adequacy that reflects the degree of risk associated with a banking organization's operations for both transactions reported on the balance sheet as assets and transactions, such as letters of credit and recourse arrangements, which are recorded as off balance sheet items. Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as certain U.S. government securities, to 100% for assets with relatively higher credit risk, such as certain loans.
In determining the capital level the Bank is required to maintain, the federal banking agencies do not, in all respects, follow generally accepted accounting principles ("GAAP") and have special rules which reduce the amount of capital they will recognize for purposes of determining the capital adequacy of the Bank. These rules are called Regulatory Accounting Principles ("RAP"). In December 1993, the federal banking agencies issued an interagency policy statement on the allowance for loan and lease losses which, among other things, established certain benchmark ratios of loan loss reserves to classified assets. Future changes in the regulations or practices of the federal banking agencies could further reduce the amount of capital recognized for purposes of capital adequacy. Such a change could affect the ability of the Company to grow and could restrict the amount of profits, if any, available for the payment of dividends.
A banking organization's risk-based capital ratios are obtained by dividing its qualifying capital by its total risk-adjusted assets and off balance sheet items. The regulators measure risk-adjusted assets and off balance sheet items against both total qualifying capital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) and Tier 1 capital. Tier 1 capital consists of common stock, retained earnings, noncumulative perpetual preferred stock, other types of qualifying preferred stock and minority interests in certain subsidiaries, less most other intangible assets and other adjustments. Tier 2 capital may consist of a
limited amount of the allowance for possible loan and lease losses, term preferred stock and other types of preferred stock not qualifying as Tier 1 capital, term subordinated debt and certain other instruments with some characteristics of equity. The inclusion of elements of Tier 2 capital are subject to certain other requirements and limitations of the federal banking agencies. Effective October 1, 1998, up to 45% of the pretax net unrealized gains on certain available-for-sale equity securities may be included in Tier 2 capital. Since December 31, 1992, the federal banking agencies have required a minimum ratio of qualifying total capital to risk-adjusted assets and off balance sheet items of 8%, and a minimum ratio of Tier 1 capital to adjusted average risk-adjusted assets and off balance sheet items of 4%.
In addition to the risk-based guidelines, federal banking regulators require banking organizations to maintain a minimum amount of Tier 1 capital to adjusted average total assets, referred to as the leverage capital ratio. The Board of Governors and other federal banking agencies have recently adopted a revised minimum leverage ratio for bank holding companies and banks. The old rule established a 3% minimum leverage standard for well-run banking organizations (bank holding companies and banks) with diversified risk profiles. Banking organizations which did not exhibit such characteristics or had greater risk due to significant growth, among other factors, were required to maintain a minimum leverage ratio 1% to 2% higher. The old rule did not take into account the implementation of the market risk capital measure set forth in the federal regulatory agency capital adequacy guidelines. The revised leverage ratio establishes a minimum tier 1 ratio of 3% (Tier 1 capital to total assets) for the highest rated bank holding companies and banks. All other banking organizations must maintain a minimum Tier 1 leverage ratio of 4% with higher leverage capital ratios required for bank holding companies that have significant financial and/or operational weaknesses, a high risk profile, or are undergoing or anticipating rapid growth.
Banking agencies have adopted regulations which mandate that regulators take into consideration concentrations of credit risk and risks from non-traditional activities, as well as an institution's ability to manage those risks, when determining the adequacy of an institution's capital. This evaluation will be made as a part of the institution's regular safety and soundness examination. Banking agencies also have adopted regulations requiring regulators to consider interest rate risk (when the interest rate sensitivity of an institution's assets does not match the sensitivity of its liabilities or its off-balance-sheet position) in evaluation of a bank's capital adequacy.
Prompt Corrective Action and Other Enforcement Mechanisms
FDICIA requires each federal banking agency to take prompt corrective action to resolve the problems of insured depository institutions, including but not limited to those that fall below one or more prescribed minimum capital ratios. The law required each federal banking agency to promulgate regulations defining the following five categories in which an insured depository institution will be placed, based on the level of its capital ratios: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized.
An institution that, based upon its capital levels, is classified as "well capitalized," "adequately capitalized" or "undercapitalized" may be treated as though it were in the next lower capital category if the appropriate federal banking agency, after notice and opportunity for hearing, determines that an unsafe or unsound condition or an unsafe or unsound practice warrants such treatment. At each successive lower capital category, an insured depository institution is subject to more restrictions. The federal banking agencies, however, may not treat an institution as "critically undercapitalized" unless its capital ratio actually warrants such treatment.
If an insured depository institution is undercapitalized, it will be closely monitored by the appropriate federal banking agency. Undercapitalized institutions must submit an acceptable
capital restoration plan with a guarantee of performance issued by the holding company. Further restrictions and sanctions are required to be imposed on insured depository institutions that are critically undercapitalized. The most important additional measure is that the appropriate federal banking agency is required to either appoint a receiver for the institution within 90 days, or obtain the concurrence of the FDIC in another form of action.
The Bank has been classified as a well-capitalized bank since adoption of the prompt corrective action regulations.
In addition to measures taken under the prompt corrective action provisions, commercial banking organizations may be subject to potential enforcement actions by the federal regulators for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the imposition of a conservator or receiver, the issuance of a cease-and-desist order that can be judicially enforced, the termination of insurance of deposits (in the case of a depository institution), the imposition of civil money penalties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the issuance of removal and prohibition orders against institution-affiliated parties and the enforcement of such actions through injunctions or restraining orders based upon a judicial determination that the agency would be harmed if such equitable relief was not granted. Additionally, a holding company's inability to serve as a source of strength to its subsidiary banking organizations could serve as an additional basis for a regulatory action against the holding company.
Safety and Soundness Standards
FDICIA also implemented certain specific restrictions on transactions and required federal banking regulators to adopt overall safety and soundness standards for depository institutions related to internal control, loan underwriting and documentation and asset growth. Among other things, FDICIA limits the interest rates paid on deposits by undercapitalized institutions, restricts the use of brokered deposits, limits the aggregate extensions of credit by a depository institution to an executive officer, director, principal shareholder or related interest, and reduces deposit insurance coverage for deposits offered by undercapitalized institutions for deposits by certain employee benefits accounts.
In addition to the statutory limitations, FDICIA originally required the federal banking agencies to prescribe, by regulation, standards for all insured depository institutions for such things as classified loans and asset growth. In 1994, FDICIA was amended to (a) authorize the agencies to establish safety and soundness standards by regulation or by guideline for all insured depository institutions; (b) give the agencies greater flexibility in prescribing asset quality and earnings standards and (c) eliminate the requirement that such standards apply to depository institution holding companies, and in 1995, the federal banking agencies published Interagency Guidelines Establishing Standards for Safety and Soundness. By adopting the standards as guidelines, the agencies retained the authority to require an institution to submit to an acceptable compliance plan as well as the flexibility to pursue other more appropriate or effective courses of action given the specific circumstances and severity of an institution's noncompliance with
one or more standards. The Bank has not been and does not expect to be required to submit a safety and soundness compliance plan because of a failure to meet any of the safety and soundness standards.
Restrictions on Dividends and Other Distributions
The power of the board of directors of an insured depository institution to declare a cash dividend or other distribution with respect to capital is subject to statutory and regulatory restrictions which limit the amount available for such distribution depending upon the earnings, financial condition and cash needs of the institution, as well as general business conditions. FDICIA prohibits insured depository institutions from paying management fees to any controlling persons or, with certain limited exceptions, making capital distributions, including dividends, if, after such transaction, the institution would be undercapitalized.
Regulators also have authority to prohibit a depository institution from engaging in business practices which are considered to be unsafe or unsound, possibly including payment of dividends or other payments under certain circumstances even if such payments are not expressly prohibited by statute.
In addition to the restrictions imposed under federal law, banks chartered under California law generally may only pay cash dividends to the extent such payments do not exceed the lesser of retained earnings of the bank or the bank's net income for its last three fiscal years (less any distributions to shareholders during such period). In the event a bank desires to pay cash dividends in excess of such amount, the bank may pay a cash dividend with the prior approval of the Commissioner in an amount not exceeding the greatest of the bank's retained earnings, the bank's net income for its last fiscal year, or the bank's net income for its current fiscal year.
Premiums for Deposit Insurance and Assessments for Examinations
FDICIA established several mechanisms to increase funds to protect deposits insured by the Bank Insurance Fund ("BIF") administered by the FDIC. The FDIC also administers the Savings Association Insurance Fund ("SAIF"), which insures deposits in thrift institutions. The FDIC is authorized to borrow up to $30 billion from the United States Treasury; up to 90% of the fair market value of assets of institutions acquired by the FDIC as receiver from the Federal Financing Bank; and from depository institutions that are members of the BIF. Any borrowings not repaid by asset sales are to be repaid through insurance premiums assessed to member institutions. Such premiums must be sufficient to repay any borrowed funds within 15 years and provide insurance fund reserves of $1.25 for each $100 of insured deposits. FDICIA also provides authority for special assessments against insured deposits. No assurance can be given at this time as to what the future level of premiums will be.
As required by FDICIA, the FDIC adopted a transitional risk-based assessment system for deposit insurance premiums which became effective January 1, 1993. On November 14, 1995 the Board of Directors of the FDIC adopted a resolution to reduce to a range of 0 to 27 basis points the assessment rates applicable to deposits assessable by the BIF for the semiannual
assessment period beginning January 1, 1996. The FDIC has continued such BIF assessment rate through 1998.
Community Reinvestment Act and Fair Lending Developments
The Bank is subject to certain fair lending requirements and reporting obligations involving home mortgage lending operations and Community Reinvestment Act ("CRA") activities. The CRA generally requires the federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of their local communities, including low and moderate income neighborhoods. In addition to substantive penalties and corrective measures that may be required for a violation of certain fair lending laws, the federal banking agencies may take compliance with such laws and CRA into account when regulating and supervising other activities.
On March 8, 1994, the federal Interagency Task Force on Fair Lending issued a policy statement on discrimination in lending. The policy statement describes the three methods that federal agencies will use to prove discrimination: overt evidence of discrimination, evidence of disparate treatment, and evidence of disparate impact.
In 1996, new compliance and examination guidelines for the CRA were promulgated by each of the federal banking regulatory agencies, fully replacing the prior rules and regulatory expectations with new ones ostensibly more performance based than before. The guidelines provide for streamlined examinations of smaller institutions. The bank has a current rating of "satisfactory" CRA Compliance.
Competition
The Bank's primary market area consists of Shasta and Trinity Counties. The banking business in California generally, and specifically in the Bank's primary market area, is highly competitive with respect to both loans and deposits. The business is dominated by a relatively small number of major banks which have many offices operating over wide geographic areas. Many of the major commercial banks offer certain services (such as international, trust and securities brokerage services) which are not offered directly by the Bank. By virtue of their greater total capitalization, such banks have substantially higher lending limits than the Bank and substantial advertising and promotional budgets.
However, smaller independent financial institutions also represent a competitive force. To illustrate the Bank's relative market share, total deposits in banks in Shasta County, California, at June 30, 1998 approximated $1,313,177,000. The Bank's deposits at June 30, 1998 represented approximately 15.54% of such figure.
To compete with major financial institutions in its service area, the Bank relies upon specialized services, responsive handling of customer needs, local promotional activity, and personal contacts by its officers, directors and staff, as opposed to large multi-branch banks,
most of which compete primarily by rate and location of branches. For customers whose loan demands exceed the Bank's lending limits, the Bank seeks to arrange for such loans on a participation basis with its correspondent banks or other independent commercial banks.
In the past, an independent bank's principal competitors for deposits and loans have been other banks (particularly major banks), savings and loan associations and credit unions. To a lesser extent, competition was also provided by thrift and loans, mortgage brokerage companies and insurance companies. Other institutions, such as brokerage houses, mutual fund companies, credit card companies, and even retail establishments have offered new investment vehicles which also compete with banks for deposit business. The direction of federal legislation in recent years seems to favor competition between different types of financial institutions and to foster new entrants into the financial services market, and it is anticipated that this trend will continue.
The enactment of the Interstate Banking and Branching Act in 1994 as well as the California Interstate Banking and Branching Act of 1995 will likely increase competition within California. Regulatory reform, as well as other changes in federal and California law, will also affect competition. While the impact of these changes, and of other proposed changes, cannot be predicted with certainty, it is clear that the business of banking in California will remain highly competitive.
Discharge of Materials Into the Environment
Compliance with federal, state and local regulations regarding the discharge of materials into the environment may have a substantial effect on the capital expenditure, earnings and competitive position of the Company and the Bank in the event of lender liability or environmental lawsuits. Under federal law, liability for environmental damage and the cost of cleanup may be imposed upon any person or entity who is an "owner" or "operator" of contaminated property. State law provisions, which were modeled after federal law, are substantially similar. Congress established an exemption under Federal law for lenders from "owner" and/or "operator" liability, which provides that "owner" and/or "operator" do not include "a person, who, without participating in the management of a vessel or facility, holds indicia of ownership primarily to protect his security interests in the vessel or facility."
In the event that the Bank were held liable as an owner or operator of a toxic property, it could be responsible for the entire cost of environmental damage and cleanup. Such an outcome could have a serious effect on the Company's consolidated financial condition depending upon the amount of liability assessed and the amount of cleanup required.
The Bank takes reasonable steps to avoid loaning against property that may be contaminated. In order to identify possible hazards, the Bank requires that all fee appraisals contain a reference to a visual assessment of hazardous waste by the appraiser.
On loans proposed to be secured by industrial, commercial or agricultural real estate, an Environmental Questionnaire must be completed by the borrower and any areas of concern
addressed. Additionally, the borrower is required to review and sign a Hazardous Substance Certificate and Indemnity at the time the note is signed.
If the investigation reveals and if certain warning signs are discovered, but it cannot be easily ascertained, that an actual environmental hazard exists, the Bank may require that the owner/buyer of the property, at his/her expense, have an Environmental Inspection performed by an insured, bonded environmental engineering firm acceptable to the Bank.
Certain Additional Business Risks
The Company's business, financial condition and operating results can be impacted by a number of factors, including but not limited to those set forth below, any one of which could cause the Company's actual results to vary materially from recent results or from the Company's anticipated future results.
Shares of Company Common Stock eligible for future sale could have a dilutive effect on the market for Company Common Stock and could adversely affect the market price. The Articles of Incorporation of the Company authorize the issuance of 20,000,000 shares of common stock, of which approximately 3,690,220 were outstanding at December 31, 1998. Pursuant to its stock option plans, at December 31, 1998, the Company had outstanding options to purchase 101,492 shares of Company Common Stock. As of December 31, 1998, 1,003,000 shares of Company Common Stock remained available for grants under the Company's stock option plans. Sales of substantial amounts of Company Common Stock in the public market could adversely affect the market price of Common Stock.
A large portion of the loan portfolio of the Company is dependent on real estate. At December 31, 1998, real estate served as the principal source of collateral with respect to approximately 57% of the Company's loan portfolio. A worsening of current economic conditions or rising interest rates could have an adverse effect on the demand for new loans, the ability of borrowers to repay outstanding loans, the value of real estate and other collateral securing loans and the value of the available-for-sale investment portfolio, as well as the Company's financial condition and results of operations in general and the market value for Company Common Stock. Acts of nature, including earthquakes and floods, which may cause uninsured damage and other loss of value to real estate that secures these loans, may also negatively impact the Company's financial condition.
The Company is subject to certain operations risks, including, but not limited to, data processing system failures and errors and customer or employee fraud. The Company maintains a system of internal controls to mitigate against such occurrences and maintains insurance coverage for such risks, but should such an event occur that is not prevented or detected by the Company's internal controls, uninsured or in excess of applicable insurance limits, it could have a significant adverse impact on the Company's business, financial condition or results of operations.
Year 2000 Compliance
The inability of computers, software and other equipment utilizing microprocessors to recognize and properly process data fields containing a 2 digit year is commonly referred to as the Year 2000 Compliance issue. As the year 2000 approaches, such systems may be unable to accurately process certain date-based information.
The Company has a written plan to mitigate the risks associated with the impact of the Year 2000. The plan directs the Company's Year 2000 activities under the framework of the Federal Financial Institutions Examination Council (FFIEC) Five-Step Program. The FFIEC's Five-Step Program includes the following phases: Awareness, Assessment, Renovation, Validation and Implementation. The Awareness Phase, 100% complete, defines the Year 2000 problem and gains executive level support for the necessary resources to prepare the Company for Year 2000 compliance. The Assessment Phase, 100% complete, assesses the size and complexity of the problem and details the magnitude of the effort necessary to address the Year 2000 issues. Although the Awareness and Assessment Phases are complete, the Company will continue to evaluate any new issues as they arise. The Renovation Phase, 80% complete, includes the incremental changes to hardware and software components. The Validation Phase includes the testing of hardware and software components and is scheduled to be substantially complete by March 31, 1999. The Implementation Phase, 50% complete, certifies that systems are Year 2000 compliant and will be accepted by the end users. The Implementation Phase is scheduled to be substantially complete by June 30, 1999. The Company has completed the development of test and validation methodologies for its Information Technology (IT) systems. Testing of applications has begun and is scheduled to be substantially complete during the first quarter of 1999. In some cases, the Company will rely on the service providers and software vendors to facilitate proxy testing with a selected group of users. The Company will review the test plans and validate the results of the proxy testing to ensure the Year 2000 compliance of those systems. The Company's business also utilizes non-IT products and services, some of which have embedded technology which might not be Year 2000 ready. Some non-IT products and services involve infrastructure issues such as power, communication and water, as well as elevators, ventilation and air conditioning equipment. The Company classifies power and communications as non-IT products and services and considers them to be of significant importance, giving them high priority. Based on responses from vendors and software providers, the Company does not anticipate incurring any material expenses due to unpreparedness. The Company has identified material third party relationships to minimize the potential loss from unpreparedness of these parties. The Company continues to work closely with Jack Henry & Associates, its data services and items processing provider, regarding Year 2000 compliance. The testing and validation of this system was substantially complete by December 31, 1998.
The Company is making efforts to ensure that its customer base is aware of the Year 2000 problem. Year 2000 correspondence has been sent to both deposit and loan customers. The
Bank has amended its credit authorization documentation to include consideration regarding the Year 2000 problem. Significant customers relationships have been identified, and such customers are being contacted by the Bank's employees to determine whether they are aware of Year 2000 risks and whether they are taking preparatory actions.
The total cost to the Company of these Year 2000 Compliance activities was approximately $28,100 for 1998 and the Company has budgeted approximately $100,000 for 1999. Costs associated with the modifications necessary are being expensed by the Company during the period in which they are incurred. These costs and the date on which the Company plans to complete the Year 2000 modification and testing processes are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources, third party modification plans and other factors. However, there can be no guarantee that the estimates of costs for 1999 will be accurate since actual results could differ from those plans. The costs incurred in 1998 did not have a material effect on the Company's net income for 1998 and the Company does not expect the costs incurred for the same period in 1999 to have a material effect on net income. It is anticipated that any disruption of services would be partial and brief, and that there will not be a material impact on revenues or earnings.
The Company and the Bank are developing contingency plans to address the possibility that efforts to mitigate Year 2000 risk are not successful either in whole or in part. These plans will include remedial efforts up to and including complete manual processing of information for critical IT systems in the event there is a failure after December 31, 1999. The Company's contingency plan should be completed by April 30, 1999, after which time the appropriate implementation training would take place.
The disclosure set forth above contains forward-looking statements. Specifically, such statements are contained in sentences including the words "expect" or "anticipate". Such forward-looking statements are subject to inherent risks and uncertainties that may cause actual results to differ materially from those contemplated by such forward-looking statements. The factors that may cause actual results to differ materially from those contemplated by the forward-looking statements include the failure by third parties to adequately remediate Year 2000 issues or the inability of the Company to complete writing and/or testing software changes on time schedules currently expected. Nevertheless, the Company expects that its Year 2000 compliance efforts will be successful without any adverse effects on its business.
ITEM 2.
ITEM 2. DESCRIPTION OF PROPERTY
The Company's principal executive office is located at 880 E. Cypress Avenue, Redding, Shasta County, California. The office, which occupies approximately 2,100 square feet of space, is located within the Enterprise Office of its subsidiary, North Valley Bank.
The Bank owns the land and building on which its headquarters office is located at 880 E. Cypress Avenue, Redding, California, as well as the land and buildings on which the Hayfork, Anderson, Weaverville, Redding and Country Club (Bechelli Lane) branches are located. On February 2, 1990, the Bank completed construction on a 6,000 square foot building adjacent to the 880 E. Cypress location. Such building and land, owned by the Bank and located at 836 E. Cypress Avenue, currently houses Bank Processing, Inc., and the Bank's Customer Service centers. Construction costs were approximately $376,000. During the year ended December 31, 1995, the Bank purchased, in the ordinary course of business, the Hayfork facility for $134,000 which the Bank previously leased from a former board member. The Palo Cedro and Westwood Village branches as well as the warehouse facilities for the Bank located at 1401 Gold Street, Redding, California, are located in leased facilities or on leased land with various lease expiration dates through August 14, 2005. During the year ended December 31, 1997, the Bank purchased land in the city of Shasta Lake for $176,000 and completed construction on a 4,250 square foot building for approximately $805,000 to relocate the Shasta Dam facility. It opened for business on October 14, 1997. On January 20, 1998, the Bank opened its first grocery store branch and leases 540 square feet located in Holiday Market in Cottonwood, CA, and on September 8, 1998, opened its second grocery store branch in the Holiday Market on Placer Street in Redding, CA, leasing 488 square feet. On May 11, 1998, the Bank opened its Business Banking Center located at 443 Redcliff Drive, Suite 110, Redding CA, and leases 3,767 square feet.
During the year ended December 31, 1998, the Company spent $90,000 for rental of the Westwood Village branch, Palo Cedro branch, the two grocery store branches, the business banking center and the warehouse for the Bank. Net occupancy expenses for all facilities for the year ended December 31, 1998, were $557,000. In the opinion of management, the properties are adequately covered by insurance.
From time to time, the Bank acquires real property through foreclosure of defaulted loans. The Bank's policy is not to use or permanently retain any such properties but to resell them when practicable.
Permissible investments of banks and bank holding companies are subject to regulation and limitation by Federal and State agencies. For example, federal law prohibits the Bank from making any investment which is prohibited for national banks. See " Financial Condition" in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operation for more information on investments in loans and securities. See "Supervision and Regulation" in Item 1, Description of Business, for additional information related to investment policies.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
There are no material legal proceedings pending against the Company or against any of its property. The Bank, because of the nature of its business, is generally subject to various legal actions, threatened or filed, which involve ordinary, routine litigation incidental to its business. Some of the pending cases seek punitive damages in addition to other relief. Although the amount of the ultimate exposure, if any, cannot be determined at this time, the Company, based on the advise of counsel, does not expect that the final outcome of threatened or filed suits will have a materially adverse effect on its consolidated financial position.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of security holders through the solicitation of proxies or otherwise, during the fourth quarter of the fiscal year covered by this Form 10-K.
PART II
ITEM 5.
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
North Valley Bancorp's common stock trades on the NASDAQ National Market under the symbol "NOVB". The shares were first listed in the NASDAQ Stock Market in April 1998.
----------------------------------- The information for March 1997 through March 1998 was provided by Hoefer & Arnett, Inc., Sutro & Co. and the Company, based upon trades of which management was aware, and does not include purchases of stock pursuant to the exercise of employee stock options or other private transactions.
The Company had approximately 1,090 shareholders of record as of March 1, 1999.
See "Supervision and Regulation - - Restrictions on Dividends and Other Distributions" and "Bank Regulation and Supervision" in Item 1, Description of Business, for information related to shareholder and dividend matters including information on limitations on dividends.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
Overview
North Valley Bancorp (the "Company") is a bank holding company for North Valley Bank (the "Bank"), a state-nonmember bank. The Company's consolidated net income, assets, and equity are derived primarily from its investment in the Bank. The Bank operates out of its main office located at 880 E. Cypress Avenue, Redding, California 96002 with nine additional branches located in Shasta County and two branches in Trinity County. The Bank's consumer financial services include residential real estate loans, retail deposit services, mutual fund products and consumer finance. Financial services for businesses include commercial loans, Small Business Administration (SBA) loans, and deposit services.
Certain statements in this Annual Report on Form 10-K (excluding statements of fact or historical financial information) involve forward-looking information within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are subject to the "safe harbor" created by those sections. These forward-looking statements involve certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Such risks and uncertainties include, but are not limited to, the following factors: competitive pressures in the banking industry increase significantly; changes in the interest rate environment reduce margins; general economic conditions, either nationally or regionally, are less favorable than expected, resulting in, among other things, a deterioration in credit quality and an increase in the provision for possible loan losses; changes in the regulatory environment; changes in business conditions, particularly in Shasta County; volatility of rate sensitive deposits; operational risks including data processing system failures or fraud; asset/liability matching risks and liquidity risks; changes in the securities markets; and Year 2000 compliance problems.
Earnings Summary
For the year ended December 31, 1998, the Company achieved earnings of $4,085,000 as compared to $5,145,000 in 1997. On a diluted per share basis, net income was $1.10 for 1998 and $1.39 for 1997 (as adjusted to give effect to the two-for-one stock split). Significant nonrecurring income and expense items in 1998 and 1997 impacted the operating results of the Company. During the twelve month period ended December 31, 1998 the Company had $979,000 in securities gains and increased the provision for loan losses in 1998 by $660,000. For the period ending December 31, 1997, the Company had $250,000 in securities gains, a lower effective tax rate and collected $889,000 in net proceeds from a life insurance policy. The Company's return on average total assets and average shareholders' equity were 1.46% and 13.73% in 1998, compared with 1.93% and 19.67% in 1997.
Net Interest Income
The Company's primary source of operating earnings is net interest income, which is the difference between interest income on earning assets and interest expense on interest-bearing liabilities.
Net interest income has been adjusted to a fully taxable equivalent (FTE) basis for tax-exempt investments included in earning assets. Net interest income (FTE) was $12,855,000 in 1998, as compared to $12,104,000 in 1997. The increase in net interest income for 1998 resulted primarily from the increase in the average balances of investment securities and loans.
Average loans increased to $175,556,000 in 1998, or 4.81% over 1997, with an increase in average available for sale securities of 46.97% and a decrease in average held to maturity securities of 9.25%. Total interest income (FTE) increased to $21,438,000 in 1998 compared to $20,748,000 in 1997, representing a 3.32% increase.
Average interest-bearing deposits in 1998 totaled $213,484,000, as compared to $206,125,000 in 1997, or a 3.57% increase. Total interest expense increased to $8,583,000 as compared to $8,644,000 in 1997.
Net interest margin (determined by dividing net interest income by total average interest-earning assets) was 5.02% for 1998, as compared to 4.95% at year end 1997. The slight increase in 1998 in the net interest margin is attributed to the increases in loans, investments and deposits, and by an increase in the net spread (the difference between rates earned on interest earning assets and rates paid on deposits), affected primarily by a declining interest rate environment and the change in the mix between loans and investment securities in 1998. Average earning assets yielded 8.37% in 1998 compared to 8.49% in 1997. The decrease in the yields on earning assets was offset by the decrease in the rates paid on interest-bearing deposits. Rates paid declined to 4.02% in 1998 as compared to 4.19% in 1997. The interest spread was 4.35% in 1998 compared to 4.30% in 1997.
Non-Interest Income
Other non-interest income, which includes income derived from service charges on deposit accounts, loan servicing fees, other fees and charges, gain on sale of securities, and insurance proceeds decreased 1.04% to $4,095,000 in 1998 as compared to $4,138,000 in 1997. For the year ended December 31, 1998, there was a $729,000 increase in gains on sale of available for sale securities, and a $386,000 increase in service charges on deposit accounts, as compared to insurance proceeds of $1,139,000 received in 1997.
A summary of non-interest income for the past three years is presented below:
Non-Interest Income (in thousands) 1998 1997 1996 ------- ------- -------
Service charges on deposit accounts $ 1,786 $ 1,400 $ 1,342 Other fees and charges 624 570 520 Gain on sale of loans 130 160 160 Gain on sale of available for sale securities 979 250 31 Life insurance proceeds 0 1,139 0 Gain (loss) on sale of trading securities 0 0 (7) Other 576 619 535 ------- ------- ------- Total non-interest income $ 4,095 $ 4,138 $ 2,581 ======= ======= =======
Non-Interest Expense
Non-interest expense totaled $8,886,000 for 1998 compared to $8,312,000 in 1997. Salaries and employee benefits increased in 1998 to $4,679,000 compared to $4,522,000 in 1997. The increase in salary expense was attributed to the additional personnel for the new branches, along with increases in staff compensation. Salaries were affected in both years from payout of contractual obligations to senior executives no longer with the Company and in 1997 by a non-recurring benefit payment of $250,000. The increase in occupancy and furniture and equipment expense was attributed to the opening of two new in-store branches, the Business Banking Center, and the relocation of the Shasta Lake branch to a new facility. The increase in professional services for the period ending December 31, 1998 was attributed to the loan portfolio and technology reviews performed for the Company, and legal costs to establish the Incentive Stock Option plan for employees. In 1997, the Company contributed $170,000 from other non-interest expense to the North Valley Bank Scholarship Fund to fund future scholarships in the community.
The Company's efficiency ratio (derived by dividing total non-interest expenses by non-interest income and net interest income exclusive of provision for loan losses) was 55.6% in 1998 compared to 54.6% in 1997. The efficiency ratio is a measurement as to how efficiently the Company allocates its resources.
A summary of non-interest expense for the past three years is presented below:
Non-Interest Expense (in thousands) 1998 1997 1996 ------ ------ ------
Salaries & employee benefits $4,679 $4,522 $3,934 Occupancy expense 557 503 456 Furniture & equipment expense 666 553 497 Professional services 373 235 136 Data processing expenses 415 360 260 Printing & supplies 292 232 222 Postage 196 182 175 Donations 50 217 35 FDIC & State banking assessments 50 70 23 Messenger 178 139 136 ATM and Online expense 284 247 134 Other 1,146 1,052 778 ------ ------ ------ Total non-interest expense $8,886 $8,312 $6,786 ====== ====== ======
Income Taxes
In 1998 and 1997, the Company recorded a tax provision of $1,579,000 and $1,000,000, respectively. The effective income tax rate for state and federal income taxes increased to 27.9% in 1998, from 16.3% in 1997. The increase in the effective income tax rate in 1998 from 1997 is mainly due to the non taxability of the proceeds from a life insurance policy. Income taxes are based on income reported in the consolidated financial statements using the effective tax rate.
Impaired, Nonaccrual, Past Due, Restructured Loans and Other Real Estate Owned
The Company considers a loan impaired if, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral. For further discussion of SFAS 114, refer to Note 5 of the Financial Statements.
Nonaccrual loans consist of loans on which the accrual of interest has been discontinued and other loans where management believes that borrowers' financial condition is such that the collection of principal or interest is doubtful, or when a loan becomes contractually past due by 90 days or more with respect to interest or principal (except that when management believes a loan is well secured and in the process of collection, interest accruals are continued on loans considered by management to be fully collectible). Loans are charged off when management determines that the loan is considered uncollectible. Other real estate owned consists of real property acquired through foreclosure on the related collateral underlying defaulted loans.
The amount of non accrual loans increased during 1998 to $2,307,000 as compared to $536,000 in 1997. During the third quarter of 1998, the Company placed $1,891,000 in secured loans to a single borrower on nonaccrual status and charged off the unsecured portion of such borrower's note (see Allowance for Loan Losses).
A summary of non-performing assets for the past three years is presented below:
Non-Performing Assets (in thousands) 1998 1997 1996 ------ ------ ------
Nonaccrual loans $2,307 $ 536 $1,190 Accruing loans past due 90 days or more 364 244 14 Restructured loans -- -- -- Other real estate owned 575 212 69 ------ ------ ------ Total $3,246 $ 992 $1,273 ====== ====== ======
Allowance for Loan Losses
The Company maintains an allowance for loan losses to absorb inherent losses in the loan portfolio. Management attributes general reserves to different types of loans using percentages which are based upon perceived risk associated with the portfolio and underlying collateral. The allowance for possible loan losses is a general reserve available against the total loan portfolio and off balance sheet credit exposure. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for possible loan losses. Such agencies may require the Company to provide additions to the allowance based on their judgment of information available to them at the time of their examination. At December 31, 1998, based on known information, management believed that the allowance for loan losses was adequate to absorb losses inherent in existing loans and commitments to extend credit, based on evaluations of the collectibility and prior loss experience of loans and commitments to extend credit as of such date.
As of December 31, 1998, the allowance for possible loan losses was $1,902,000 as compared to the December 31, 1997 amount of $1,702,000. When a loan is considered uncollectible by management it is charged against the allowance for loan losses. Any recoveries on previously charged off loans are credited back to the allowance. Net charge-offs were $1,230,000, $322,000, and $791,000 in 1998, 1997, and 1996, respectively. Additions to the allowance for loan losses are charged against income. Provisions for loan losses of $1,430,000, $770,000, and $720,000 were charged to income in 1998, 1997, and 1996, respectively.
The evaluation process is designed to determine the adequacy of the allowance for loan losses. This process attempts to assess the risk of losses inherent in the loan portfolio by segregating the allowance for loan losses into three components: "Specific," "loss migration," and "general." The specific component is established by allocating a portion of the allowance for loan losses to individual classified credits on the basis of specific circumstances and assessments. The loss migration component is calculated as a function of the historical loss migration experience of the internal loan credit risk rating categories. The general component is an unallocated portion that supplements the first two components and includes:
management's judgement of the current economic conditions, borrower's financial condition, loan impairment, evaluation of the performing loan portfolio, continual evaluation of problem loans identified as having a higher degree of risk, off balance sheet risks, net charge off trends, and other factors.
December 31 1994 ----------------- Allowance % for of Losses Allowance Loan Categories: Commercial, financial and agricultural $ 583 51%
Real Estate - construction -0- -- Real Estate - mortgage 114 10% Installment 447 39%
Other -0- -- Unallocated -0- -- ------ --- $1,144 100% ====== ===
There is uncertainty concerning future economic trends. Accordingly, it is not possible to predict the effect future economic trends may have on the level of the provision for possible loan losses in future periods.
Liquidity and Interest Rate Sensitivity
The fundamental objective of the Company's management is to increase shareholders' value while maintaining adequate liquidity, to manage interest rate risk, and to increase the economic value of its assets and liabilities. Liquidity is the ability to provide funds to support asset growth and satisfy cash flow requirements created by fluctuations in deposits and to meet borrowers' credit needs. Effective liquidity management insures that sufficient funds are available to satisfy demands from depositors, borrowers and other commitments on a timely basis. Collection of principal and interest on loans, the liquidations and maturities of investment securities, deposits with other banks, deposit inflow and short term borrowing, when needed, are primary sources of funds that contribute to liquidity. Unused lines of credit from correspondent banks to provide federal funds in the aggregate amount of $6,000,000 as of December 31, 1998, were available to provide liquidity. In addition, the Bank is a member of the Federal Home Loan Bank ("FHLB") System provides an additional line of credit of $3,743,000 secured by first deeds of trust on eligible 1-4 unit residential loans. The Company had not utilized the line of credit from the FHLB as of December 31, 1998.
The Company manages both assets and liabilities by monitoring asset and liability mixes, volumes, maturities, yields and rates in order to preserve liquidity and earnings stability. Total liquid assets (cash and due from banks, federal funds sold, and investment securities) totaled $82,108,000 and $87,774,000 (or 27.71% and 32.42% of total assets) at December 31, 1998 and 1997, respectively. Total liquid assets for 1998 and 1997 include investment securities of $33,914,000 and $39,219,000, respectively, classified as held to maturity based on the Company's intent to hold such securities to maturity.
Core deposits, defined as demand deposits, NOW, regular savings, money market deposit accounts and time deposits of less than $100,000, continue to provide the Company with a relatively stable
and low cost source of funds. Core deposits totaled $241,412,000 and $220,608,000 at December 31, 1998 and 1997, respectively.
In assessing liquidity, historical information such as seasonal loan demand, local economic cycles and the economy in general are considered along with current ratios, management goals and unique characteristics of the Company. Management believes the Company is in compliance with its policies relating to liquidity.
The Company has no definitive commitments for capital expenditures in 1999 or beyond.
Parent company liquidity is maintained by cash flows stemming from dividends and the exercise of stock options issued to the Bank's employees and directors. The amount of dividends from the Bank is subject to certain regulatory restrictions as discussed in Note 16 of the Notes to the Consolidated Financial Statements and elsewhere within this Report. Subject to said restrictions, at December 31, 1998, up to $9.4 million could have been paid to the parent Company by the Bank without regulatory approval. Condensed financial statements of North Valley Bancorp are presented in Note 18 of the Notes to Consolidated Financial Statements.
Asset and liability management focuses on interest rate risk due to asset and liability cash flows and market interest rate movement. The primary objective of managing interest rate risk is to ensure that both assets and liabilities react to changes in interest rates to minimize the effects of interest rate movements on net interest income. An asset and liability management simulation model is used to quantify the exposure and impact of changing interest rates on earnings. That model projects changes by analyzing the mix and repricing characteristics of interest rate sensitive assets and liabilities using multipliers (how interest rates change when the Fed Funds rate changes by 1%) and lags (time it takes for rates to change after the Fed Funds rate changes). The model simulates the effects on net interest income when the Fed Funds rate experiences a 1% increase or decrease compared to current levels.
At December 31, 1998, the foregoing table indicates the Company as liability sensitive in the preceding twelve month period. The interest rate sensitivity gap is defined as the difference between amount of interest-earning assets anticipated to mature or reprice within a specific time period and the amount of interest-bearing liabilities anticipated to mature or reprice within that same time period. The yearend gap report is based on the contractual interest repricing date. The gap method does not consider the impact of different multipliers (how interest rates change when the Fed Funds rate changes by 1%) and lags (time it takes for rates to change after the Fed Funds rate changes). The interest rate relationships between the repriceable assets and repriceable liabilities are not necessarily constant and may be affected by many factors, including the behavior of customers in response to changes in interest rates and future impact of new business strategies. This table should, therefore, be used only as a guide as to the possible effect changes in interest rates might have on the net margins of the Company. The Company's model analyzes the impact on earnings of future rate changes by including factors for lags and multipliers for key bank rates. Both methods of measuring interest rate sensitivity do not take into account actions taken by management to modify the effect to net interest income if interest rates were to rise or fall.
Even though the Company had a negative gap in the twelve month period ended December 31, 1998, the asset liability simulation model showed the Bank was slightly asset sensitive in 1998. Due to a declining interest rate environment in 1998, the Bank's slightly asset sensitive posture had a positive impact on net interest margins. Even though the Bank is slightly asset sensitive the decline in yields on earning assets were offset by the reduction in yields on interest-bearing deposits.
Financial Condition
Total assets at December 31, 1998, were $296,362,000, representing an increase of 9.5% over December 31, 1997 assets of $270,757,000. Increased deposits were used to fund a 4.84% increase in average earning assets in 1998.
Investment securities and federal funds sold totaled $75,056,000 at December 31, 1998, compared to $78,932,000 at December 31, 1997. The Company is a member of Federal Home Loan Bank of San Francisco and holds $841,000 in FHLB stock. Additional information regarding investment securities held by the Company at year end 1998 is set forth in Note 3 of "Notes to Consolidated Financial Statements".
During 1998, net loans increased to $197,434,000 from $167,507,000 for the same period in 1997. Loans are the Company's major component of earning assets. The Bank's average loan to deposit ratio was 71.21% and 70.58% in 1998 and 1997, respectively. Additional information regarding loans is shown in Note 4 of the Notes to Consolidated Financial Statements.
Funding for increased investments and loan activity came from increases in deposits. Total deposits increased $21,359,000 in 1998 to $259,881,000, as compared to $238,522,000 in 1997. The majority of the increase was in interest-bearing instruments.
The Company maintains capital to support capital needs, future growth and dividend payouts while maintaining the confidence of depositors and investors by increasing shareholders' value. The Company has provided the majority of its capital requirements through the retention of earnings.
Shareholders' equity increased to $30,180,000 as of December 31, 1998, as compared to $28,066,000 as of December 31, 1997. This increase was primarily attributable to retention of earnings, offset by $1,383,000 in dividends to shareholders.
The Company's and the Bank's regulatory capital ratios continue to be strong and remain above regulatory minimums. The Company's total risk based capital ratio at December 31, 1998 was 15.05% and its Tier 1 Risk Based Capital (RBC) ratio was 14.14%, exceeding the minimum guidelines of 8% and 4%. The same ratios at December 31, 1997 were 15.73% and 14.80%, respectively.
The Company's leverage ratios were 10.18% and 9.94% at December 31, 1998 and 1997, respectively, exceeding the minimum guideline of 4%.
Under current regulations adopted by federal regulatory agencies, a "well-capitalized" institution must have a Tier 1 RBC ratio of at least 6%, a total capital ratio of at least 10% and leverage ratio of at least 5% and not be subject to a capital directive order. The Bank had a total capital ratio of 14.08%, a
Tier 1 RBC ratio of 13.17% and a leverage ratio of 9.49% at December 31, 1998, compared with 14.69%, 13.76% and 9.24%, respectively at December 31, 1997.
The most recent notifications from the Federal Deposit Insurance Corporation for the Bank as of December 31, 1998 and 1997, categorized the Bank as "well capitalized" under the regulatory framework for prompt corrective action. There are no conditions or events since such notification that management believes have changed the Bank's category.
Impact of Inflation
Impact of inflation on a financial institution differs significantly from that exerted on an industrial concern, primarily because a financial institution's assets and liabilities consist largely of monetary items. The relatively low proportion of the Bank's fixed assets (approximately 1.7% at December 31, 1998) reduces both the potential of inflated earnings resulting from understated depreciation and the potential understatement of absolute asset values.
Year 2000 Compliance
The inability of computers, software and other equipment utilizing microprocessors to recognize and properly process data fields containing a 2-digit year is commonly referred to as the Year 2000 Compliance issue. As the year 2000 approaches, such systems may be unable to accurately process certain date-based information.
The Company has a written plan to mitigate the risks associated with the impact of the Year 2000. The plan directs the Company's Year 2000 activities under the framework of the Federal Financial Institutions Examination Council (FFIEC) Five-Step Program. The FFIEC's Five-Step Program includes the following phases: Awareness, Assessment, Renovation, Validation and Implementation. The Awareness Phase, 100% complete, defines the Year 2000 problem and gains executive level support for the necessary resources to prepare the Company for Year 2000 compliance. The Assessment Phase, 100% complete, assesses the size and complexity of the problem and details the magnitude of the effort necessary to address the Year 2000 issues. Although the Awareness and Assessment Phases are complete, the Company will continue to evaluate any new issues as they arise. The Renovation Phase, 80% complete, includes the incremental changes to hardware and software components. The Validation Phase includes the testing of hardware and software components and is scheduled to be substantially complete by March 31, 1999. The Implementation Phase, 50% complete, certifies that systems are Year 2000 compliant and will be accepted by the end users. The Implementation Phase is scheduled to be substantially complete by June 30, 1999. The Company has completed the development of test and validation methodologies for its Information Technology (IT) systems. Testing of applications has begun and is scheduled to be substantially complete during the first quarter of 1999. In some cases, the Company will rely on the service providers and software vendors to facilitate proxy testing with a selected group of users. The Company will review the test plans and validate the results of the proxy testing to ensure the Year 2000 compliance of those systems. The Company's business also utilizes non-IT products and services, some of which have embedded technology, which might not be Year 2000 ready. Some non-IT products and services involve infrastructure issues such as power, communication and water, as well as elevators, ventilation and air conditioning equipment. The Company classifies power and communications as non-IT products and services and considers them to be of significant importance, giving them high priority. Based on responses from vendors and software providers, the Company does not anticipate incurring any material expenses due to unpreparedness. The Company has identified material third party
relationships to minimize the potential loss from unpreparedness of these parties. The Company continues to work closely with Jack Henry & Associates, its data services and items processing provider, regarding Year 2000 compliance. The testing and validation of this system was substantially complete by December 31, 1998.
The Company is making efforts to ensure that its customer base is aware of the Year 2000 problem. Year 2000 correspondence has been sent to both deposit and loan customers. The Bank has amended its credit authorization documentation to include consideration regarding the Year 2000 problem. Significant customers relationships have been identified, and such customers are being contacted by the Bank's employees to determine whether they are aware of Year 2000 risks and whether they are taking preparatory actions.
The total cost to the Company of these Year 2000 Compliance activities was approximately $28,100 for 1998 and the Company has budgeted approximately $110,000 for 1999. Costs associated with the modifications necessary are being expensed by the Company during the period in which they are incurred. These costs and the date on which the Company plans to complete the Year 2000 modification and testing processes are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources, third party modification plans and other factors. However, there can be no guarantee that the estimates of costs for 1999 will be accurate since actual results could differ from those plans. The costs incurred in 1998 did not have a material effect on the Company's net income for 1998 and the Company does not expect the costs incurred for the same period in 1999 to have a material effect on net income. It is anticipated that any disruption of services would be partial and brief, and that there will not be a material impact on revenues or earnings.
The Company and the Bank are developing contingency plans to address the possibility that efforts to mitigate Year 2000 risk are not successful either in whole or in part. These plans will include remedial efforts up to and including complete manual processing of information for critical IT systems in the event there is a failure after December 31, 1999. The Company's contingency plan should be completed by April 30, 1999, after which time the appropriate implementation training would take place.
The disclosure set forth above contains forward-looking statements. Specifically, such statements are contained in sentences including the words "expect" or "anticipate". Such forward-looking statements are subject to inherent risks and uncertainties that may cause actual results to differ materially from those contemplated by such forward-looking statements. The factors that may cause actual results to differ materially from those contemplated by the forward-looking statements include the failure by third parties to adequately remediate Year 2000 issues or the inability of the Company to complete writing and/or testing software changes on time schedules currently expected. Nevertheless, the Company expects that its Year 2000 compliance efforts will be successful without any adverse effects on its business.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Derivative financial instruments include futures, forwards, interest rate swaps, option contracts, and other financial instruments with similar characteristics. The Company currently does not enter into futures, forwards, swaps or options. However, the Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and letters of credit. These instruments
involve to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. 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 and generally require collateral from the borrower. Letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party up to a stipulated amount and with specified terms and conditions.
Commitments to extend credit and letters of credit are not recorded as an asset or liability by the Company until the instrument is exercised.
The Company's exposure to market risk is reviewed on a regular basis by management. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximize income. Management realizes certain risks are inherent and that the goal is to identify and minimize the risks. An asset and liability management simulation model is used by the Company to quantify the exposure and impact of changing interest rates on earnings. The Company has no market risk sensitive instruments held for trading purposes. In the opinion of management, it appears the Company's market risk is reasonable at this time. The condensed GAP report summarizing the Company's interest rate sensitivity is as follows:
Average Estimated Interest Fair Total Rate Value
ASSETS
Debt Securities $56,569 5.79% $58,594
Loans 199,785 8.44% 202,990
LIABILITIES
Savings, Demand, MMDA 103,915 2.31% 103,915
Time Deposits $118,594 4.96% $118,951
Average Estimated Interest Fair Total Rate Value
ASSETS
Debt Securities $63,525 6.00% $65,614
Loans 169,844 9.23% 171,486
LIABILITIES
Savings,Demand, MMDA 88,110 2.70% 88,110
Time Deposits $118,159 5.29% $118,448
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Financial Statements required by this item are set forth following Item 14 of this Form 10-K, and are incorporated herein by reference.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT
The information concerning directors and executive officers required by this item is incorporated by reference from the section of the Company's Definitive Proxy Statement for the 1999 Annual Meeting of Shareholders of the Company to be filed with the Securities and Exchange Commission (the "Commission") entitled "Election of Directors" (not including the share information included in the beneficial ownership tables nor the footnotes thereto nor the subsections entitled "Committees of the Board of Directors", "Compensation Committee Interlocks and Insider Participation" and "Meetings of the Board of Directors.") and the section entitled "Section 16(a) Beneficial Ownership Reporting Compliance."
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference from the section of the Company's Definitive Proxy Statement for the 1999 Annual Meeting of Shareholders of the Company to be filed with the Commission entitled "Executive Compensation" and the subsection entitled "Election of Directors - Compensation Committee Interlocks and Insider Participation."
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information required by this item is incorporated by reference from sections of the Company's Definitive Proxy Statement for the 1999 Annual Meeting of Shareholders of the Company to be filed with the Commission, entitled "Election of Directors - Security Ownership of Certain Beneficial Owners and Management", as to share information in the tables of beneficial ownership and footnotes thereto.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required by this item is incorporated by reference from the section of the Company's Definitive Proxy Statement for the 1999 Annual Meeting of Shareholders to be filed with the Commission, entitled "Certain Relationships and Related Transactions".
ITEM 14. EXHIBITS AND REPORTS ON FORM 8-K
(A) The following documents are filed as part of the report:
1. Financial Statements:
2. Exhibits:
See Index to Exhibits at page 72.
(B) Reports on Form 8-K.
No reports on Form 8-K were filed by the Company during the last quarter of 1998.
(C) Exhibits
See Index to Exhibits at page 72 of this Annual Report on Form 10-K, which is incorporated herein by reference.
(D) Financial Statement Schedules
Not applicable.
NORTH VALLEY BANCORP AND SUBSIDIARIES
Consolidated Financial Statements as of December 31, 1998 and 1997 and for each of the Three Years in the Period Ended December 31, 1998 and Independent Auditors' Report
Deloitte & Touche Deloitte & Touche LLP Telephone: (916) 498-7100 Suite 2000 Facsimile: (916) 444-7963 400 Capitol Mall Sacramento, California 95814-4424
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders North Valley Bancorp Redding, California
We have audited the accompanying consolidated balance sheets of North Valley Bancorp and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the North Valley Bancorp and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles.
/s/ Deloitte & Touche LLP
January 27, 1999
Deloitte Touche Tohmatsu
NORTH VALLEY BANCORP AND SUBSIDIARIES
NORTH VALLEY BANCORP AND SUBSIDIARIES
NORTH VALLEY BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 - --------------------------------------------------------------------------------
1. SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations - North Valley Bancorp and subsidiaries (Company) operates 12 branches, which include two supermarket branches, in Shasta and Trinity Counties in Northern California. The Company operates as one business segment providing banking services to the Company's clients in Northern California. The Company's principal business consists of attracting deposits from the general public and using the funds to originate commercial, real estate and installment loans to customers, who are predominately small and middle market businesses and middle income individuals. The Company's primary source of revenues is interest income from its loan and investment securities portfolios. The Company is not dependent on any single customer for more than ten percent of the Company's revenues.
General - The accounting and reporting policies of the Company conform to generally accepted accounting principles and to prevailing practices within the banking industry. The Company follows the accrual method of accounting.
Use of Estimates in the Preparation of Financial Statements - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
The more significant accounting and reporting policies are discussed below.
Consolidation - The consolidated financial statements include North Valley Bancorp and its wholly owned subsidiaries, Bank Processing, Inc., North Valley Trading Company, and North Valley Bank (the Bank) and its wholly-owned subsidiary, North Valley Basic Securities. North Valley Trading Company and North Valley Basic Securities did not have any activity in 1998. All material intercompany accounts and transactions have been eliminated in consolidation.
Cash and Cash Equivalents - For the purposes of the statements of cash flows, cash and cash equivalents have been defined as cash, demand deposits with correspondent banks, cash items and settlements in transit, and federal funds sold. Generally, federal funds are sold for one-day periods. Cash equivalents have remaining terms to maturity of three months or less from the date of acquisition.
Investments - The Company's policy with regard to investments is as follows:
Trading securities are carried at fair value. Changes in fair value are included in other operating income. The Company did not have any securities classified as trading at December 31, 1998 and 1997.
Available for sale securities are carried at fair value and represent securities not classified as trading securities nor as held to maturity securities. Unrealized gains and losses resulting from changes in fair value are recorded, net of tax, as a separate component of stockholders' equity. Gains or losses on disposition are recorded in other operating income based on the net proceeds received and the carrying amount of the securities sold, using the specific identification method.
Held to maturity securities are carried at cost adjusted for amortization of premiums and accretion of discounts, which are recognized as adjustments to interest income. The Company's policy of carrying such investment securities at amortized cost is based upon its ability and management's intent to hold such securities to maturity.
Loans Receivable - Loans are reported at the principal amount outstanding, net of deferred loan fees and the allowance for loan losses. Interest on loans is calculated by using the simple interest method on the daily balance of the principal amount outstanding.
Loans on which the accrual of interest has been discontinued are designated as nonaccrual loans. Accrual of interest on loans is discontinued either when reasonable doubt exists as to the full and timely collection of interest or principal, or when a loan becomes contractually past due by 90 days or more with respect to interest or principal. When a loan is placed on nonaccrual status, all interest previously accrued but not collected is reversed against current period interest income. Income on such loans is then recognized only to the extent that cash is received and where the future collection of principal is probable. Interest accruals are resumed on such loans when, in the judgment of management, the loans are estimated to be fully collectible as to both principal and interest.
Deferred Loan Fees - Loan fees and certain related direct costs to originate loans are deferred and amortized to income by a method that approximates a level yield over the contractual life of the underlying loans.
Allowance for Loan Losses - The allowance for loan losses is established through a provision for loan losses charged to operations. Loans are charged against the allowance for loan losses when management believes that the collectibility of the principal is unlikely or, with respect to consumer installment loans, according to an established delinquency schedule. Management attributes general reserves to different types of loans using percentages which are based upon perceived risk associated with the portfolio and underlying collateral, historical loss experience, and vulnerability to changing economic conditions which may affect the collectibility of the loans. Specific reserves are allocated for impaired loans, for loans which have experienced a decline in internal loan grading, and when management believes additional loss exposure exists. Although the allowance for loan losses is allocated to various portfolio segments, it is general in nature and is available for the loan portfolio in its entirety. The allowance is an amount that management believes will be adequate to absorb losses inherent in existing loans and commitments to extend credit. Actual amounts could differ from those estimates.
The Company considers a loan impaired if, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral.
Premises and Equipment - Premises and equipment are stated at cost less accumulated depreciation, which is computed principally on the straight-line method over the estimated useful lives of the respective assets. Leasehold improvements are amortized on the straight-line method over the shorter of the estimated useful lives of the improvements or the terms of the respective leases.
Other Real Estate Owned - Real estate acquired through, or in lieu of, loan foreclosures is expected to be sold and is recorded at the date of foreclosure at the lower of the recorded investment in the property or its fair value less estimated costs to sell (fair value) establishing a new cost basis through a charge to allowance for loan losses, if
necessary. After foreclosure, valuations are periodically performed by management with any subsequent write-downs recorded as a valuation allowance and charged against operating expenses. Operating expenses of such properties, net of related income are included in other expenses and gains and losses on their disposition are included in other income and other expenses.
Income Taxes - The Company applies an asset and liability method in accounting for deferred income taxes. Deferred tax assets and liabilities are calculated by applying applicable tax laws to the differences between the financial statement basis and the tax basis of assets and liabilities. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date.
Preferred Stock - During 1998, the Board of Directors amended the Articles of Incorporation to authorize 5,000,000 shares of no par value preferred stock. There were no shares of preferred stock outstanding at December 31, 1998.
Common Stock Split - On September 21, 1998, the Company's Board of Directors authorized a two-for-one stock split distributed on October 30, 1998 to stockholders of record as of October 15, 1998. This resulted in the issuance of 1,844,610 additional shares of common stock. All share and per share amounts have been restated to reflect this stock split.
Stock-Based Compensation - The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to Employees. The Company presents the required pro forma disclosures of the effect of stock-based compensation on net income and earnings per share using the fair value method in accordance with Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation.
Comprehensive Income - The Company has retroactively adopted SFAS No. 130, Reporting Comprehensive Income, which requires that an enterprise report and display, by major components and as a single total, the change in its net assets during the period from nonowner sources. The adoption of this Statement resulted in a change in the financial statement presentation but did not have an impact on the Company's consolidated financial position, results of operations or cash flows.
Disclosures About Segments of an Enterprise - On January 1, 1998, the Company adopted SFAS No. 131, Disclosures About Segments Of An Enterprise And Related Information, which establishes annual and interim reporting standards for an enterprise's business segments and related disclosures about its products, services, geographic areas, and major customers. This statement will not impact the Company's consolidated financial position, results of operations or cash flows. Management evaluates the Company's performance as a whole and does not allocate resources based on the performance of different lending or transaction activities. Therefore, the financial disclosures of this standard related to operating performance of reportable segments do not apply.
Disclosures About Pensions and Other Post Retirement Benefits - On January 1, 1998, the Company adopted SFAS No. 132, Employers' Disclosures about Pensions and Other Postretirement Benefits, which revises employers' disclosures about pension and other postretirement benefit plans. It does not change the measurement or recognition of those plans.
New Accounting Pronouncements - In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, Accounting For Derivative Instruments and Hedging Activities. The statement establishes accounting and reporting standards for derivative instruments and hedging activities. The statement is effective for all fiscal quarter of fiscal years beginning after June 15, 1999. The Company is in the process of determining the impact of SFAS No. 133 on the Company's financial position and results of operations.
Reclassification - Certain amounts in 1997 and 1996 have been reclassified to conform with the 1998 financial statement presentation.
2. RESTRICTED CASH BALANCES
The Bank is subject to regulation by the Federal Reserve Board. The regulations required the Bank to maintain average cash reserve balances on hand or at the Federal Reserve Bank of $1,009,000 and $3,345,000 at December 31, 1998 and 1997. As compensation for check-clearing services, additional compensating balances of $1,000,000 are required to be maintained with the Federal Reserve Bank.
3. SECURITIES
Gross realized gains on sales of securities categorized as available for sale securities were $979,000, $250,000 and $31,000 in 1998, 1997 and 1996. There were no gross realized losses on sale of available for sales securities in 1998, 1997 or 1996.
Scheduled maturities of held to maturity and available for sale securities (other than equity securities with an amortized cost of approximately $215,000 and a carrying value of approximately $187,000) at December 31, 1998, are shown below (in thousands). Expected maturities may differ from contractual maturities because borrowers may have the right to prepay with or without penalty.
At December 31, 1998 and 1997, securities having carrying amounts of approximately $16,448,000 and $18,790,000 were pledged to secure public deposits and short-term borrowings and for other purposes required by law or contract.
4. LOANS RECEIVABLE
The Company originates loans for business, consumer and real estate activities. Such loans are concentrated in Shasta and Trinity Counties and neighboring communities. Substantially all loans are collateralized. Generally, real estate loans are secured by real property. Commercial and other loans are secured by bank deposits or business or personal assets. The Company's policy for requiring collateral reflects the Company's analysis of the borrower, the borrower's industry and the economic environment in which the loan would be granted. The loans are expected to be repaid from cash flows or proceeds from the sale of selected assets of the borrower.
Major classifications of loans at December 31 were as follows (in thousands):
1998 1997
Commercial $ 72,102 $ 64,666 Real estate - construction 4,177 1,688 Real estate - mortgage 52,909 45,590 Installment 56,686 44,510 Other 13,911 13,390 -------- -------- Total loans receivable 199,785 169,844
Less: Allowance for loan losses 1,902 1,702 Deferred loan fees 449 635 -------- -------- Net loans receivable $197,434 $167,507 ======== ========
At December 31, 1998 and 1997, the Bank serviced real estate loans and loans guaranteed by the Small Business Administration which it had sold to the secondary market of approximately $78,568,000 and $88,640,000.
Changes in the allowance for loan losses for the years ended December 31, were as follows (in thousands):
1998 1997 1996
Balance, beginning of year $ 1,702 $ 1,254 $ 1,325 Provision charged to operations 1,430 770 720 Loans charged off (1,360) (362) (813) Recoveries 130 40 22 ------- ------- -------
Balance, end of year $ 1,902 $ 1,702 $ 1,254 ======= ======= =======
5. IMPAIRED AND NONPERFORMING LOANS
At December 31, 1998 and 1997, the recorded investment in loans for which impairment has been recognized was approximately $2,871,000 and $4,353,000. Of the 1998 balance approximately $2,269,000 has a related valuation allowance of $226,900. The remaining $602,000 did not require a valuation allowance. No significant impaired balances required a valuation allowance at December 31, 1997. For the years ended December 31, 1998, 1997 and 1996, the average recorded investment in loans for which impairment has been recognized was approximately $3,201,000, $3,455,000 and $2,244,000. During the portion of the year that the loans were impaired the Company recognized interest income of approximately $232,000, $153,000 and $203,000 for cash payments received in 1998, 1997 and 1996.
Nonperforming loans at December 31 were as follows (in thousands):
1998 1997
Nonaccrual loans $2,307 $ 536 Loans 90 days past due but still accruing interest 364 244 ------ ------
Total nonaccrual and 90 days past due loans $2,671 $ 780 ====== ======
If interest on nonaccrual loans had been accrued, such income would have approximated $132,000, in 1998, $32,000 in 1997 and $82,000 in 1996. Interest income of $33,000 in 1998, $28,000 in 1997, and $27,000 in 1996 was
recorded when it was received on the nonaccrual loans.
At December 31, 1998, there were no commitments to lend additional funds to borrowers whose loans were classified as nonaccrual.
6. PREMISES AND EQUIPMENT
Major classifications of premises and equipment at December 31 are summarized as follows (in thousands): 1998 1997
Land $ 1,080 $ 1,080 Buildings and improvements 4,323 4,084 Furniture, fixtures and equipment 4,902 4,234 Leasehold improvements 174 174 -------- -------- 10,479 9,572
Accumulated depreciation and amortization (5,451) (4,925) -------- --------
$ 5,028 $ 4,647 ======== ========
Building and equipment rental expense was approximately $90,000 for the year ended December 31, 1998 and $77,000 for the years ended December 31, 1997 and 1996.
7. OTHER ASSETS
Major classifications of other assets at December 31 were as follows (in thousands):
1998 1997
Cash surrender value of life insurance policies $3,850 $3,009 Prepaid expenses 723 745 Income tax receivable 664 528 Deferred taxes 1,786 1,881 Other 710 71 ------ ------
Total $7,733 $6,234 ====== ======
8. DEPOSITS
The aggregate amount of time certificates of deposit in denominations of $100,000 or more was $18,469,000 and $17,914,000 at December 31, 1998 and 1997. Interest expense incurred on such time certificates of deposit was $713,000, $925,000, and $882,000, for the years ended December 31, 1998, 1997 and 1996.
At December 31, 1998, the scheduled maturities of all time deposits was as follows (in thousands):
Year Amount
1999 $ 112,444 2000 5,281 2001 780 2002 11 2003 and thereafter 78 ----------
Total $ 118,594 ==========
9. LINES OF CREDIT
At December 31, 1998, the Bank had the following lines of credit with correspondent banks to purchase federal funds (in thousands):
Type Amount Expiration
Unsecured $6,000 July 31, 1999 Secured $3,743 Quarterly (First deeds of trust on eligible 1-4 unit residential loans)
10. INCOME TAXES
The provision for income taxes for the years ended December 31, was as follows (in thousands):
1998 1997 1996 Currently payable: Federal $ 459 $ 1,185 $ 1,212 State 530 490 647 ------- ------- ------- Total 989 1,675 1,859 ------- ------- -------
Deferred taxes (benefit): Federal 565 (539) (297) State 25 (136) (30) ------- ------- ------- Total 590 (675) (327) ------- ------- -------
Total $ 1,579 $ 1,000 $ 1,532 ======= ======= =======
The effective federal tax rate for the years ended December 31, differs from the statutory tax rate as follows:
1998 1997 1996
Federal income tax at statutory rates 35.0% 35.0% 35.0% State income taxes, net of federal income tax benefit 6.5 3.8 7.4 Tax exempt income (13.7) (13.6) (14.2) Officer's life insurance proceeds (6.3) Other .1 (2.6) (1.0) ------ ------ ------
Total 27.9% 16.3% 27.2% ====== ====== ======
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's net deferred tax asset at December 31, are as follows (in thousands):
1998 1997
Deferred tax assets: Allowance for loan losses $ 522 $ 530 Deferred loan fee income 201 285 Deferred compensation 635 530 Accrued pension obligation 673 651 Accrued severance 62 119 Mark to market adjustment 333 Alternative minimum tax credit 108 ------- -------
Total deferred tax assets 2,093 2,556 ------- -------
Deferred tax liabilities: Tax depreciation in excess of book depreciation (133) (119) California franchise tax (7) (26) Unrealized gain on securities available for sale (8) (297) Mark to market adjustment (23) Other (342) (233) ------- -------
Total deferred tax liabilities (513) (675) ------- -------
Net deferred tax asset $ 1,580 $ 1,881 ======= =======
The Company believes that it is more likely than not that it will realize the above deferred tax assets in the future periods; therefore, no valuation allowance has been provided against its deferred tax assets.
11. RETIREMENT AND DEFERRED COMPENSATION PLANS
Substantially all employees with at least one year of service participate in a Company-sponsored employee stock ownership plan (ESOP). The Company made contributions to the ESOP of $60,000 in 1998, 1997 and 1996, respectively. At December 31, 1998, the ESOP owned approximately 191,000 shares of the Company's stock.
The Company maintains a 401(k) plan covering employees who have completed 1,000 hours of service during a 12-month period and are aged 21 or older. Voluntary employee contributions are partially matched by the Company. The Company made contributions to the Plan for the years ended December 31, 1998, 1997, and 1996 of $26,000, $20,000, and $21,000, respectively.
The Company has a nonqualified executive deferred compensation plan for key executives and directors. Under this plan, participants voluntarily elect to defer a portion of their salary, bonus or fees and the Company is required to credit these deferrals with interest. The Company's deferred compensation obligation of $1,415,000 and $1,183,000 as of December 31, 1998 and 1997, respectively, is included in accrued interest and other liabilities.
The Company has a supplemental retirement plan for directors and a supplemental executive retirement plan covering key executives. These plans are nonqualified defined benefit plans and are unsecured and unfunded. The Company has purchased insurance on the lives of the participants and intends to use the cash values of these policies ($3,850,000 and $3,009,000 at December 31, 1998 and 1997, respectively) to pay the retirement obligations. The accrued pension obligation of $2,325,000, $1,927,000, and $1,544,000, as of December 31, 1998, 1997, and 1996, respectively, is included in accrued interest and other liabilities.
12. STOCK BASED COMPENSATION
During 1998 each director was awarded 600 shares of common stock, resulting in an additional 4,200 shares being issued.
The fair value of the options granted during 1998, 1997 and 1996 is estimated as $311,000, $45,000, and $36,000 on the date of grant using a binomial option-pricing model with the following assumptions: $0.375 annual dividend, volatility of 21.89%, 15.19%, and 15.19%, risk-free interest rate of 5.40%, 6.36%, 5.37%, assumed forfeiture rate of zero, and an expected life of six years. The weighted average per share fair value of the 1998, 1997 and 1996 awards was $5.10, $3.22, and $2.57, respectively. The impact of outstanding nonvested stock options granted prior to 1995 has been excluded from the pro forma calculations; accordingly the 1996, 1997 and 1998 pro forma adjustments are not indicative of future pro forma adjustments when the calculation will apply to all applicable stock options.
13. EARNINGS PER SHARE
Basic earnings per share is computed by dividing net income by the weighted average common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if options or other contracts to issue common stock were exercised and converted into common stock.
14. COMMITMENTS AND CONTINGENCIES
The Company is involved in a number of legal actions arising from normal business activities. Management, based upon the advice of legal counsel, believes that the ultimate resolution of all pending actions will not have a material effect on the financial statements.
The Bank was contingently liable under letters of credit issued on behalf of its customers in the amount of $485,000 and $1,189,000 at December 31, 1998 and 1997. At December 31, 1998 commercial and consumer lines of credit, and real estate loans of approximately $23,975,000 and $2,191,000 respectively, were undisbursed. These instruments involve, to varying degrees, elements of credit and market risk in excess of the amounts recognized in the balance sheet. The contractual or notional amounts of these transactions express the extent of the Bank's involvement in these instruments and do not necessarily represent the actual amount subject to credit loss.
15. RELATED PARTY TRANSACTIONS
At December 31, 1998 and 1997, certain officers and directors and their associates were indebted to the Bank for loans made on substantially the same terms, including interest rates and collateral, as comparable transactions with unaffiliated parties.
16. REGULATORY MATTERS
The Company and the Bank are subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - and, possibly, additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the Company's consolidated financial statements. Under capital adequacy guidelines, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company's and the Bank's assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Company's and the Bank's capital amounts and the Bank's prompt corrective action 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 the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 1998, that the Company and the Bank meet all capital adequacy requirements to which they are subject.
The most recent notifications from the Federal Deposit Insurance Corporation for the Bank as of December 31, 1998 and 1997, categorized the Bank as well capitalized under the regulatory framework for prompt correction action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier I risk-based, Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Bank's category.
The Company's and the Bank's actual capital amounts (in thousands) and ratios are also presented, respectively, in the following tables.
Under federal and California state banking laws, dividends paid by the Bank to the Company in any calendar year may not exceed certain limitations without the prior written approval of the appropriate bank regulatory agency. At December 31, 1998, the amount available for such dividends without prior written approval was approximately $9,384,000. Similar restrictions apply to the amounts and terms of loans, advances and other transfers of funds from the Bank to the Company.
17. FAIR VALUE OF FINANCIAL INSTRUMENTS
SFAS No. 107, Disclosures About Fair Value of Financial Instruments requires certain disclosures regarding the estimated fair value of financial instruments for which it is practicable to estimate. Although management uses its best judgment in assessing fair value, there are inherent weaknesses in any estimating technique that may be reflected in the fair values disclosed. The fair value estimates are made at a discrete point in time based on relevant market data, information about the financial instruments, and other factors. Estimates of fair value of instruments without quoted market prices are subjective in nature and involve various assumptions and estimates that are matters of judgment. Changes in the assumptions used could significantly affect these estimates. Fair value has not been adjusted to reflect changes in market conditions subsequent to December 31, 1998, therefore, estimates presented herein are not necessarily indicative of amounts which could be realized in a current transaction.
The following estimates and assumptions were used as of December 31, 1998 and 1997 to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value.
(a) Cash and Cash Equivalents - The carrying amount represents a reasonable estimate of fair value.
(b) Securities - Held to maturity securities are based on quoted market prices, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. Available for sale securities are carried at fair value.
(c) Loans Receivable - Commercial loans, residential mortgages, and construction loans, are segmented by fixed and adjustable rate interest terms, by maturity, and by performing and nonperforming categories.
The fair value of performing loans is estimated by discounting contractual cash flows using the current interest rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Assumptions regarding credit risk, cash flow, and discount rates are judgmentally determined using available market information.
The fair value of nonperforming loans and loans delinquent more than 30 days is estimated by discounting estimated future cash flows using current interest rates with an additional risk adjustment reflecting the individual characteristics of the loans.
(d) Cash Surrender Value of Life Insurance - The carrying amount represents a reasonable estimate of fair value.
(e) Deposit Liabilities - Noninterest bearing and interest bearing demand deposits and savings accounts are payable on demand and are assumed to be at fair value. Time deposits are based on the discounted value of contractual cash flows. The discount rate is based on rates currently offered for deposits of similar size and remaining maturities.
(f) Commitments to Fund Loans/Standby Letters of Credit - The fair values of commitments are estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. The differences between the carrying value of commitments to fund loans or stand by letters of credit and their fair value is not significant and therefore not included in the following table.
18. CONDENSED FINANCIAL INFORMATION OF NORTH VALLEY BANCORP
The condensed financial statements of North Valley Bancorp are presented below (in thousands except share amounts):
NORTH VALLEY BANCORP
BALANCE SHEETS DECEMBER 31, 1998 AND 1997 --------------------------
1998 1997 Assets: Cash and cash equivalents $ 2,332 $ 554 Available for sale securities at fair value 187 2,230 Investments in subsidiaries 28,326 25,556 Other assets 208 ---------- ----------
Total $ 31,053 $ 28,340 ========== ==========
Liabilities and stockholders' equity: Dividend payable $ 738 Other liabilities 135 $ 274 Stockholders' equity 30,180 28,066 ---------- ----------
Total $ 31,053 $ 28,340 ========== ==========
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
Overview
North Valley Bancorp (the "Company") is a bank holding company for North Valley Bank (the "Bank"), a state-nonmember bank. The Company's consolidated net income, assets, and equity are derived primarily from its investment in the Bank. The Bank operates out of its main office located at 880 E. Cypress Avenue, Redding, California 96002 with nine additional branches located in Shasta County and two branches in Trinity County. The Bank's consumer financial services include residential real estate loans, retail deposit services, mutual fund products and consumer finance. Financial services for businesses include commercial loans, Small Business Administration (SBA) loans, and deposit services.
Certain statements in this Annual Report on Form 10-K (excluding statements of fact or historical financial information) involve forward-looking information within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are subject to the "safe harbor" created by those sections. These forward-looking statements involve certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Such risks and uncertainties include, but are not limited to, the following factors: competitive pressures in the banking industry increase significantly; changes in the interest rate environment reduce margins; general economic conditions, either nationally or regionally, are less favorable than expected, resulting in, among other things, a deterioration in credit quality and an increase in the provision for possible loan losses; changes in the regulatory environment; changes in business conditions, particularly in Shasta County; volatility of rate sensitive deposits; operational risks including data processing system failures or fraud; asset/liability matching risks and liquidity risks; changes in the securities markets; and Year 2000 compliance problems.
Earnings Summary
For the year ended December 31, 1998, the Company achieved earnings of $4,085,000 as compared to $5,145,000 in 1997. On a diluted per share basis, net income was $1.10 for 1998 and $1.39 for 1997 (as adjusted to give effect to the two-for-one stock split). Significant nonrecurring income and expense items in 1998 and 1997 impacted the operating results of the Company. During the twelve month period ended December 31, 1998 the Company had $979,000 in securities gains and increased the provision for loan losses in 1998 by $660,000. For the period ending December 31, 1997, the Company had $250,000 in securities gains, a lower effective tax rate and collected $889,000 in net proceeds from a life insurance policy. The Company's return on average total assets and average shareholders' equity were 1.46% and 13.73% in 1998, compared with 1.93% and 19.67% in 1997.
Net Interest Income
The Company's primary source of operating earnings is net interest income, which is the difference between interest income on earning assets and interest expense on interest-bearing liabilities.
Net interest income has been adjusted to a fully taxable equivalent (FTE) basis for tax-exempt investments included in earning assets. Net interest income (FTE) was $12,855,000 in 1998, as compared to $12,104,000 in 1997. The increase in net interest income for 1998 resulted primarily from the increase in the average balances of investment securities and loans.
Average loans increased to $175,556,000 in 1998, or 4.81% over 1997, with an increase in average available for sale securities of 46.97% and a decrease in average held to maturity securities of 9.25%. Total interest income (FTE) increased to $21,438,000 in 1998 compared to $20,748,000 in 1997, representing a 3.32% increase.
Average interest-bearing deposits in 1998 totaled $213,484,000, as compared to $206,125,000 in 1997, or a 3.57% increase. Total interest expense increased to $8,583,000 as compared to $8,644,000 in 1997.
Net interest margin (determined by dividing net interest income by total average interest-earning assets) was 5.02% for 1998, as compared to 4.95% at year end 1997. The slight increase in 1998 in the net interest margin is attributed to the increases in loans, investments and deposits, and by an increase in the net spread (the difference between rates earned on interest earning assets and rates paid on deposits), affected primarily by a declining interest rate environment and the change in the mix between loans and investment securities in 1998. Average earning assets yielded 8.37% in 1998 compared to 8.49% in 1997. The decrease in the yields on earning assets was offset by the decrease in the rates paid on interest-bearing deposits. Rates paid declined to 4.02% in 1998 as compared to 4.19% in 1997. The interest spread was 4.35% in 1998 compared to 4.30% in 1997.
Non-Interest Income
Other non-interest income, which includes income derived from service charges on deposit accounts, loan servicing fees, other fees and charges, gain on sale of securities, and insurance proceeds decreased 1.04% to $4,095,000 in 1998 as compared to $4,138,000 in 1997. For the year ended December 31, 1998, there was a $729,000 increase in gains on sale of available for sale securities, and a $386,000 increase in service charges on deposit accounts, as compared to insurance proceeds of $1,139,000 received in 1997.
A summary of non-interest income for the past three years is presented below:
Non-Interest Income (in thousands) 1998 1997 1996 ------- ------- -------
Service charges on deposit accounts $ 1,786 $ 1,400 $ 1,342 Other fees and charges 624 570 520 Gain on sale of loans 130 160 160 Gain on sale of available for sale securities 979 250 31 Life insurance proceeds 0 1,139 0 Gain (loss) on sale of trading securities 0 0 (7) Other 576 619 535 ------- ------- ------- Total non-interest income $ 4,095 $ 4,138 $ 2,581 ======= ======= =======
Non-Interest Expense
Non-interest expense totaled $8,886,000 for 1998 compared to $8,312,000 in 1997. Salaries and employee benefits increased in 1998 to $4,679,000 compared to $4,522,000 in 1997. The increase in salary expense was attributed to the additional personnel for the new branches, along with increases in staff compensation. Salaries were affected in both years from payout of contractual obligations to senior executives no longer with the Company and in 1997 by a non-recurring benefit payment of $250,000. The increase in occupancy and furniture and equipment expense was attributed to the opening of two new in-store branches, the Business Banking Center, and the relocation of the Shasta Lake branch to a new facility. The increase in professional services for the period ending December 31, 1998 was attributed to the loan portfolio and technology reviews performed for the Company, and legal costs to establish the Incentive Stock Option plan for employees. In 1997, the Company contributed $170,000 from other non-interest expense to the North Valley Bank Scholarship Fund to fund future scholarships in the community.
The Company's efficiency ratio (derived by dividing total non-interest expenses by non-interest income and net interest income exclusive of provision for loan losses) was 55.6% in 1998 compared to 54.6% in 1997. The efficiency ratio is a measurement as to how efficiently the Company allocates its resources.
A summary of non-interest expense for the past three years is presented below:
Non-Interest Expense (in thousands) 1998 1997 1996 ------ ------ ------
Salaries & employee benefits $4,679 $4,522 $3,934 Occupancy expense 557 503 456 Furniture & equipment expense 666 553 497 Professional services 373 235 136 Data processing expenses 415 360 260 Printing & supplies 292 232 222 Postage 196 182 175 Donations 50 217 35 FDIC & State banking assessments 50 70 23 Messenger 178 139 136 ATM and Online expense 284 247 134 Other 1,146 1,052 778 ------ ------ ------ Total non-interest expense $8,886 $8,312 $6,786 ====== ====== ======
Income Taxes
In 1998 and 1997, the Company recorded a tax provision of $1,579,000 and $1,000,000, respectively. The effective income tax rate for state and federal income taxes increased to 27.9% in 1998, from 16.3% in 1997. The increase in the effective income tax rate in 1998 from 1997 is mainly due to the non taxability of the proceeds from a life insurance policy. Income taxes are based on income reported in the consolidated financial statements using the effective tax rate.
Impaired, Nonaccrual, Past Due, Restructured Loans and Other Real Estate Owned
The Company considers a loan impaired if, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral. For further discussion of SFAS 114, refer to Note 5 of the Financial Statements.
Nonaccrual loans consist of loans on which the accrual of interest has been discontinued and other loans where management believes that borrowers' financial condition is such that the collection of principal or interest is doubtful, or when a loan becomes contractually past due by 90 days or more with respect to interest or principal (except that when management believes a loan is well secured and in the process of collection, interest accruals are continued on loans considered by management to be fully collectible). Loans are charged off when management determines that the loan is considered uncollectible. Other real estate owned consists of real property acquired through foreclosure on the related collateral underlying defaulted loans.
The amount of non accrual loans increased during 1998 to $2,307,000 as compared to $536,000 in 1997. During the third quarter of 1998, the Company placed $1,891,000 in secured loans to a single borrower on nonaccrual status and charged off the unsecured portion of such borrower's note (see Allowance for Loan Losses).
A summary of non-performing assets for the past three years is presented below:
Non-Performing Assets (in thousands) 1998 1997 1996 ------ ------ ------
Nonaccrual loans $2,307 $ 536 $1,190 Accruing loans past due 90 days or more 364 244 14 Restructured loans -- -- -- Other real estate owned 575 212 69 ------ ------ ------ Total $3,246 $ 992 $1,273 ====== ====== ======
Allowance for Loan Losses
The Company maintains an allowance for loan losses to absorb inherent losses in the loan portfolio. Management attributes general reserves to different types of loans using percentages which are based upon perceived risk associated with the portfolio and underlying collateral. The allowance for possible loan losses is a general reserve available against the total loan portfolio and off balance sheet credit exposure. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for possible loan losses. Such agencies may require the Company to provide additions to the allowance based on their judgment of information available to them at the time of their examination. At December 31, 1998, based on known information, management believed that the allowance for loan losses was adequate to absorb losses inherent in existing loans and commitments to extend credit, based on evaluations of the collectibility and prior loss experience of loans and commitments to extend credit as of such date.
As of December 31, 1998, the allowance for possible loan losses was $1,902,000 as compared to the December 31, 1997 amount of $1,702,000. When a loan is considered uncollectible by management it is charged against the allowance for loan losses. Any recoveries on previously charged off loans are credited back to the allowance. Net charge-offs were $1,230,000, $322,000, and $791,000 in 1998, 1997, and 1996, respectively. Additions to the allowance for loan losses are charged against income. Provisions for loan losses of $1,430,000, $770,000, and $720,000 were charged to income in 1998, 1997, and 1996, respectively.
The evaluation process is designed to determine the adequacy of the allowance for loan losses. This process attempts to assess the risk of losses inherent in the loan portfolio by segregating the allowance for loan losses into three components: "Specific," "loss migration," and "general." The specific component is established by allocating a portion of the allowance for loan losses to individual classified credits on the basis of specific circumstances and assessments. The loss migration component is calculated as a function of the historical loss migration experience of the internal loan credit risk rating categories. The general component is an unallocated portion that supplements the first two components and includes:
management's judgement of the current economic conditions, borrower's financial condition, loan impairment, evaluation of the performing loan portfolio, continual evaluation of problem loans identified as having a higher degree of risk, off balance sheet risks, net charge off trends, and other factors.
December 31 1994 ----------------- Allowance % for of Losses Allowance Loan Categories: Commercial, financial and agricultural $ 583 51%
Real Estate - construction -0- -- Real Estate - mortgage 114 10% Installment 447 39%
Other -0- -- Unallocated -0- -- ------ --- $1,144 100% ====== ===
There is uncertainty concerning future economic trends. Accordingly, it is not possible to predict the effect future economic trends may have on the level of the provision for possible loan losses in future periods.
Liquidity and Interest Rate Sensitivity
The fundamental objective of the Company's management is to increase shareholders' value while maintaining adequate liquidity, to manage interest rate risk, and to increase the economic value of its assets and liabilities. Liquidity is the ability to provide funds to support asset growth and satisfy cash flow requirements created by fluctuations in deposits and to meet borrowers' credit needs. Effective liquidity management insures that sufficient funds are available to satisfy demands from depositors, borrowers and other commitments on a timely basis. Collection of principal and interest on loans, the liquidations and maturities of investment securities, deposits with other banks, deposit inflow and short term borrowing, when needed, are primary sources of funds that contribute to liquidity. Unused lines of credit from correspondent banks to provide federal funds in the aggregate amount of $6,000,000 as of December 31, 1998, were available to provide liquidity. In addition, the Bank is a member of the Federal Home Loan Bank ("FHLB") System provides an additional line of credit of $3,743,000 secured by first deeds of trust on eligible 1-4 unit residential loans. The Company had not utilized the line of credit from the FHLB as of December 31, 1998.
The Company manages both assets and liabilities by monitoring asset and liability mixes, volumes, maturities, yields and rates in order to preserve liquidity and earnings stability. Total liquid assets (cash and due from banks, federal funds sold, and investment securities) totaled $82,108,000 and $87,774,000 (or 27.71% and 32.42% of total assets) at December 31, 1998 and 1997, respectively. Total liquid assets for 1998 and 1997 include investment securities of $33,914,000 and $39,219,000, respectively, classified as held to maturity based on the Company's intent to hold such securities to maturity.
Core deposits, defined as demand deposits, NOW, regular savings, money market deposit accounts and time deposits of less than $100,000, continue to provide the Company with a relatively stable
and low cost source of funds. Core deposits totaled $241,412,000 and $220,608,000 at December 31, 1998 and 1997, respectively.
In assessing liquidity, historical information such as seasonal loan demand, local economic cycles and the economy in general are considered along with current ratios, management goals and unique characteristics of the Company. Management believes the Company is in compliance with its policies relating to liquidity.
The Company has no definitive commitments for capital expenditures in 1999 or beyond.
Parent company liquidity is maintained by cash flows stemming from dividends and the exercise of stock options issued to the Bank's employees and directors. The amount of dividends from the Bank is subject to certain regulatory restrictions as discussed in Note 16 of the Notes to the Consolidated Financial Statements and elsewhere within this Report. Subject to said restrictions, at December 31, 1998, up to $9.4 million could have been paid to the parent Company by the Bank without regulatory approval. Condensed financial statements of North Valley Bancorp are presented in Note 18 of the Notes to Consolidated Financial Statements.
Asset and liability management focuses on interest rate risk due to asset and liability cash flows and market interest rate movement. The primary objective of managing interest rate risk is to ensure that both assets and liabilities react to changes in interest rates to minimize the effects of interest rate movements on net interest income. An asset and liability management simulation model is used to quantify the exposure and impact of changing interest rates on earnings. That model projects changes by analyzing the mix and repricing characteristics of interest rate sensitive assets and liabilities using multipliers (how interest rates change when the Fed Funds rate changes by 1%) and lags (time it takes for rates to change after the Fed Funds rate changes). The model simulates the effects on net interest income when the Fed Funds rate experiences a 1% increase or decrease compared to current levels.
At December 31, 1998, the foregoing table indicates the Company as liability sensitive in the preceding twelve month period. The interest rate sensitivity gap is defined as the difference between amount of interest-earning assets anticipated to mature or reprice within a specific time period and the amount of interest-bearing liabilities anticipated to mature or reprice within that same time period. The yearend gap report is based on the contractual interest repricing date. The gap method does not consider the impact of different multipliers (how interest rates change when the Fed Funds rate changes by 1%) and lags (time it takes for rates to change after the Fed Funds rate changes). The interest rate relationships between the repriceable assets and repriceable liabilities are not necessarily constant and may be affected by many factors, including the behavior of customers in response to changes in interest rates and future impact of new business strategies. This table should, therefore, be used only as a guide as to the possible effect changes in interest rates might have on the net margins of the Company. The Company's model analyzes the impact on earnings of future rate changes by including factors for lags and multipliers for key bank rates. Both methods of measuring interest rate sensitivity do not take into account actions taken by management to modify the effect to net interest income if interest rates were to rise or fall.
Even though the Company had a negative gap in the twelve month period ended December 31, 1998, the asset liability simulation model showed the Bank was slightly asset sensitive in 1998. Due to a declining interest rate environment in 1998, the Bank's slightly asset sensitive posture had a positive impact on net interest margins. Even though the Bank is slightly asset sensitive the decline in yields on earning assets were offset by the reduction in yields on interest-bearing deposits.
Financial Condition
Total assets at December 31, 1998, were $296,362,000, representing an increase of 9.5% over December 31, 1997 assets of $270,757,000. Increased deposits were used to fund a 4.84% increase in average earning assets in 1998.
Investment securities and federal funds sold totaled $75,056,000 at December 31, 1998, compared to $78,932,000 at December 31, 1997. The Company is a member of Federal Home Loan Bank of San Francisco and holds $841,000 in FHLB stock. Additional information regarding investment securities held by the Company at year end 1998 is set forth in Note 3 of "Notes to Consolidated Financial Statements".
During 1998, net loans increased to $197,434,000 from $167,507,000 for the same period in 1997. Loans are the Company's major component of earning assets. The Bank's average loan to deposit ratio was 71.21% and 70.58% in 1998 and 1997, respectively. Additional information regarding loans is shown in Note 4 of the Notes to Consolidated Financial Statements.
Funding for increased investments and loan activity came from increases in deposits. Total deposits increased $21,359,000 in 1998 to $259,881,000, as compared to $238,522,000 in 1997. The majority of the increase was in interest-bearing instruments.
The Company maintains capital to support capital needs, future growth and dividend payouts while maintaining the confidence of depositors and investors by increasing shareholders' value. The Company has provided the majority of its capital requirements through the retention of earnings.
Shareholders' equity increased to $30,180,000 as of December 31, 1998, as compared to $28,066,000 as of December 31, 1997. This increase was primarily attributable to retention of earnings, offset by $1,383,000 in dividends to shareholders.
The Company's and the Bank's regulatory capital ratios continue to be strong and remain above regulatory minimums. The Company's total risk based capital ratio at December 31, 1998 was 15.05% and its Tier 1 Risk Based Capital (RBC) ratio was 14.14%, exceeding the minimum guidelines of 8% and 4%. The same ratios at December 31, 1997 were 15.73% and 14.80%, respectively.
The Company's leverage ratios were 10.18% and 9.94% at December 31, 1998 and 1997, respectively, exceeding the minimum guideline of 4%.
Under current regulations adopted by federal regulatory agencies, a "well-capitalized" institution must have a Tier 1 RBC ratio of at least 6%, a total capital ratio of at least 10% and leverage ratio of at least 5% and not be subject to a capital directive order. The Bank had a total capital ratio of 14.08%, a
Tier 1 RBC ratio of 13.17% and a leverage ratio of 9.49% at December 31, 1998, compared with 14.69%, 13.76% and 9.24%, respectively at December 31, 1997.
The most recent notifications from the Federal Deposit Insurance Corporation for the Bank as of December 31, 1998 and 1997, categorized the Bank as "well capitalized" under the regulatory framework for prompt corrective action. There are no conditions or events since such notification that management believes have changed the Bank's category.
Impact of Inflation
Impact of inflation on a financial institution differs significantly from that exerted on an industrial concern, primarily because a financial institution's assets and liabilities consist largely of monetary items. The relatively low proportion of the Bank's fixed assets (approximately 1.7% at December 31, 1998) reduces both the potential of inflated earnings resulting from understated depreciation and the potential understatement of absolute asset values.
Year 2000 Compliance
The inability of computers, software and other equipment utilizing microprocessors to recognize and properly process data fields containing a 2-digit year is commonly referred to as the Year 2000 Compliance issue. As the year 2000 approaches, such systems may be unable to accurately process certain date-based information.
The Company has a written plan to mitigate the risks associated with the impact of the Year 2000. The plan directs the Company's Year 2000 activities under the framework of the Federal Financial Institutions Examination Council (FFIEC) Five-Step Program. The FFIEC's Five-Step Program includes the following phases: Awareness, Assessment, Renovation, Validation and Implementation. The Awareness Phase, 100% complete, defines the Year 2000 problem and gains executive level support for the necessary resources to prepare the Company for Year 2000 compliance. The Assessment Phase, 100% complete, assesses the size and complexity of the problem and details the magnitude of the effort necessary to address the Year 2000 issues. Although the Awareness and Assessment Phases are complete, the Company will continue to evaluate any new issues as they arise. The Renovation Phase, 80% complete, includes the incremental changes to hardware and software components. The Validation Phase includes the testing of hardware and software components and is scheduled to be substantially complete by March 31, 1999. The Implementation Phase, 50% complete, certifies that systems are Year 2000 compliant and will be accepted by the end users. The Implementation Phase is scheduled to be substantially complete by June 30, 1999. The Company has completed the development of test and validation methodologies for its Information Technology (IT) systems. Testing of applications has begun and is scheduled to be substantially complete during the first quarter of 1999. In some cases, the Company will rely on the service providers and software vendors to facilitate proxy testing with a selected group of users. The Company will review the test plans and validate the results of the proxy testing to ensure the Year 2000 compliance of those systems. The Company's business also utilizes non-IT products and services, some of which have embedded technology, which might not be Year 2000 ready. Some non-IT products and services involve infrastructure issues such as power, communication and water, as well as elevators, ventilation and air conditioning equipment. The Company classifies power and communications as non-IT products and services and considers them to be of significant importance, giving them high priority. Based on responses from vendors and software providers, the Company does not anticipate incurring any material expenses due to unpreparedness. The Company has identified material third party
relationships to minimize the potential loss from unpreparedness of these parties. The Company continues to work closely with Jack Henry & Associates, its data services and items processing provider, regarding Year 2000 compliance. The testing and validation of this system was substantially complete by December 31, 1998.
The Company is making efforts to ensure that its customer base is aware of the Year 2000 problem. Year 2000 correspondence has been sent to both deposit and loan customers. The Bank has amended its credit authorization documentation to include consideration regarding the Year 2000 problem. Significant customers relationships have been identified, and such customers are being contacted by the Bank's employees to determine whether they are aware of Year 2000 risks and whether they are taking preparatory actions.
The total cost to the Company of these Year 2000 Compliance activities was approximately $28,100 for 1998 and the Company has budgeted approximately $110,000 for 1999. Costs associated with the modifications necessary are being expensed by the Company during the period in which they are incurred. These costs and the date on which the Company plans to complete the Year 2000 modification and testing processes are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources, third party modification plans and other factors. However, there can be no guarantee that the estimates of costs for 1999 will be accurate since actual results could differ from those plans. The costs incurred in 1998 did not have a material effect on the Company's net income for 1998 and the Company does not expect the costs incurred for the same period in 1999 to have a material effect on net income. It is anticipated that any disruption of services would be partial and brief, and that there will not be a material impact on revenues or earnings.
The Company and the Bank are developing contingency plans to address the possibility that efforts to mitigate Year 2000 risk are not successful either in whole or in part. These plans will include remedial efforts up to and including complete manual processing of information for critical IT systems in the event there is a failure after December 31, 1999. The Company's contingency plan should be completed by April 30, 1999, after which time the appropriate implementation training would take place.
The disclosure set forth above contains forward-looking statements. Specifically, such statements are contained in sentences including the words "expect" or "anticipate". Such forward-looking statements are subject to inherent risks and uncertainties that may cause actual results to differ materially from those contemplated by such forward-looking statements. The factors that may cause actual results to differ materially from those contemplated by the forward-looking statements include the failure by third parties to adequately remediate Year 2000 issues or the inability of the Company to complete writing and/or testing software changes on time schedules currently expected. Nevertheless, the Company expects that its Year 2000 compliance efforts will be successful without any adverse effects on its business.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Derivative financial instruments include futures, forwards, interest rate swaps, option contracts, and other financial instruments with similar characteristics. The Company currently does not enter into futures, forwards, swaps or options. However, the Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and letters of credit. These instruments
involve to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. 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 and generally require collateral from the borrower. Letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party up to a stipulated amount and with specified terms and conditions.
Commitments to extend credit and letters of credit are not recorded as an asset or liability by the Company until the instrument is exercised.
The Company's exposure to market risk is reviewed on a regular basis by management. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximize income. Management realizes certain risks are inherent and that the goal is to identify and minimize the risks. An asset and liability management simulation model is used by the Company to quantify the exposure and impact of changing interest rates on earnings. The Company has no market risk sensitive instruments held for trading purposes. In the opinion of management, it appears the Company's market risk is reasonable at this time. The condensed GAP report summarizing the Company's interest rate sensitivity is as follows:
Average Estimated Interest Fair Total Rate Value
ASSETS
Debt Securities $56,569 5.79% $58,594
Loans 199,785 8.44% 202,990
LIABILITIES
Savings, Demand, MMDA 103,915 2.31% 103,915
Time Deposits $118,594 4.96% $118,951
Average Estimated Interest Fair Total Rate Value
ASSETS
Debt Securities $63,525 6.00% $65,614
Loans 169,844 9.23% 171,486
LIABILITIES
Savings,Demand, MMDA 88,110 2.70% 88,110
Time Deposits $118,159 5.29% $118,448
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Financial Statements required by this item are set forth following Item 14 of this Form 10-K, and are incorporated herein by reference.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT
The information concerning directors and executive officers required by this item is incorporated by reference from the section of the Company's Definitive Proxy Statement for the 1999 Annual Meeting of Shareholders of the Company to be filed with the Securities and Exchange Commission (the "Commission") entitled "Election of Directors" (not including the share information included in the beneficial ownership tables nor the footnotes thereto nor the subsections entitled "Committees of the Board of Directors", "Compensation Committee Interlocks and Insider Participation" and "Meetings of the Board of Directors.") and the section entitled "Section 16(a) Beneficial Ownership Reporting Compliance."
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference from the section of the Company's Definitive Proxy Statement for the 1999 Annual Meeting of Shareholders of the Company to be filed with the Commission entitled "Executive Compensation" and the subsection entitled "Election of Directors - Compensation Committee Interlocks and Insider Participation."
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information required by this item is incorporated by reference from sections of the Company's Definitive Proxy Statement for the 1999 Annual Meeting of Shareholders of the Company to be filed with the Commission, entitled "Election of Directors - Security Ownership of Certain Beneficial Owners and Management", as to share information in the tables of beneficial ownership and footnotes thereto.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required by this item is incorporated by reference from the section of the Company's Definitive Proxy Statement for the 1999 Annual Meeting of Shareholders to be filed with the Commission, entitled "Certain Relationships and Related Transactions".
ITEM 14.
ITEM 14. EXHIBITS AND REPORTS ON FORM 8-K
(A) The following documents are filed as part of the report:
1. Financial Statements:
2. Exhibits:
See Index to Exhibits at page 72.
(B) Reports on Form 8-K.
No reports on Form 8-K were filed by the Company during the last quarter of 1998.
(C) Exhibits
See Index to Exhibits at page 72 of this Annual Report on Form 10-K, which is incorporated herein by reference.
(D) Financial Statement Schedules
Not applicable.
NORTH VALLEY BANCORP AND SUBSIDIARIES
Consolidated Financial Statements as of December 31, 1998 and 1997 and for each of the Three Years in the Period Ended December 31, 1998 and Independent Auditors' Report
Deloitte & Touche Deloitte & Touche LLP Telephone: (916) 498-7100 Suite 2000 Facsimile: (916) 444-7963 400 Capitol Mall Sacramento, California 95814-4424
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders North Valley Bancorp Redding, California
We have audited the accompanying consolidated balance sheets of North Valley Bancorp and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the North Valley Bancorp and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles.
/s/ Deloitte & Touche LLP
January 27, 1999
Deloitte Touche Tohmatsu
NORTH VALLEY BANCORP AND SUBSIDIARIES
NORTH VALLEY BANCORP AND SUBSIDIARIES
NORTH VALLEY BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 - --------------------------------------------------------------------------------
1. SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations - North Valley Bancorp and subsidiaries (Company) operates 12 branches, which include two supermarket branches, in Shasta and Trinity Counties in Northern California. The Company operates as one business segment providing banking services to the Company's clients in Northern California. The Company's principal business consists of attracting deposits from the general public and using the funds to originate commercial, real estate and installment loans to customers, who are predominately small and middle market businesses and middle income individuals. The Company's primary source of revenues is interest income from its loan and investment securities portfolios. The Company is not dependent on any single customer for more than ten percent of the Company's revenues.
General - The accounting and reporting policies of the Company conform to generally accepted accounting principles and to prevailing practices within the banking industry. The Company follows the accrual method of accounting.
Use of Estimates in the Preparation of Financial Statements - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
The more significant accounting and reporting policies are discussed below.
Consolidation - The consolidated financial statements include North Valley Bancorp and its wholly owned subsidiaries, Bank Processing, Inc., North Valley Trading Company, and North Valley Bank (the Bank) and its wholly-owned subsidiary, North Valley Basic Securities. North Valley Trading Company and North Valley Basic Securities did not have any activity in 1998. All material intercompany accounts and transactions have been eliminated in consolidation.
Cash and Cash Equivalents - For the purposes of the statements of cash flows, cash and cash equivalents have been defined as cash, demand deposits with correspondent banks, cash items and settlements in transit, and federal funds sold. Generally, federal funds are sold for one-day periods. Cash equivalents have remaining terms to maturity of three months or less from the date of acquisition.
Investments - The Company's policy with regard to investments is as follows:
Trading securities are carried at fair value. Changes in fair value are included in other operating income. The Company did not have any securities classified as trading at December 31, 1998 and 1997.
Available for sale securities are carried at fair value and represent securities not classified as trading securities nor as held to maturity securities. Unrealized gains and losses resulting from changes in fair value are recorded, net of tax, as a separate component of stockholders' equity. Gains or losses on disposition are recorded in other operating income based on the net proceeds received and the carrying amount of the securities sold, using the specific identification method.
Held to maturity securities are carried at cost adjusted for amortization of premiums and accretion of discounts, which are recognized as adjustments to interest income. The Company's policy of carrying such investment securities at amortized cost is based upon its ability and management's intent to hold such securities to maturity.
Loans Receivable - Loans are reported at the principal amount outstanding, net of deferred loan fees and the allowance for loan losses. Interest on loans is calculated by using the simple interest method on the daily balance of the principal amount outstanding.
Loans on which the accrual of interest has been discontinued are designated as nonaccrual loans. Accrual of interest on loans is discontinued either when reasonable doubt exists as to the full and timely collection of interest or principal, or when a loan becomes contractually past due by 90 days or more with respect to interest or principal. When a loan is placed on nonaccrual status, all interest previously accrued but not collected is reversed against current period interest income. Income on such loans is then recognized only to the extent that cash is received and where the future collection of principal is probable. Interest accruals are resumed on such loans when, in the judgment of management, the loans are estimated to be fully collectible as to both principal and interest.
Deferred Loan Fees - Loan fees and certain related direct costs to originate loans are deferred and amortized to income by a method that approximates a level yield over the contractual life of the underlying loans.
Allowance for Loan Losses - The allowance for loan losses is established through a provision for loan losses charged to operations. Loans are charged against the allowance for loan losses when management believes that the collectibility of the principal is unlikely or, with respect to consumer installment loans, according to an established delinquency schedule. Management attributes general reserves to different types of loans using percentages which are based upon perceived risk associated with the portfolio and underlying collateral, historical loss experience, and vulnerability to changing economic conditions which may affect the collectibility of the loans. Specific reserves are allocated for impaired loans, for loans which have experienced a decline in internal loan grading, and when management believes additional loss exposure exists. Although the allowance for loan losses is allocated to various portfolio segments, it is general in nature and is available for the loan portfolio in its entirety. The allowance is an amount that management believes will be adequate to absorb losses inherent in existing loans and commitments to extend credit. Actual amounts could differ from those estimates.
The Company considers a loan impaired if, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral.
Premises and Equipment - Premises and equipment are stated at cost less accumulated depreciation, which is computed principally on the straight-line method over the estimated useful lives of the respective assets. Leasehold improvements are amortized on the straight-line method over the shorter of the estimated useful lives of the improvements or the terms of the respective leases.
Other Real Estate Owned - Real estate acquired through, or in lieu of, loan foreclosures is expected to be sold and is recorded at the date of foreclosure at the lower of the recorded investment in the property or its fair value less estimated costs to sell (fair value) establishing a new cost basis through a charge to allowance for loan losses, if
necessary. After foreclosure, valuations are periodically performed by management with any subsequent write-downs recorded as a valuation allowance and charged against operating expenses. Operating expenses of such properties, net of related income are included in other expenses and gains and losses on their disposition are included in other income and other expenses.
Income Taxes - The Company applies an asset and liability method in accounting for deferred income taxes. Deferred tax assets and liabilities are calculated by applying applicable tax laws to the differences between the financial statement basis and the tax basis of assets and liabilities. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date.
Preferred Stock - During 1998, the Board of Directors amended the Articles of Incorporation to authorize 5,000,000 shares of no par value preferred stock. There were no shares of preferred stock outstanding at December 31, 1998.
Common Stock Split - On September 21, 1998, the Company's Board of Directors authorized a two-for-one stock split distributed on October 30, 1998 to stockholders of record as of October 15, 1998. This resulted in the issuance of 1,844,610 additional shares of common stock. All share and per share amounts have been restated to reflect this stock split.
Stock-Based Compensation - The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to Employees. The Company presents the required pro forma disclosures of the effect of stock-based compensation on net income and earnings per share using the fair value method in accordance with Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation.
Comprehensive Income - The Company has retroactively adopted SFAS No. 130, Reporting Comprehensive Income, which requires that an enterprise report and display, by major components and as a single total, the change in its net assets during the period from nonowner sources. The adoption of this Statement resulted in a change in the financial statement presentation but did not have an impact on the Company's consolidated financial position, results of operations or cash flows.
Disclosures About Segments of an Enterprise - On January 1, 1998, the Company adopted SFAS No. 131, Disclosures About Segments Of An Enterprise And Related Information, which establishes annual and interim reporting standards for an enterprise's business segments and related disclosures about its products, services, geographic areas, and major customers. This statement will not impact the Company's consolidated financial position, results of operations or cash flows. Management evaluates the Company's performance as a whole and does not allocate resources based on the performance of different lending or transaction activities. Therefore, the financial disclosures of this standard related to operating performance of reportable segments do not apply.
Disclosures About Pensions and Other Post Retirement Benefits - On January 1, 1998, the Company adopted SFAS No. 132, Employers' Disclosures about Pensions and Other Postretirement Benefits, which revises employers' disclosures about pension and other postretirement benefit plans. It does not change the measurement or recognition of those plans.
New Accounting Pronouncements - In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, Accounting For Derivative Instruments and Hedging Activities. The statement establishes accounting and reporting standards for derivative instruments and hedging activities. The statement is effective for all fiscal quarter of fiscal years beginning after June 15, 1999. The Company is in the process of determining the impact of SFAS No. 133 on the Company's financial position and results of operations.
Reclassification - Certain amounts in 1997 and 1996 have been reclassified to conform with the 1998 financial statement presentation.
2. RESTRICTED CASH BALANCES
The Bank is subject to regulation by the Federal Reserve Board. The regulations required the Bank to maintain average cash reserve balances on hand or at the Federal Reserve Bank of $1,009,000 and $3,345,000 at December 31, 1998 and 1997. As compensation for check-clearing services, additional compensating balances of $1,000,000 are required to be maintained with the Federal Reserve Bank.
3. SECURITIES
Gross realized gains on sales of securities categorized as available for sale securities were $979,000, $250,000 and $31,000 in 1998, 1997 and 1996. There were no gross realized losses on sale of available for sales securities in 1998, 1997 or 1996.
Scheduled maturities of held to maturity and available for sale securities (other than equity securities with an amortized cost of approximately $215,000 and a carrying value of approximately $187,000) at December 31, 1998, are shown below (in thousands). Expected maturities may differ from contractual maturities because borrowers may have the right to prepay with or without penalty.
At December 31, 1998 and 1997, securities having carrying amounts of approximately $16,448,000 and $18,790,000 were pledged to secure public deposits and short-term borrowings and for other purposes required by law or contract.
4. LOANS RECEIVABLE
The Company originates loans for business, consumer and real estate activities. Such loans are concentrated in Shasta and Trinity Counties and neighboring communities. Substantially all loans are collateralized. Generally, real estate loans are secured by real property. Commercial and other loans are secured by bank deposits or business or personal assets. The Company's policy for requiring collateral reflects the Company's analysis of the borrower, the borrower's industry and the economic environment in which the loan would be granted. The loans are expected to be repaid from cash flows or proceeds from the sale of selected assets of the borrower.
Major classifications of loans at December 31 were as follows (in thousands):
1998 1997
Commercial $ 72,102 $ 64,666 Real estate - construction 4,177 1,688 Real estate - mortgage 52,909 45,590 Installment 56,686 44,510 Other 13,911 13,390 -------- -------- Total loans receivable 199,785 169,844
Less: Allowance for loan losses 1,902 1,702 Deferred loan fees 449 635 -------- -------- Net loans receivable $197,434 $167,507 ======== ========
At December 31, 1998 and 1997, the Bank serviced real estate loans and loans guaranteed by the Small Business Administration which it had sold to the secondary market of approximately $78,568,000 and $88,640,000.
Changes in the allowance for loan losses for the years ended December 31, were as follows (in thousands):
1998 1997 1996
Balance, beginning of year $ 1,702 $ 1,254 $ 1,325 Provision charged to operations 1,430 770 720 Loans charged off (1,360) (362) (813) Recoveries 130 40 22 ------- ------- -------
Balance, end of year $ 1,902 $ 1,702 $ 1,254 ======= ======= =======
5. IMPAIRED AND NONPERFORMING LOANS
At December 31, 1998 and 1997, the recorded investment in loans for which impairment has been recognized was approximately $2,871,000 and $4,353,000. Of the 1998 balance approximately $2,269,000 has a related valuation allowance of $226,900. The remaining $602,000 did not require a valuation allowance. No significant impaired balances required a valuation allowance at December 31, 1997. For the years ended December 31, 1998, 1997 and 1996, the average recorded investment in loans for which impairment has been recognized was approximately $3,201,000, $3,455,000 and $2,244,000. During the portion of the year that the loans were impaired the Company recognized interest income of approximately $232,000, $153,000 and $203,000 for cash payments received in 1998, 1997 and 1996.
Nonperforming loans at December 31 were as follows (in thousands):
1998 1997
Nonaccrual loans $2,307 $ 536 Loans 90 days past due but still accruing interest 364 244 ------ ------
Total nonaccrual and 90 days past due loans $2,671 $ 780 ====== ======
If interest on nonaccrual loans had been accrued, such income would have approximated $132,000, in 1998, $32,000 in 1997 and $82,000 in 1996. Interest income of $33,000 in 1998, $28,000 in 1997, and $27,000 in 1996 was
recorded when it was received on the nonaccrual loans.
At December 31, 1998, there were no commitments to lend additional funds to borrowers whose loans were classified as nonaccrual.
6. PREMISES AND EQUIPMENT
Major classifications of premises and equipment at December 31 are summarized as follows (in thousands): 1998 1997
Land $ 1,080 $ 1,080 Buildings and improvements 4,323 4,084 Furniture, fixtures and equipment 4,902 4,234 Leasehold improvements 174 174 -------- -------- 10,479 9,572
Accumulated depreciation and amortization (5,451) (4,925) -------- --------
$ 5,028 $ 4,647 ======== ========
Building and equipment rental expense was approximately $90,000 for the year ended December 31, 1998 and $77,000 for the years ended December 31, 1997 and 1996.
7. OTHER ASSETS
Major classifications of other assets at December 31 were as follows (in thousands):
1998 1997
Cash surrender value of life insurance policies $3,850 $3,009 Prepaid expenses 723 745 Income tax receivable 664 528 Deferred taxes 1,786 1,881 Other 710 71 ------ ------
Total $7,733 $6,234 ====== ======
8. DEPOSITS
The aggregate amount of time certificates of deposit in denominations of $100,000 or more was $18,469,000 and $17,914,000 at December 31, 1998 and 1997. Interest expense incurred on such time certificates of deposit was $713,000, $925,000, and $882,000, for the years ended December 31, 1998, 1997 and 1996.
At December 31, 1998, the scheduled maturities of all time deposits was as follows (in thousands):
Year Amount
1999 $ 112,444 2000 5,281 2001 780 2002 11 2003 and thereafter 78 ----------
Total $ 118,594 ==========
9. LINES OF CREDIT
At December 31, 1998, the Bank had the following lines of credit with correspondent banks to purchase federal funds (in thousands):
Type Amount Expiration
Unsecured $6,000 July 31, 1999 Secured $3,743 Quarterly (First deeds of trust on eligible 1-4 unit residential loans)
10. INCOME TAXES
The provision for income taxes for the years ended December 31, was as follows (in thousands):
1998 1997 1996 Currently payable: Federal $ 459 $ 1,185 $ 1,212 State 530 490 647 ------- ------- ------- Total 989 1,675 1,859 ------- ------- -------
Deferred taxes (benefit): Federal 565 (539) (297) State 25 (136) (30) ------- ------- ------- Total 590 (675) (327) ------- ------- -------
Total $ 1,579 $ 1,000 $ 1,532 ======= ======= =======
The effective federal tax rate for the years ended December 31, differs from the statutory tax rate as follows:
1998 1997 1996
Federal income tax at statutory rates 35.0% 35.0% 35.0% State income taxes, net of federal income tax benefit 6.5 3.8 7.4 Tax exempt income (13.7) (13.6) (14.2) Officer's life insurance proceeds (6.3) Other .1 (2.6) (1.0) ------ ------ ------
Total 27.9% 16.3% 27.2% ====== ====== ======
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's net deferred tax asset at December 31, are as follows (in thousands):
1998 1997
Deferred tax assets: Allowance for loan losses $ 522 $ 530 Deferred loan fee income 201 285 Deferred compensation 635 530 Accrued pension obligation 673 651 Accrued severance 62 119 Mark to market adjustment 333 Alternative minimum tax credit 108 ------- -------
Total deferred tax assets 2,093 2,556 ------- -------
Deferred tax liabilities: Tax depreciation in excess of book depreciation (133) (119) California franchise tax (7) (26) Unrealized gain on securities available for sale (8) (297) Mark to market adjustment (23) Other (342) (233) ------- -------
Total deferred tax liabilities (513) (675) ------- -------
Net deferred tax asset $ 1,580 $ 1,881 ======= =======
The Company believes that it is more likely than not that it will realize the above deferred tax assets in the future periods; therefore, no valuation allowance has been provided against its deferred tax assets.
11. RETIREMENT AND DEFERRED COMPENSATION PLANS
Substantially all employees with at least one year of service participate in a Company-sponsored employee stock ownership plan (ESOP). The Company made contributions to the ESOP of $60,000 in 1998, 1997 and 1996, respectively. At December 31, 1998, the ESOP owned approximately 191,000 shares of the Company's stock.
The Company maintains a 401(k) plan covering employees who have completed 1,000 hours of service during a 12-month period and are aged 21 or older. Voluntary employee contributions are partially matched by the Company. The Company made contributions to the Plan for the years ended December 31, 1998, 1997, and 1996 of $26,000, $20,000, and $21,000, respectively.
The Company has a nonqualified executive deferred compensation plan for key executives and directors. Under this plan, participants voluntarily elect to defer a portion of their salary, bonus or fees and the Company is required to credit these deferrals with interest. The Company's deferred compensation obligation of $1,415,000 and $1,183,000 as of December 31, 1998 and 1997, respectively, is included in accrued interest and other liabilities.
The Company has a supplemental retirement plan for directors and a supplemental executive retirement plan covering key executives. These plans are nonqualified defined benefit plans and are unsecured and unfunded. The Company has purchased insurance on the lives of the participants and intends to use the cash values of these policies ($3,850,000 and $3,009,000 at December 31, 1998 and 1997, respectively) to pay the retirement obligations. The accrued pension obligation of $2,325,000, $1,927,000, and $1,544,000, as of December 31, 1998, 1997, and 1996, respectively, is included in accrued interest and other liabilities.
12. STOCK BASED COMPENSATION
During 1998 each director was awarded 600 shares of common stock, resulting in an additional 4,200 shares being issued.
The fair value of the options granted during 1998, 1997 and 1996 is estimated as $311,000, $45,000, and $36,000 on the date of grant using a binomial option-pricing model with the following assumptions: $0.375 annual dividend, volatility of 21.89%, 15.19%, and 15.19%, risk-free interest rate of 5.40%, 6.36%, 5.37%, assumed forfeiture rate of zero, and an expected life of six years. The weighted average per share fair value of the 1998, 1997 and 1996 awards was $5.10, $3.22, and $2.57, respectively. The impact of outstanding nonvested stock options granted prior to 1995 has been excluded from the pro forma calculations; accordingly the 1996, 1997 and 1998 pro forma adjustments are not indicative of future pro forma adjustments when the calculation will apply to all applicable stock options.
13. EARNINGS PER SHARE
Basic earnings per share is computed by dividing net income by the weighted average common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if options or other contracts to issue common stock were exercised and converted into common stock.
14. COMMITMENTS AND CONTINGENCIES
The Company is involved in a number of legal actions arising from normal business activities. Management, based upon the advice of legal counsel, believes that the ultimate resolution of all pending actions will not have a material effect on the financial statements.
The Bank was contingently liable under letters of credit issued on behalf of its customers in the amount of $485,000 and $1,189,000 at December 31, 1998 and 1997. At December 31, 1998 commercial and consumer lines of credit, and real estate loans of approximately $23,975,000 and $2,191,000 respectively, were undisbursed. These instruments involve, to varying degrees, elements of credit and market risk in excess of the amounts recognized in the balance sheet. The contractual or notional amounts of these transactions express the extent of the Bank's involvement in these instruments and do not necessarily represent the actual amount subject to credit loss.
15. RELATED PARTY TRANSACTIONS
At December 31, 1998 and 1997, certain officers and directors and their associates were indebted to the Bank for loans made on substantially the same terms, including interest rates and collateral, as comparable transactions with unaffiliated parties.
16. REGULATORY MATTERS
The Company and the Bank are subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - and, possibly, additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the Company's consolidated financial statements. Under capital adequacy guidelines, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company's and the Bank's assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Company's and the Bank's capital amounts and the Bank's prompt corrective action 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 the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 1998, that the Company and the Bank meet all capital adequacy requirements to which they are subject.
The most recent notifications from the Federal Deposit Insurance Corporation for the Bank as of December 31, 1998 and 1997, categorized the Bank as well capitalized under the regulatory framework for prompt correction action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier I risk-based, Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Bank's category.
The Company's and the Bank's actual capital amounts (in thousands) and ratios are also presented, respectively, in the following tables.
Under federal and California state banking laws, dividends paid by the Bank to the Company in any calendar year may not exceed certain limitations without the prior written approval of the appropriate bank regulatory agency. At December 31, 1998, the amount available for such dividends without prior written approval was approximately $9,384,000. Similar restrictions apply to the amounts and terms of loans, advances and other transfers of funds from the Bank to the Company.
17. FAIR VALUE OF FINANCIAL INSTRUMENTS
SFAS No. 107, Disclosures About Fair Value of Financial Instruments requires certain disclosures regarding the estimated fair value of financial instruments for which it is practicable to estimate. Although management uses its best judgment in assessing fair value, there are inherent weaknesses in any estimating technique that may be reflected in the fair values disclosed. The fair value estimates are made at a discrete point in time based on relevant market data, information about the financial instruments, and other factors. Estimates of fair value of instruments without quoted market prices are subjective in nature and involve various assumptions and estimates that are matters of judgment. Changes in the assumptions used could significantly affect these estimates. Fair value has not been adjusted to reflect changes in market conditions subsequent to December 31, 1998, therefore, estimates presented herein are not necessarily indicative of amounts which could be realized in a current transaction.
The following estimates and assumptions were used as of December 31, 1998 and 1997 to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value.
(a) Cash and Cash Equivalents - The carrying amount represents a reasonable estimate of fair value.
(b) Securities - Held to maturity securities are based on quoted market prices, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. Available for sale securities are carried at fair value.
(c) Loans Receivable - Commercial loans, residential mortgages, and construction loans, are segmented by fixed and adjustable rate interest terms, by maturity, and by performing and nonperforming categories.
The fair value of performing loans is estimated by discounting contractual cash flows using the current interest rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Assumptions regarding credit risk, cash flow, and discount rates are judgmentally determined using available market information.
The fair value of nonperforming loans and loans delinquent more than 30 days is estimated by discounting estimated future cash flows using current interest rates with an additional risk adjustment reflecting the individual characteristics of the loans.
(d) Cash Surrender Value of Life Insurance - The carrying amount represents a reasonable estimate of fair value.
(e) Deposit Liabilities - Noninterest bearing and interest bearing demand deposits and savings accounts are payable on demand and are assumed to be at fair value. Time deposits are based on the discounted value of contractual cash flows. The discount rate is based on rates currently offered for deposits of similar size and remaining maturities.
(f) Commitments to Fund Loans/Standby Letters of Credit - The fair values of commitments are estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. The differences between the carrying value of commitments to fund loans or stand by letters of credit and their fair value is not significant and therefore not included in the following table.
18. CONDENSED FINANCIAL INFORMATION OF NORTH VALLEY BANCORP
The condensed financial statements of North Valley Bancorp are presented below (in thousands except share amounts):
NORTH VALLEY BANCORP
BALANCE SHEETS DECEMBER 31, 1998 AND 1997 --------------------------
1998 1997 Assets: Cash and cash equivalents $ 2,332 $ 554 Available for sale securities at fair value 187 2,230 Investments in subsidiaries 28,326 25,556 Other assets 208 ---------- ----------
Total $ 31,053 $ 28,340 ========== ==========
Liabilities and stockholders' equity: Dividend payable $ 738 Other liabilities 135 $ 274 Stockholders' equity 30,180 28,066 ---------- ----------
Total $ 31,053 $ 28,340 ========== ==========