ITEM 1. BUSINESS
Washington Trust Bancorp, Inc. Washington Trust Bancorp, Inc. (the "Corporation" or "Washington Trust") is a publicly-owned, registered bank holding company, organized in 1984 under the laws of the state of Rhode Island, whose subsidiaries are permitted to engage in banking and other financial services and businesses. The Corporation conducts its business through its wholly-owned subsidiary, The Washington Trust Company (the "Bank"), a Rhode Island chartered commercial bank. The deposits of the Bank are insured by the Federal Deposit Insurance Corporation ("FDIC"), subject to regulatory limits.
The Corporation was formed in 1984 under a plan of reorganization in which outstanding common shares of The Washington Trust Company were exchanged for common shares of Washington Trust Bancorp, Inc. At December 31, 1998 the Corporation had total consolidated assets of $935.1 million, deposits of $575.3 million and equity capital of $73.1 million.
The Washington Trust Company The Washington Trust Company was originally chartered in 1800 as the Washington Bank and is the oldest banking institution headquartered in its market area. Its current corporate charter dates to 1902. See discussion under "Market Area and Competition" for further information.
The Bank provides a broad range of financial services, including:
Residential mortgages Commercial and consumer demand deposits Commercial loans Savings, NOW and money market deposits Construction loans Certificates of deposit Consumer installment loans Retirement accounts Home equity lines of credit Cash management services VISA and Mastercard accounts Safe deposit boxes Merchant credit card services Trust and investment management services Automated teller machines (ATMs) Telephone banking services
Automated teller machines (ATMs) are located throughout the Bank's market area. The Bank is a member of various ATM networks.
Data processing for most of the Bank's deposit and loan accounts and other applications is conducted internally, using owned equipment. Application software is primarily obtained through purchase or licensing agreements.
The Bank provides fiduciary services as trustee under wills and trust agreements; as executor or administrator of estates; as a provider of agency and custodial investment services to individuals and institutions; and as a trustee for employee benefit plans. The market value of total trust assets amounted to $789.8 million as of December 31, 1998.
The Bank's primary source of income is net interest income, the difference between interest earned on interest-earning assets and interest paid on interest-bearing deposits and other borrowed funds. Sources of noninterest income include fees for management of customer investment portfolios, trusts and estates, service charges on deposit accounts, gains on sales of loans, merchant processing fees and other banking-related fees. Noninterest expenses include the provision for loan losses, salaries and employee benefits, occupancy, equipment, office supplies, merchant processing, advertising and promotion and other administrative expenses.
The Bank's lending activities are conducted primarily in southern Rhode Island and southeastern Connecticut. The Bank provides a variety of commercial and retail lending products. The Bank generally underwrites its residential mortgages based upon secondary market standards. Loans are originated both for sale in the secondary market as well as for portfolio. Most secondary market loans are sold with servicing retained.
The following is a summary of the relative amounts of income producing functions as a percentage of gross operating income during the past five years:
1998 1997 1996 1995 1994 - -------------------------------------------------------------------------------- Interest and fees on: Residential real estate loans 20% 22% 27% 29% 31% Commercial and other loans 24 27 30 33 32 Consumer loans 9 9 10 10 9 - -------------------------------------------------------------------------------- Total loan income 53 58 67 72 72
Interest and dividends on securities 30 27 18 13 13 Trust revenue 7 7 7 7 7 Other noninterest income 10 8 8 8 8 - -------------------------------------------------------------------------------- Gross operating income 100% 100% 100% 100% 100% - --------------------------------------------------------------------------------
The percentage of gross income derived from interest and fees on loans was 53% in 1998, down from a five-year high of 72% in 1995. Income derived from interest and dividends on securities was 30% in 1998 and resulted from growth in the portfolio due to a securities purchase program. (See the caption "Securities" in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations.)
Market Area and Competition The Bank's market area includes Washington County and a portion of Kent County in southern Rhode Island, as well as a portion of New London County in southeastern Connecticut. The Bank operates eleven banking offices in these Rhode Island and Connecticut counties. The locations of the banking offices are as follows:
Westerly, RI (3 locations) Charlestown, RI Narragansett, RI Richmond, RI North Kingstown, RI New Shoreham (Block Island), RI Mystic, CT (3 locations)
The Bank's banking offices in Charlestown and on Block Island are the only bank facilities in those Rhode Island communities. The Bank opened a financial services branch office during the first quarter of 1998 in New London, Connecticut, which offers trust and investment management, commercial lending and residential mortgage origination.
The Bank faces strong competition from branches of major Rhode Island and regional commercial banks, local branches of certain Connecticut banks, as well as various credit unions, savings institutions and, to some extent, finance companies. The principal methods of competition are through interest rates, financing terms and other customer conveniences. The Bank had 32% of total deposits reported by all financial institutions for communities in which the Bank operates banking offices as of June 30, 1998. The closest competitor held 23%, and the second closest competitor held 15% of total deposits in the same communities. The Corporation believes that being the largest commercial banking institution headquartered within the market area provides a competitive advantage over other financial institutions. The Bank has a marketing department which is responsible for the review of existing products and services and the development of new products and services.
Employees As of December 31, 1998 the Corporation employed approximately 320 full-time and 51 part-time employees, an increase of 8.7% in full-time equivalent employees over 1997. The increase in employees is primarily attributable to the Corporation's market area expansion efforts that began in 1997. Management believes that its employee relations are good.
Supervision and Regulation General - The business in which the Corporation and the Bank are engaged is subject to extensive supervision, regulation, and examination by various bank regulatory authorities and other agencies of federal and state government. The supervisory and regulatory activities of these authorities are often intended primarily for the protection of customers or are aimed at carrying out broad public policy goals that may not be directly related to the financial services provided by the Corporation and the Bank, nor intended for the protection of the Corporation's shareholders. To the extent that the following information describes statutory and regulatory provisions, it is qualified in its entirety by reference to the particular statutory and regulatory provisions. Proposals to change regulations and laws which affect the banking industry are frequently raised at the federal and state level. The potential impact on the Corporation of any future revisions to the supervisory or regulatory structure cannot be determined.
The Corporation and the Bank are required by various authorities to file extensive periodic reports of financial and other information and such other reports as the regulatory and supervisory authorities may require. The Corporation is also subject to the reporting and other requirements of the Securities Exchange Act of 1934, as amended.
The Corporation is a bank holding company registered under the Bank Holding Company Act of 1956, as amended (the "BHC Act"). As a bank holding company, the activities of the Corporation are regulated by the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"). The BHC Act requires that the Corporation obtain prior approval of the Federal Reserve Board to acquire control over a bank or certain nonbank entities and restricts the activities of the Corporation to those closely related to banking. Federal law also regulates transactions between the Corporation and the Bank, including loans or extensions of credit.
The Bank is subject to the supervision of, and examination by, the FDIC, the State of Rhode Island and the State of Connecticut, in which the Bank has established branches. The Bank is also subject to various Rhode Island and Connecticut business and banking regulations.
Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) - Among other things, FDICIA requires the federal banking regulators to take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements.
FDICIA established five capital tiers, ranging from "well-capitalized" to "critically undercapitalized". A depository institution is well-capitalized if it significantly exceeds the minimum level required by regulation for each relevant capital measure. Under FDICIA, an institution that is not well-capitalized is generally prohibited from accepting brokered deposits and offering interest rates on deposits higher than the prevailing rate in its market. At December 31, 1998, the Bank's capital ratios placed it in the well-capitalized category. Reference is made to Note 15 to the Corporation's Consolidated Financial Statements for additional discussion of the Corporation's regulatory capital requirements.
Another primary purpose of FDICIA was to recapitalize the Bank Insurance Fund (BIF). The FDIC adopted a risk-related premium system for the assessment period beginning January 1, 1993. Under this new system, each institution's assessment rate is based on its capital ratios in combination with a supervisory evaluation of the risk the institution poses to the BIF. Banks deemed to be well-capitalized and who pose the lowest risk to the BIF will pay the lowest assessment rates, while undercapitalized banks, who present the highest risk, will pay the highest rates.
FDICIA contained other significant provisions that require the federal banking regulators to establish standards for safety and soundness for depository institutions and their holding companies in three areas: (i) operational and managerial; (ii) asset quality, earnings and stock valuation; and (iii) management compensation. The legislation also required that risk-based capital requirements contain provisions for interest rate risk, credit risk and risks of nontraditional activities. FDICIA also imposed expanded accounting and audit reporting requirements for depository institutions. In addition, FDICIA imposed numerous restrictions on state-chartered banks, including those which generally limit investments and activities to those permitted to national banks, and contains several consumer banking law provisions.
Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (Interstate Act) - The Interstate Act permits adequately capitalized bank holding companies to acquire banks in any state subject to certain concentration limits and other conditions. The Interstate Act also authorizes the interstate merger of banks, subject to the right of individual states to "opt in" or "opt out" of this authority prior to such date. In addition, among other things, the Interstate Act permits banks to establish new branches on an interstate basis provided that such action is specifically authorized by the law of the host state. Both Rhode Island and Connecticut, the two states in which the Corporation conducts banking operations, have adopted legislation to "opt in" to interstate merger and branching provisions that effectively eliminated state law barriers.
Dividend Restrictions - The Corporation's revenues consist of cash dividends paid to it by the Bank. Such payments are restricted pursuant to various state and federal regulatory limitations. Reference is made to Note 15 to the Corporation's Consolidated Financial Statements for additional discussion of the Corporation's ability to pay dividends.
Capital Guidelines - Regulatory guidelines have been established that require bank holding companies and banks to maintain minimum ratios of capital to risk-adjusted assets. Banks are required to have minimum core capital (Tier 1) of 4% and total risk-adjusted capital (Tier 1 and Tier 2) of 8%. For the Corporation, Tier 1 capital is essentially equal to shareholders' equity excluding the net unrealized gain on securities available for sale. Tier 2 capital consists of a portion of the allowance for loan losses (limited to 1.25% of total risk-weighted assets). As of December 31, 1998, the Corporation's net risk-weighted assets amounted to $497.0 million, its Tier 1 capital ratio was 12.99% and its total risk-based capital ratio was 15.17%.
The Tier 1 leverage ratio is defined as Tier 1 capital (as defined under the risk-based capital guidelines) divided by average assets (net of intangible assets and excluding the effects of accounting for securities available for sale under SFAS No. 115). The minimum leverage ratio is 3% for bank holding companies that do not anticipate significant growth and that have well-diversified risk (including no undue interest rate risk), excellent asset quality, high liquidity and strong earnings. Other bank holding companies are expected to have ratios of at least 4 - 5%, depending on their particular condition and growth plans. Higher capital ratios could be required if warranted by the particular circumstances or risk profile of a given bank holding company. The Corporation's Tier 1 leverage ratio was 7.25% as of December 31, 1998. The Federal Reserve has not advised the Corporation of any specific minimum Tier 1 leverage capital ratio applicable to it.
Allowance for Loan Losses The Corporation evaluates the adequacy of the allowance for loan losses based upon the composition of the loan portfolio, historical experience, industry statistics, prevailing economic and business conditions and industry concentration. The Corporation utilizes a credit rating system which assesses individual loans in the commercial, commercial mortgage and commercial construction and development portfolios. Management applies the allowance percentages it considers appropriate to the balances in each rating classification. In addition, specific allowances for loans in these categories considered impaired are determined in accordance with the Statement of Financial Accounting Standards No. 114, "Allowance for Loan Losses". Loans in other portfolios are not individually assessed utilizing the credit rating system mentioned above, but may be similarly rated when information is known to management which indicates such action is warranted. For loans in other portfolios, management applies the allowance percentages it considers appropriate to each portfolio. Loss allocation percentages are based on the Corporation's historical loss experience, industry trends and the actual or anticipated impact of economic conditions on the borrowers. As a result, the percentage allocations are adjusted as necessary when changes in the aforementioned factors warrant. Based on analyses performed, the allowance for loan losses is maintained at levels considered adequate by management to provide for loan losses inherent in the loan portfolio.
GUIDE 3 STATISTICAL DISCLOSURES
The following tables contain additional consolidated statistical data about the Corporation and the Bank.
I. DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY; INTEREST RATES AND INTEREST DIFFERENTIAL
A. Average balance sheets are presented under the caption "Average Balances/Net Interest Margin (Fully Taxable Equivalent Basis)" of Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations. Nonaccrual loans are included in average loan balances. Average balances are based upon daily averages.
B. An analysis of net interest earnings, including interest earned and paid, average yields and costs, and net yield on interest-earning assets, is presented under the caption "Average Balances/Net Interest Margin (Fully Taxable Equivalent Basis)" of Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations.
Interest income is reported on the fully taxable-equivalent basis. Tax exempt income is converted to a fully taxable equivalent basis by assuming a 34% marginal federal income tax rate adjusted for applicable state income taxes net of the related federal tax benefit. For dividends on corporate stocks, the 70% federal dividends received deduction is also used in the calculation of tax equivalency. Interest on nonaccrual loans is included in the analysis of net interest earnings to the extent that such interest income has been recognized in the Consolidated Statements of Income. See Guide 3 Statistical Disclosures - Item III.C.1.
C. An analysis of rate/volume changes in interest income and interest expense is presented under the caption "Volume/Rate Analysis - Interest Income and Expense (Fully Taxable Equivalent Basis)" of Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations. The net change attributable to both volume and rate has been allocated proportionately.
II. SECURITIES AVAILABLE FOR SALE AND SECURITIES HELD TO MATURITY
A. The carrying amounts of securities as of the dates indicated are presented in the following tables:
(Dollars in thousands)
December 31, 1998 1997 1996 --------------------------------------------------------------------------- Securities Available for Sale: U.S. Treasury obligations and obligations of U.S. government-sponsored agencies $115,527 $90,292 $48,756 Mortgage-backed securities 144,077 122,532 128,504 Corporate bonds 27,503 2,000 - Corporate stocks 28,158 22,242 20,711 --------------------------------------------------------------------------- Total securities available for sale $315,265 $237,066 $197,971 ---------------------------------------------------------------------------
(Dollars in thousands)
December 31, 1998 1997 1996 --------------------------------------------------------------------------- Securities Held to Maturity: U.S. Treasury obligations and obligations of U.S. government-sponsored agencies $21,987 $23,932 $ - Mortgage-backed securities 46,088 10,695 12,344 States and political subdivisions 27,572 17,180 15,582 --------------------------------------------------------------------------- Total securities held to maturity $95,647 $51,807 $27,926 ---------------------------------------------------------------------------
B. Maturities of debt securities as of December 31, 1998 are presented in the following tables. Mortgage-backed securities are included based on their weighted average maturities, adjusted for anticipated prepayments. Yields on tax exempt obligations are not computed on a tax equivalent basis.
C. Not applicable.
III. LOAN PORTFOLIO
A. The following table sets forth the composition of the Corporation's loan portfolio for each of the past five years:
B. An analysis of the maturity and interest rate sensitivity of Real Estate Construction and Other Commercial loans as of December 31, 1998 follows:
Sensitivity to changes in interest rates for all such loans due after one year is as follows:
(Dollars in thousands) Floating or Predetermined Adjustable Rates Rates Totals --------------------------------------------------------------------------- Principal due after one year $42,139 $41,343 $83,482 ---------------------------------------------------------------------------
C. Risk Elements Reference is made to the caption "Asset Quality" included in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations. Included therein is a discussion of the Corporation's credit review and accounting practices, as well as information relevant to nonperforming assets at December 31, 1998.
1. Nonaccrual, Past Due and Restructured Loans a) Nonaccrual loans as of the dates indicated were as follows:
(Dollars in thousands)
December 31, 1998 1997 1996 1995 1994 --------------------------------------------------------------------------- $5,613 $7,335 $7,542 $8,574 $10,912 ---------------------------------------------------------------------------
Loans, with the exception of credit card loans and certain well-secured residential mortgage loans, are placed on nonaccrual status and interest recognition is suspended when such loans are 90 days or more overdue with respect to principal and/or interest. Well-secured residential mortgage loans are permitted to remain on accrual status provided that full collection of principal and interest is assured. Loans are also placed on nonaccrual status when, in the opinion of management, full collection of principal and interest is doubtful. Interest previously accrued, but not collected on such loans is reversed against current period income. Cash receipts on nonaccrual loans are recorded as interest income, or as a reduction of principal if full collection of the loan is doubtful or if impairment of the collateral is identified. Loans are removed from nonaccrual status when they have been current as to principal and interest for a period of time, the borrower had demonstrated an ability to comply with repayment terms, and when, in management's opinion, the loans are considered to be fully collectible.
For the year ended December 31, 1998, the gross interest income that would have been recognized if loans on nonaccrual status had been current in accordance with their original terms was approximately $520 thousand. Interest recognized on these loans amounted to approximately $149 thousand.
There were no significant commitments to lend additional funds to borrowers whose loans were on nonaccrual status at December 31, 1998.
b) Loans contractually past due 90 days or more and still accruing for the dates indicated were as follows:
(Dollars in thousands)
December 31, 1998 1997 1996 1995 1994 --------------------------------------------------------------------------- $150 $644 $1,447 $256 $24 ---------------------------------------------------------------------------
c) Restructured accruing loans for the dates indicated were as follows:
(Dollars in thousands)
December 31, 1998 1997 1996 1995 1994 ---------------------------------------------------------------------------
$ - $ - $ - $ - $365 ---------------------------------------------------------------------------
Restructured accruing loans include those for which concessions, such as reduction of interest rates other than normal market rate adjustments or deferral of principal or interest payments, have been granted due to a borrower's financial condition. Interest on restructured loans is accrued at the reduced rate.
2. Potential Problem Loans Potential problem loans consist of certain accruing commercial loans that were less than 90 days past due at December 31, 1998, but were identified by management of the Bank as potential problem loans. Such loans are characterized by weaknesses in the financial condition of borrowers or collateral deficiencies. Based on historical experience, the credit quality of some of these loans may improve as a result of collection efforts, while the credit quality of other loans may deteriorate, resulting in some amount of losses. These loans are not included in the analysis of nonaccrual, past due and restructured loans in Section III.C.1 above. At December 31, 1998, potential problem loans amounted to approximately $187 thousand. The Corporation's loan policy provides guidelines for the review of such loans in order to facilitate collection.
Depending on future events, these potential problem loans, and others not currently identified, could be classified as nonperforming in the future.
3. Foreign Outstandings: None
4. Loan Concentrations; The Corporation has no concentration of loans which exceed 10% of its total loans except as disclosed by types of loan in Section III.A.
D. Other Interest-Bearing Assets: None
IV. SUMMARY OF LOAN LOSS EXPERIENCE
A. The allowance for loan losses is available for future credit losses inherent in the loan portfolio. The level of the allowance is based on management's ongoing review of the growth and composition of the loan portfolio, net charge-off experience, current and expected economic conditions, and other pertinent factors. Loans (or portions thereof) deemed to be uncollectible are charged against the allowance and recoveries of amounts previously charged off are added to the allowance. Loss provisions charged to earnings are added to the allowance to bring it to the desired level. Loss experience on loans is presented in the following table for the years indicated:
B. The following table presents the allocation of the allowance for loan losses:
V. DEPOSITS
A. Average deposit balances outstanding and the average rates paid thereon are presented in the following table:
B. Not Applicable
C. Not Applicable
D. The maturity schedule of time deposits in amounts of $100 thousand or more at December 31, 1998 was as follows:
E. Not applicable
VI. RETURN ON EQUITY AND ASSETS
1998 1997 1996 --------------------------------------------------------------------------- Return on average assets 1.15% 1.17% 1.44% Return on average shareholders' equity 14.22% 14.27% 14.95% Dividend payout ratio 39.85% 38.24% 36.55% Average equity to average total assets 8.07% 8.22% 9.61%
VII. SHORT-TERM BORROWINGS
The following is a summary of amounts relating to short-term borrowings which consist primarily of securities sold under repurchase agreements generally maturing within 90 days:
(Dollars in thousands)
Years ended December 31, 1998 1997 1996 --------------------------------------------------------------------------- Balance at end of year $15,033 $20,337 $14,000 Maximum amount outstanding at any month-end 26,767 26,820 14,000 Average amount outstanding 15,085 14,773 3,260
Weighted average interest rate during the year 5.56% 5.64% 5.59% Weighted average interest rate at end of year 5.12% 5.58% 5.68%
ITEM 2.
ITEM 2. PROPERTIES
The Corporation conducts its business from its corporate headquarters and other properties listed below all of which are considered to be in good condition and adequate for the purposes for which they are used.
The following table sets forth certain information relating to bank premises owned or used by the Corporation in conducting its business:
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
On January 28, 1997, a suit was filed against the Bank in the Superior Court of Washington County, Rhode Island by Maxson Automatic Machinery Company ("Maxson"), a corporate customer, and Maxson's shareholders for damages which the plaintiffs allegedly incurred as a result of an embezzlement by Maxson's former president and treasurer. The suit alleges that the Bank wrongly permitted this individual, while an officer of Maxson, to divert funds from Maxson's account at the Bank for his personal benefit. The claims against the Bank are based upon theories of breach of fiduciary duty, negligence, breach of contract, unjust enrichment, conversion, failure to act in a commercially reasonable manner, and constructive fraud.
The suit as originally filed sought recovery for losses alleged to be directly related to the embezzlement of approximately $3.1 million, as well as consequential damages amounting to approximately $2.6 million. On March 19, 1998, the plaintiffs amended their claims to seek recovery of an additional $2.6 million in losses, plus an unspecified amount of interest thereon, which are alleged to be directly related to the embezzlement.
Management believes, based on its review with counsel of the development of this matter to date, that the Bank has asserted meritorious affirmative defenses in this litigation. Additionally, the Bank has filed counterclaims against Maxson and its principal shareholder as well as claims against the officer allegedly responsible for the embezzlement. The Bank intends to vigorously assert its defenses and affirmative claims. The case is in discovery and management and legal counsel are unable to estimate or assess the extent of risk of an adverse result. Consequently, no loss provision has been recorded.
The Corporation is involved in various other claims and legal proceedings arising out of the ordinary course of business. Management is of the opinion, based on its review with counsel of the development of such matters to date, that the ultimate disposition of such other matters will not materially affect the consolidated financial position or results of operations of the Corporation.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 1998.
EXECUTIVE OFFICERS OF THE REGISTRANT The following is a list of all executive officers of the Corporation and the Bank with their titles, ages, and length of service, followed by certain biographical information.
John C. Warren joined the Bank and the Corporation in 1996 as President and Chief Operating Officer. In 1997, he was elected President and Chief Executive Officer of the Bank and the Corporation. He served as President and Chief Executive Officer of Sterling Bancshares Corporation from 1990 to 1994 and as Chairman from 1993 to 1994.
David V. Devault joined the Bank in 1986 as Controller. He was elected Vice President and Chief Financial Officer of the Corporation and the Bank in 1987. He was elected Senior Vice President and Chief Financial Officer of the Bank in 1990. In 1997, he was also elected Treasurer of the Bank and the Corporation. In 1998 he was elected Executive Vice President, Treasurer and Chief Financial Officer of the Bank and the Corporation.
Harvey C. Perry II joined the Bank in 1974 and was elected Assistant Trust Officer in 1977, Trust Officer in 1981 and Secretary and Trust Officer in 1982. He was elected Vice President and Secretary of the Corporation and the Bank in 1984, and Senior Vice President and Secretary of the Bank in 1990.
Stephen M. Bessette joined the Bank in February 1997 as Senior Vice President - Retail Lending. Prior to joining the Bank he held the position of Executive Vice President at Ameristone Mortgage Corporation since June 1995. From February 1993 to May 1995 he held the position of President at New England Pacific Mortgage Company, Inc. He was Executive Vice President at Old Stone Development Corporation from May 1990 to January 1993.
Vernon F. Bliven joined the Bank in 1972 and was elected Assistant Vice President in 1980, Vice President in 1986 and Senior Vice President - Human Resources in 1993.
Robert G. Cocks, Jr. joined the Bank in 1992 as Senior Vice President - Lending. In 1997 he was named Senior Vice President - Commercial Lending.
Barbara J. Perino joined the Bank in 1988 as Financial Accounting Officer. She was named Controller in 1989 and Vice President Controller in 1992. In 1998 she was promoted to Senior Vice President - Operations and Technology.
B. Michael Rauh, Jr. joined the Bank in 1991 as Vice President - Marketing and was promoted in 1993 to Senior Vice President - Retail Banking.
James M. Vesey joined the Bank in 1998 as Senior Vice President - Commercial Lending. Prior to joining the Bank he held the position of Senior Vice President and Director of Business Banking at Citizens Bank since December 1995. He worked for Fleet Bank for 24 years prior to pursuing consulting, teaching and investment opportunities in 1994.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
The Corporation's common stock has traded on the Nasdaq National Market since May 1996. Previously, the Corporation's stock traded on the Nasdaq Small-Cap Market since June 1992, and had been listed on the Nasdaq Over-The-Counter Market system since June 1987.
The quarterly common stock price ranges and dividends paid per share for the years ended December 31, 1998 and 1997 are presented in the following table. The stock prices are based on the high and low sales prices during the respective quarter. Stock price and dividend amounts for 1997 and for the first, second and third quarters of 1998 have been restated to reflect 3-for-2 stock splits paid in the form of stock dividends on August 3, 1998 and on November 19, 1997.
1998 Quarters 1 2 3 4 ---------------------------------------------------------------------------- Stock prices: High $24.17 $26.67 $28.50 $26.00 Low 20.00 20.00 20.00 18.00
Cash dividend declared per share $.10 $.10 $.10 $.10
1997 Quarters 1 2 3 4 ---------------------------------------------------------------------------- Stock prices: High $14.33 $13.67 $14.67 $23.83 Low 12.22 11.33 12.89 14.00
Cash dividend declared per share $.08 $.08 $.09 $.09
The Corporation will continue to review future common stock dividends based on profitability, financial resources and economic conditions. The Corporation (including the Bank prior to 1984) has recorded consecutive quarterly dividends for over one hundred years.
The Corporation's primary source of funds for dividends paid to shareholders is the receipt of dividends from the Bank. A discussion of the restrictions on the advance of funds or payment of dividends to the Corporation is included in Note 15 to the Consolidated Financial Statements.
At February 26 1999 there were 1,807 holders of record of the Corporation's common stock.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Financial Overview Washington Trust recorded net income of $10.0 million for 1998, an increase of 10.6% over the $9.1 million of net income recorded in 1997. Diluted earnings per share amounted to $.97 for 1998, up 9.0% from $.89 per share earned on net income in 1997.
Washington Trust's rates of return on average assets and average equity ("ROA" and "ROE") for 1998 were 1.15% and 14.22%, respectively. ROA and ROE for the year ended December 31, 1997 amounted to 1.17% and 14.27%, respectively.
Total assets amounted to $935.1 million at December 31, 1998, up 14.8% from the December 31, 1997 balance of $814.4 million. Average assets rose 12.96% during 1998 and amounted to $875.6 million, up from the comparable 1997 amount of $775.1 million. The growth in assets was primarily attributable to purchases of securities. The growth in assets was funded by increases in Federal Home Loan Bank ("FHLB") advances as well as an 8.4% increase in total deposits. Total deposits amounted to $575.3 million and $530.9 million at December 31, 1998 and 1997, respectively. FHLB advances totaled $262.1 million at December 31, 1998, up 40.2% from the prior year balance of $187.0 million.
Total shareholders' equity amounted to $73.1 million at December 31, 1998, up 8.7% from the December 31, 1997 amount of $67.2 million. Included in shareholders' equity at December 31, 1998 and 1997 was $7.4 million and $7.1 million, respectively, attributable to net unrealized gains on securities available for sale, net of tax.
Book value per share as of December 31, 1998 and 1997 amounted to $7.30 and $6.80, respectively.
Nonperforming assets (nonaccrual loans and property acquired through foreclosure) amounted to $5.9 million or .63% of total assets at December 31, 1998, down from $7.8 million, or .96% of total assets at December 31, 1997. The Corporation's loan loss provision was $1.8 million and $1.4 million in 1998 and 1997, respectively.
For the year ended December 31, 1998, net interest income (the difference between interest earned on loans and securities and interest paid on deposits and other borrowings) amounted to $30.1 million, up by 6.5% over the 1997 amount. The net interest margin for the year ended December 31, 1998 amounted to 3.78%, compared to 4.07% in 1997. Other noninterest income (noninterest income excluding net gains on sales of securities available for sale) amounted to $12.0 million for the year ended December 31, 1998, up 26.2% from $9.5 million in 1997. The increase resulted primarily from increases in net gains on loan sales, higher revenues for trust services and increases in service charges on deposits.
Total noninterest expense amounted to $26.8 million in 1998, up by 10.0% from the 1997 amount of $24.4 million. The increase was primarily attributable to higher salaries and benefits expense and increases in other expenses resulting from the Corporation's expansion of its market area. (See additional discussion of the expansion of the Corporation's market area under the caption "Branch Expansion".) Equipment and net occupancy costs rose 17.4% and 6.6%, respectively, over the 1997 amounts due primarily to rental expense and depreciation of premises and equipment incurred in connection with the Corporation's market area expansion efforts.
Branch Expansion During the first quarter of 1998, the Corporation opened a financial services branch office in New London, Connecticut. Financial services provided at the office include trust and investment management, commercial lending and residential mortgage origination. The office does not currently accept deposits nor perform other retail banking services, but may offer them in the future. The Corporation has also opened an operations center located in Westerly, Rhode Island. Operations functions previously performed at the Corporation's headquarters were relocated to this leased facility during the second quarter of 1998. In January 1999, this facility was purchased by the Corporation. In October 1998, the Corporation announced an agreement to provide trust and investment management services to customers of Bank Rhode Island and PierBank, two Rhode Island financial institutions. Under the agreement, the Corporation will provide a full-line of investment management and trust services, including financial planning, estate and tax planning. The alliances enable the Corporation to generate fee income and also enable Bank Rhode Island and Pier Bank to offer professional trust services to their customers.
During 1997, the Corporation expanded its market area and opened five additional branch offices, increasing the total number of branch offices to eleven. In February 1997, the Corporation opened a new branch in North Kingstown, Rhode Island. This branch is a full service banking office, offering deposit and loan services for businesses and consumers, as well as trust and investment services. The Corporation also acquired a branch of a Connecticut bank, including its deposits of approximately $8.2 million, in March 1997. This branch, located in Mystic, Connecticut, was the Corporation's first branch office located in Connecticut. During the second quarter of 1997, the Corporation opened two branches in local supermarkets, one of which is located in Mystic, Connecticut, the other in Westerly, Rhode Island. An additional supermarket branch located in Mystic, Connecticut was opened by the Corporation in November 1997. The supermarket branches are full service banking offices offering extended service hours.
Net Interest Income Net interest income is the primary source of Washington Trust's operating income. The level of net interest income is affected by the volume of average interest-earning assets and interest-bearing liabilities, market interest rates and other factors. The following discussion presents net interest income on a fully taxable equivalent (FTE) basis by adjusting income and yields on tax-exempt loans and securities to be comparable to taxable loans and securities.
FTE net interest income increased by $1.5 million or 4.9% from 1998 to 1997, due primarily to the growth in interest-earning assets. The interest rate spread declined by 31 basis points to 3.18% in 1998, while the net interest margin (FTE net interest income as a percentage of average interest-earning assets) fell from 4.07% in 1997 to 3.78% in 1998. Earning asset yields fell 39 basis points during 1998, while the cost of interest-bearing liabilities declined 8 basis points, thereby narrowing the net interest spread. Growth in the securities portfolio as well as interest expense associated with the increases in FHLB advances, were primarily responsible for the decrease in the net interest margin.
FTE interest income totaled $63.7 million in 1998, up from $59.1 million in 1997. The yield on interest-earning assets was 7.73% in 1998, down from 8.12% in 1997. Average interest-earning assets increased by $95.5 million or 13.1% in 1998, most of which was attributable to increases in securities. Total average securities rose by $82.8 million or 28.5% in 1998, mainly due to purchases of taxable debt securities. The securities purchased were funded with Federal Home Loan Bank advances. The FTE rate of return on securities was 6.37% in 1998, down from 6.86% in 1997. The decrease in yield reflects lower marginal rates on investment purchases during 1998 relative to the prior year.
Average loans amounted to $451.0 million in 1998, up $12.7 million from 1997. The FTE rate of return on total loans was 8.86% in 1998, down slightly from 8.95% in 1997, due primarily to lower yields on new loan originations. The yield on residential real estate loans amounted to 8.06% in 1998, compared to 8.20% for 1997. Average residential mortgages rose 3.8% in 1998 and amounted to $187.6 million. The yields on commercial loans amounted to 9.62% and 9.55% in 1998 and 1997, respectively. The increase in yields on commercial loans was mainly due to the recognition of interest income relating to payoffs of nonaccrual loans. Average commercial loans amounted to $188.4 million in 1998, down slightly from prior year levels. Average consumer loans grew 9.6% in 1998 to $75.0 million. The yield on consumer loans amounted to 8.98% in 1998, down from 9.31% in 1997.
As a result of higher levels of FHLB advances and increases in savings and time deposits, average interest-bearing liabilities amounted to $715.8 million, up by 12.4% from 1997, and interest expense amounted to $32.6 million, up 10.6% from 1997. The rate paid on interest-bearing liabilities declined 8 basis points to 4.55% in 1998 primarily due to lower interest rates. Average Federal Home Loan Bank advances increased by $45.5 million or 24.9% from 1997 and amounted to $228.2 million in 1998. The advances were used primarily to match fund the purchase of securities. The average rate paid on Federal Home Loan Bank advances for 1998 was 5.79%, a decrease of 11 basis points from the prior year.
Average savings deposits increased by $16.7 million or 9.4% from 1997 and fell 17 basis points in the rate paid. Average time deposits grew $16.4 million or 6.3% in 1998 with an decrease of 8 basis points in the rate paid. These factors offset the benefit of an increase in average demand deposits, an interest-free source of funding. Average demand deposits increased by 15.0% from 1997 and amounted to $80.8 million in 1998.
Average Balances/Net Interest Margin (Fully Taxable Equivalent Basis) The following table presents average balance and interest rate information. Tax-exempt income is converted to a fully taxable equivalent basis by assuming a 34% federal income tax rate adjusted for applicable state income taxes net of the related federal tax benefit. For dividends on corporate stocks, the 70% federal dividends received deduction is also used in the calculation of tax equivalency. Nonaccrual and renegotiated loans, as well as interest earned on these loans (to the extent recognized in the Consolidated Statements of Income), are included in amounts presented for loans.
Noninterest Income Noninterest income is an important source of revenue for the Corporation. For the year ended December 31, 1998, noninterest income, excluding net gains on sales of securities, accounted for 15.9% of gross revenue. Washington Trust generates recurring noninterest income by charging for trust-related services such as management of customer investment portfolios, trusts and estates, and by assessing fees for servicing deposit accounts, servicing residential mortgages sold in the secondary market, and processing merchant credit card activity.
Revenue from trust-related services continues to be the largest component of noninterest income. Trust revenue represented 41.9% of noninterest income and amounted to $5.2 million in 1998, up by 17.0% from the $4.5 million reported in 1997. This increase in trust revenue is primarily attributable to the increase in assets under management, which amounted to $789.8 million at December 31, 1998, up from $643.6 million in 1997.
Service charges on deposit accounts rose 17.1% to $2.8 million in 1998. Changes in the fee structures of various deposit products during the year, as well as growth in the Corporation's total deposit base, were contributing factors in this increase.
Net gains on loan sales totaled $1.4 million for the year ended December 31, 1998, up from net gains of $532 thousand during 1997, due to increased loan sales in 1998. Gains on loan sales include the capitalization of mortgage servicing rights of $551 thousand and $216 thousand in 1998 and 1997, respectively.
The Corporation retains servicing rights on substantially all residential mortgage loans sold. Mortgage servicing fee income amounted to $148 thousand for the year ended December 31, 1998, down from the prior year amount of $338 thousand. The decrease is mainly due to additions to the mortgage servicing rights valuation allowance and amortization of capitalized mortgage servicing rights. Servicing income, excluding valuation adjustments and amortization, as a percentage of average loans serviced was 33 basis points in 1998, down from 36 basis points in the prior year. The balance of serviced loans at December 31, 1998 amounted to $174.7 million, compared to $119.5 million at December 31, 1997.
Noninterest Expense Total noninterest expense rose 10.0% to $26.8 million in 1998. This increase was primarily attributable to higher salaries and to increases in occupancy, equipment and other costs associated with Washington Trust's branch expansion efforts.
Occupancy costs totaled $2.1 million in 1998, up 6.6% from the 1997 amount of $2.0 million. Depreciation expense associated with equipment purchases in 1998 amounted to $1.7 million, up 19.8% over the comparable 1997 amount.
Net foreclosed property costs and expenses were down in 1998 due to the decline in the number of foreclosed properties and the decline in the level of nonperforming loans. (See discussion under "Asset Quality" for additional information.) Foreclosed property costs in 1998 fell 82.7% from the prior year.
Income Taxes Income tax expense amounted to $3.9 million and $3.6 million in 1998 and 1997, respectively. The Corporation's effective tax rate was 28.2% in 1998, compared to a rate of 28.6% in 1997. These rates differed from the federal rate of 34.0% due to the benefits of tax-exempt income and the dividends received deduction as well as the results of the tax planning strategies designed to reduce income taxes.
The Corporation had a net deferred tax liability amounting to $1.6 million and $2.0 million at December 31, 1998 and 1997, respectively. A significant portion of the Corporation's gross deferred tax asset is expected to be realized for tax purposes within a five year period from future taxable income and the reversal of existing deferred tax liabilities. (See Note 12 to the Consolidated Financial Statements for additional information regarding income taxes.)
Financial Condition Securities Securities are designated as either available for sale or held to maturity at the time of purchase. Securities available for sale may be sold in response to changes in market conditions, prepayment risk, rate fluctuations, liquidity, or capital requirements. Securities available for sale are reported at fair value, with any unrealized gains and losses excluded from earnings and reported as a separate component of shareholders' equity, net of tax, until realized. Securities designated as held to maturity are part of the Corporation's portfolio of long-term interest-earning assets. These securities are classified as long-term because the Corporation has the intent and ability to hold them until maturity. Securities held to maturity are reported at amortized cost.
Securities Available for Sale The amortized cost of securities available for sale at December 31, 1998 amounted to $303.0 million, an increase of $77.7 million over the 1997 amount. This increase is primarily attributable to purchases of securities.
At December 31, 1998, the net unrealized gains on securities available for sale amounted to $12.2 million, an increase of $500 thousand over the comparable 1997 amount. This increase is attributable to the decline in interest rates occurring in 1998, as well as the year to date increase in portfolio balances. (See Note 3 to the Consolidated Financial Statements for detail of unrealized gains and losses associated with securities available for sale.)
Securities Held to Maturity The amortized cost of securities held to maturity increased by $43.8 million, to $95.6 million at December 31, 1998. This increase is primarily attributable to purchases of mortgage-backed securities. The net unrealized gain on securities held to maturity amounted to $901 thousand at December 31, 1998, up by $122 thousand from December 31, 1997.
Federal Home Loan Bank Stock The Corporation is required to maintain a level of investment in FHLB stock which is based on the level of its FHLB advances. As of December 31, 1998, the Corporation's investment in FHLB stock remained unchanged from the prior year amount of $16.4 million.
Loans Total loans amounted to $449.5 million at December 31, 1998, down slightly by $6.4 million, or 1.4%, from the December 31, 1997 amount of $455.9 million. The decrease in total loans can be attributed to heavy mortgage refinancing activity, spurred by a low interest rate environment, as well as aggressive competition for commercial and consumer loans.
Total residential real estate loans increased by $1.7 million, or 0.9%, in 1998. Total commercial loans decreased by $11.2 million, or 5.8%, in 1998. Consumer loans were up by $3.0 million, or 4.1%, in 1998, with the largest increase occurring in the home equity line of credit portfolio. The Corporation has benefited from marketing efforts dedicated to the home equity line of credit product.
At December 31, 1998, credit card loans amounted to $5.4 million, or 1.2% of total loans, compared to $5.2 million, or 1.1% of total loans, at December 31, 1997.
Deposits Total deposits at December 31, 1998 amounted to $575.3 million, up 8.4% from the prior year balance of $530.9 million. The increase in deposits is attributable to the additional branch offices opened throughout 1997, as well as growth in time deposits in denominations of $100 thousand or more which increased by $19.2 million in 1998. All categories of deposits increased over prior year levels. Time deposits rose by 2.7% to $277.8 million, savings deposits (regular savings, NOW and money market accounts) rose by 13.5% to $210.1 and total demand deposits rose by 16.1% to $87.4 million.
Borrowings Washington Trust uses advances from the Federal Home Loan Bank of Boston as well as other short-term borrowings as part of its overall funding strategy. The additional FHLB advances and short-term borrowings were used to meet short-term liquidity needs, to fund loan growth and to purchase securities. Total advances amounted to $262.1 million at December 31, 1998, up from $187.0 million one year earlier. (See Note 10 to the Consolidated Financial Statements for additional information about borrowings.)
Asset Quality Nonperforming Assets Nonperforming assets include nonaccrual loans and other real estate owned. Nonperforming assets declined to .63% of total assets at December 31, 1998, compared to .96% of total assets at December 31, 1997. Nonaccrual loans as a percentage of total loans fell from 1.61% at the end of 1997 to 1.25% at December 31, 1998. Approximately $3.2 million, or 56.9% of total nonaccrual loans, were less than 90 days past due at December 31, 1998
The following table presents nonperforming assets and related ratios:
(Dollars in thousands)
December 31, 1998 1997 --------------------------------------------------------------------------- Nonaccrual loans: Residential real estate $1,417 $1,290 Commercial and other: Mortgages 1,522 1,977 Construction and development - - Other 2,141 3,616 Consumer 533 452 --------------------------------------------------------------------------- Total nonaccrual loans 5,613 7,335 Other real estate owned, net 243 497 --------------------------------------------------------------------------- Total nonperforming assets $5,856 $7,832 ---------------------------------------------------------------------------
Nonaccrual loans as a percentage of total loans 1.25% 1.61% Nonperforming assets as a percentage of total assets .63% .96%
Nonaccrual Loans Loans, with the exception of credit card loans and certain well-secured residential mortgage loans, are placed on nonaccrual status and interest recognition is suspended when such loans are 90 days or more past due with respect to principal and/or interest. Well-secured residential mortgage loans are permitted to remain on accrual status provided that full collection of principal and interest is assured. Loans are also placed on nonaccrual status when, in the opinion of management, full collection of principal and interest is doubtful. Interest previously accrued, but uncollected, is reversed against current period income. Subsequent cash receipts on nonaccrual loans are recognized as interest income, or recorded as a reduction of principal if full collection of the loan is doubtful or if impairment of the collateral is identified. Credit card loans remain on accruing status after becoming 90 days or more past due, but are generally charged off after becoming 180 days past due.
Nonaccrual loans are returned to accrual status when the obligation has performed in accordance with the contract terms for a reasonable period of time and the ultimate collectibility of the contractual principal and interest is no longer doubtful.
Included in accruing loans 90 days or more past due at December 31, 1998 are residential mortgages amounting to $116 thousand which are considered well-collateralized and in the process of collection and therefore are deemed to have no loss exposure.
(Dollars in thousands)
December 31, 1998 1997 --------------------------------------------------------------------------- Nonaccrual loans 90 days or more past due $2,421 $4,089 Nonaccrual loans less than 90 days past due 3,192 3,246 --------------------------------------------------------------------------- Total nonaccrual loans $5,613 $7,335 --------------------------------------------------------------------------- Accruing loans 90 days or more past due, primarily all residential mortgages (1) $150 $644 --------------------------------------------------------------------------- (1) Not included in nonperforming assets
Restructured Loans Loans are considered restructured when the Corporation has granted concessions to a borrower due to the borrower's financial condition that it otherwise would not have considered. These concessions include modifications of the terms of the debt such as reduction of the stated interest rate other than normal market rate adjustments, extension of maturity dates, or reduction of principal balance or accrued interest. The decision to restructure a loan, versus aggressively enforcing the collection of the loan, may benefit the Corporation by increasing the ultimate probability of collection. Included in nonaccrual loans at December 31, 1998, are loans amounting to $1.1 million whose terms have been restructured. There were no commitments to lend additional funds to borrowers whose loans had been restructured.
Other Real Estate Owned Other real estate owned ("OREO") is comprised of properties acquired through foreclosure and other legal means, and loans determined to be substantively repossessed. A loan is considered to be substantively repossessed when the Corporation has taken possession of the collateral, but has not completed legal foreclosure proceedings. OREO is carried at the lower of cost or fair value minus estimated costs to sell. A valuation allowance is maintained for potential declines in market value, known declines in market value, and estimated selling costs.
The balance of OREO amounted to $243 thousand at December 31, 1998, down from the prior year amount of $497 thousand, as sales of foreclosed properties exceeded the level of foreclosures. During 1998, proceeds from sales of foreclosed properties amounted to $1.0 million. Washington Trust has provided financing to facilitate the sales of some of these properties. Financing is generally provided at market rates with credit terms similar to those available to other borrowers.
Allowance for Loan Losses The allowance for loan losses represents the amount available for credit losses inherent in the loan portfolio. Washington Trust assesses the quality of its loans by performing ongoing reviews of its portfolio to determine potential loss exposure and to assess delinquency trends. During this review, management gives consideration to such factors as overall borrower relationship, delinquency trends, credit and collateral quality, prior loss experience, prevailing economic and business conditions, industry concentrations, the size and characteristics of the loan portfolio and other pertinent factors. Based on this review, the management believes that its year-end allowance for loan losses is adequate.
Loans are charged off once the probability of loss has been established, through the review of the factors mentioned above.
The determination of the adequacy of the allowance is necessarily judgmental and involves consideration of various factors and assumptions. Management believes that an allocation of the allowance is not necessarily indicative of the specific amount of future charge-offs or the specific loan categories in which these charge-offs may ultimately occur. The unallocated component of the allowance for loan losses represents management's evaluation of the loan portfolio, including its size and complexity, with consideration given to the Corporation's expanded market area and industry concentrations. Also, management realizes that there are losses that have been incurred within the portfolio that have not yet been specifically identified. The allowance for loan losses amounted to $10.4 million, or 2.32% of total loans at December 31, 1998, compared to $8.8 million or 1.94% at December 31, 1997.
The following table reflects the activity in the allowance for loan losses:
(Dollars in thousands)
Years ended December 31, 1998 1997 ------------------------------------------------------------------------- Beginning balance $8,835 $8,495 Charge-offs, net of recoveries: Residential real estate (5) (131) Commercial: Mortgages 51 (140) Construction and development - 7 Other (41) (508) Consumer (224) (288) ------------------------------------------------------------------------- Net charge-offs (219) (1,060) Provision for loan losses 1,800 1,400 ------------------------------------------------------------------------- Ending balance $10,416 $8,835 ------------------------------------------------------------------------- Allowance for loan losses to nonaccrual loans 185.58% 120.45% Allowance for loan losses to total loans 2.32% 1.94% -------------------------------------------------------------------------
The provision for loan losses amounted to $1.8 million in 1998, up from $1.4 million in 1997. The provision amount is determined by management to maintain the allowance at a level which is deemed appropriate.
Capital Resources Total shareholders' equity rose 8.7% during 1998 and amounted to $73.1 million at December 31, 1998. Capital growth resulted from $6.0 million of earnings retention and $2.5 million from stock option exercises. On August 3, 1998, the Corporation paid a stock split in the form of a three-for-two stock dividend. Additionally, cash dividends declared per share rose by 14.3% in 1998 for a total of $.40 per share.
The ratio of total equity to total assets amounted to 7.8% at December 31, 1998, compared to 8.3% at December 31, 1997. The reduction in this ratio was due primarily to the growth in assets resulting from purchases of securities. Book value rose to $7.30 per share at December 31, 1998, up from the year-earlier amount of $6.80 per share.
The Corporation and the Bank are subject to various regulatory capital requirements. The Corporation and the Bank are categorized as well-capitalized under the regulatory framework for prompt corrective action. (See Note 15 to the Consolidated Financial Statements for additional discussion of capital requirements.)
Litigation As discussed under Note 14 to the Corporation's Consolidated Financial Statements, the Bank is party to a lawsuit filed by a corporate customer and the customer's shareholders for damages which the plaintiffs allegedly incurred as a result of an embezzlement by an officer of the customer. The suit as originally filed sought recovery from the Bank for losses directly related to the embezzlement of approximately $3.1 million, as well as consequential damages amounting to approximately $2.6 million. On March 19, 1998, the customer amended its claims to seek recovery of an additional $2.6 million in losses, plus an unspecified amount of interest thereon, which are alleged to be directly related to the embezzlement. Management believes, based on its review with counsel of the development of this matter to date, that the Bank has asserted meritorious affirmative defenses in this litigation. Additionally, the Bank has filed counterclaims against the customer and its principal shareholder, as well as claims against the officer allegedly responsible for the embezzlement. The Bank intends to vigorously assert its defenses and affirmative claims. Because of the numerous uncertainties which surround the litigation, management and legal counsel are unable to estimate the amount of loss, if any, that the Bank may incur with respect to this litigation. Consequently, no loss provision for this lawsuit has been recorded.
Year 2000 The statements in the following section include "Year 2000 readiness disclosure" within the meaning of the Year 2000 Information and Readiness Disclosure Act. The following "Year 2000" discussion contains forward-looking statements which represent the Corporation's beliefs or expectations regarding future events. When used in the Year 2000 discussion, the words "believes," "expects," "estimates," and similar expressions are intended to identify forward-looking statements. Forward-looking statements include, without limitation, the Corporation's expectations as to when it will complete the phases of the Plan, its estimated costs, and its belief that its statements involve a number of risks and uncertainties that could cause the actual results to differ materially from the projected results. Factors that may cause these differences include, but are not limited to, the availability of qualified personnel and other information technology resources, the ability to identify and remediate all date sensitive lines of computer code, and the actions of governmental agencies or other third parties with respect to Year 2000 problems.
The Corporation has developed a Year 2000 Project Plan (the "Plan") to address the computer-related issues concerning the century date change (the transition from the year 1999 to 2000). The Corporation's information technology (IT) and non-information technology (non IT) systems have been included in the Plan. The Corporation uses internal computer systems, data communications systems and telecommunications systems as well as outside service providers (including hardware and software) to support and account for loans, deposits, fiduciary services and other purposes. Substantially all of the application software used by the Corporation is provided by outside vendors, under license or through outside service bureaus. The Corporation has distinguished between mission-critical and other, less critical, systems in assessing the needs of the Plan.
The Plan includes five phases: awareness, assessment, renovation, validation and testing, and contingency planning. The Plan calls for validation and testing of mission critical IT systems to be completed by March 31, 1999. Although this process is on-going and dynamic, the Corporation expects to complete its preparations for year 2000 by June 30, 1999. The Corporation's evaluation is subject to on-going verification and review by its internal audit staff.
The Corporation expects that the total costs associated with the project will amount to approximately $500 thousand. The Corporation plans to account for most of these costs as expense items. In some cases, acquired hardware and software items will be capitalized and amortized in accordance with the Corporation's existing accounting policy. Total costs incurred for the year ended December 31, 1998 amounted to approximately $200 thousand. These costs consisted primarily of system testing and modification, internal staffing and consulting, and were primarily recorded in noninterest expenses. Most of the remaining project costs will be incurred in the first half of 1999. The costs of the project and the date on which the Corporation plans to complete Year 2000 testing 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.
There can be no guarantee that the systems of other companies, or outside vendors on which the Corporation's systems rely, will be remedied on a timely basis. Therefore, the Corporation could possibly experience a negative impact to the extent other entities not affiliated with the Corporation are not Year 2000 compliant.
The Corporation is in the process of evaluating the risk of customer failure to prepare for the century date change, any associated effect on the ability of customers to repay outstanding loans, and impact on the adequacy of the level of the allowance for loan losses. Because these efforts are now on-going, the Corporation is unable to assess the likelihood of any material adverse effect at this time.
The Corporation's risk management program includes emergency backup and recovery procedures to be followed in the event of failure of a business-critical system. These procedures will be expanded to include specific procedures for potential Year 2000 issues, and contingency plans to protect against Year 2000-related interruptions. These plans will include development of backup procedures and identification of alternative suppliers. Contingency plans are expected to be complete by June 30, 1999.
While the Corporation believes that it is taking reasonable steps with respect to the Year 2000 issue, if the phases of the Plan are not completed on time, the costs associated with becoming Year 2000 compliant exceed the Corporation's estimates, third party providers are not Year 2000 compliant on a timely basis, or customers with material loan obligations are unable to meet their repayment obligations due to Year 2000 problems, the Year 2000 issue could have a material impact on the Corporation's financial results. In addition, the Corporation's efforts to address the Year 2000 issue are being monitored by its federal banking regulators. Failure to be Year 2000 compliant on a timely basis could subject the Corporation to formal supervisory or enforcement actions.
Recent Accounting Developments Accounting for Derivative Instruments and Hedging Activities Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities" establishes accounting and reporting standards for derivative instruments and for hedging activities. SFAS No. 133 requires a corporation to recognize all derivatives as either assets or liabilities in the balance sheet and to measure those instruments at fair value. This Statement defines conditions and criteria to be used in designating a derivative as a specific type of hedging instrument. SFAS No. 133 also explains the accounting for changes in the fair value of a derivative which depends on the intended use and the resulting designation. Under this Statement, a corporation is required to establish at the inception of the hedge the method to be used for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. Those methods must be consistent with the corporation's approach to managing risk. SFAS No. 133 is effective for all fiscal quarters beginning after June 15, 1999 and is not to be applied retroactively to financial statements of prior periods. The Corporation has not yet determined what the effect of the adoption of this pronouncement will have on the financial position and earnings of the Corporation.
Comparison of 1997 with 1996 Washington Trust recorded net income of $9.1 million in 1997, a 7.9% increase over the $8.4. million of net income recorded in 1996. Diluted earnings per share amounted to $.89 for 1997, up from $.84 per share earned in 1996. ROA and ROE amounted to 1.17% and 14.27%, respectively in 1997. Comparable amounts for 1996 were 1.44% and 14.95%.
Fully taxable equivalent net interest income rose 8.6% over the 1996 amount. The interest rate spread declined 84 basis points to 3.49% in 1997, while the net interest margin fell from 4.99% in 1996 to 4.07% in 1997. Growth in the securities portfolios and increases in interest-bearing sources of funding relative to noninterest-bearing sources of funding (i.e., demand deposits and shareholders' equity), as well as interest expense associated with increases in FHLB advances, were primarily responsible for the decrease in the net interest margin. The yield on total interest-earning assets amounted to 8.12% in 1997, down from 8.57% in 1996. The Corporation's cost of funds rose 39 basis points in 1997 to 4.63% due to changes in deposit mix as well as increases in volume. The rate of interest paid on time deposits rose 10 basis points, which resulted in a shift of funds from lower yielding savings deposits to the time deposit category.
Total assets rose $119.4 million or 17.2% during 1997 to $814.4 million at December 31, 1997. Average assets amounted to $775.1 million in 1997, up 32.3% over the prior year. Asset growth was primarily attributable to an increase of $39.1 million in securities available for sale. Total securities available for sale amounted to $237.1 million at the end of 1997. Total loans increased by 8.8% in 1997 and amounted to $455.9 million at December 31, 1997. All categories of loans, except for commercial construction and development, exhibited increases over 1996 levels.
Nonperforming assets declined to .96% of total assets at December 31, 1997, down from 1.24% of total assets at December 31,1996. The Corporation's loan loss provision amounted to $1.4 million in 1997, compared to $1.2 million in 1996. Net loan charge-offs amounted to $1.1 million in 1997, up from $490 million in 1996.
Shareholders' equity rose by 13.1% in 1997. Approximately $5.6 million of this increase was attributable to earnings retention and $1.2 million from stock option exercises. Book value per share rose to $6.80 at December 31, 1997, up from the year-earlier amount of $6.05 per share. The ratio of capital to assets was 8.2% and 8.6% at December 31, 1997 and 1996, respectively. Dividends paid per share amounted to $.35 in 1997, up 12.8% from the prior year.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest Rate Sensitivity and Liquidity Interest rate risk is one of the major market risks faced by the Corporation. The Corporation's Asset/Liability Committee ("ALCO") is responsible for establishing policy guidelines on liquidity and acceptable exposure to interest rate risk. The objective of the ALCO is to manage assets and funding sources to produce results which are consistent with Washington Trust's liquidity, capital adequacy, growth, risk and profitability goals. The ALCO establishes and monitors guidelines for proper origination and matching of assets and funding sources, and determines asset/liability origination and pricing strategies to meet its goals. The ALCO meets regularly to review the economic environment and the volume, mix and maturity of assets and liabilities, and implements appropriate changes in strategy that will manage the Corporation's exposure to interest rate risk and liquidity risk.
The ALCO manages the Corporation's interest rate risk using income simulation to measure interest rate risk inherent in the Corporation's on-balance sheet and off-balance sheet financial instruments at a given point in time by showing the effect of interest rate shifts on net interest income over a 60-month period. The ALCO uses both parallel and non-parallel rate shifts of up to 200 basis points and Monte Carlo rate simulations based on the historical volatility of interest rates to perform income simulations. The simulations assume that the composition of the Corporation's balance sheet remains constant over the 60-month simulation horizon, and take into account the specific repricing, maturity, call options, and prepayment characteristics of differing financial instruments which may vary under different interest rate scenarios. Prepayment estimates for the Corporation's loans are based on historical experience. Call options and prepayment characteristics for securities are calculated using industry-standard pricing and prepayment estimates. Non-contractual savings deposits are classified as short-term (three months or less) for both maturity and repricing purposes. The characteristics of financial instrument classes are reviewed periodically by the ALCO to ensure their accuracy and consistency.
The ALCO reviews simulation results to determine whether the negative exposure of net interest income to changes in interest rates remains within established tolerance levels over a 24-month horizon, and to develop appropriate strategies to manage this exposure. In addition, the ALCO reviews 60-month horizon results to assess longer-term risk inherent in the balance sheet, although no 60-month horizon tolerance levels are specified. As of December 31, 1998 and December 31, 1997, net interest income simulation indicated exposure to changing interest rates over a 24-month horizon to a degree that remained within tolerance levels established by the Corporation. The Corporation defines maximum unfavorable net interest income exposure to be a change of no more than 5% in net interest income over the first 12 months and no more than 10% over the second 12 months of the simulation horizon.
The following table summarizes the effect that interest rate shifts would have on net interest income for a 24-month period using the Corporation's on and off-balance sheet financial instruments as of December 31, 1998. Interest rates are assumed to shift by a parallel 200 basis points over a 12-month period, except for core savings deposits, which are assumed to shift by only 100 basis points due to their historical insensitivity to rate changes. Further, core savings are assumed to have certain minimum rate levels below which they will not fall. It should be noted that the rate scenario used does not necessarily reflect the ALCO's view of the "most likely" change in interest rates over the next 24 months. Furthermore, since a static balance sheet is assumed, the results do not reflect the anticipated future net interest income of the Corporation for the same period. The following table presents these 24 month net interest income simulation results:
The ALCO estimates that the negative exposure of net interest income to rising rates results from a gradual balance sheet shift toward longer term fixed rate assets and away from variable rate assets during 1998. The shift reflects increased customer demand for fixed rate loans as interest rates declined throughout the year. In the event of an increase in interest rates, funding costs should rise more rapidly than asset yields over the near term, reducing interest income. Conversely, net interest income should increase as rates fall because shorter-term liabilities would decrease in cost over the near term, while yields on fixed rate assets decline more slowly. While the ALCO reviews simulation assumptions to ensure that they are reasonable and current, income simulation may not always prove to be an accurate indicator of interest rate risk since the repricing, maturity and prepayment characteristics of financial instruments, especially core savings deposits, may change to a different degree than estimated. In addition, since income simulations assume that the Corporation's balance sheet will remain static over the 60-month simulation horizon, the results do not reflect adjustments in strategy that the ALCO could implement in response to rate shifts.
The Corporation also monitors the potential change in market value of its available for sale debt securities in parallel rate shifts of up to 200 basis points. The purpose is to determine market value exposure which may not be captured by income simulation, but which might result in changes to the Corporation's capital position. Results are calculated using industry-standard analytical techniques and securities data. The Corporation uses the results to manage the effect of market value changes on the Corporation's capital position. The following table summarizes the potential change in market value of the Corporation's available for sale debt securities as of December 31, 1998 and 1997 resulting from immediate 200 basis point parallel rate shifts:
The Corporation also monitors the potential change in market value of its available for sale debt securities using "value at risk" analysis. "Value at risk" analysis measures the theoretical maximum market value loss over a given time period based on recent historical price activity of different classes of securities. The anticipated maximum market value reduction for the bank's available for sale securities portfolio at December 31, 1998, including both debt and equity securities, was 5.4%, assuming a one-year time horizon and a 5% probability of occurrence for "value at risk" analysis.
At December 31, 1998, gap analysis showed that the Corporation's cumulative one-year gap was a negative $176.5 million, or 19.8% of earning assets. The following table details the amounts of interest-earning assets and interest-bearing liabilities at December 31, 1998 that are expected to mature or reprice in each of the time periods presented. To the extent applicable, amounts of assets and liabilities which mature or reprice within a particular period were determined in accordance with their contractual terms. Fixed rate mortgages, mortgage-backed securities and consumer installment loans have been allocated based on expected amortization and prepayment rates using standard industry assumptions. Savings, NOW and money market deposit accounts, which have no contractual term and are subject to immediate repricing, are presented in the under three-month category. Management believes that gap analysis has significant shortcomings as a measure of interest rate risk, as it does not address the effect of changes in interest rates nor the magnitude of resulting changes in net interest income. For this reason, the ALCO does not use gap analysis to establish interest rate risk targets or assess interest rate risk exposure.
The following table summarizes the Corporation's gap analysis as of December 31, 1998:
The Corporation supplements its interest rate risk management strategies with off-balance sheet transactions. Such transactions are intended to hedge specifically identified risks inherent in the Corporation's balance sheet, and not to produce speculative profits. The Corporation has written policy guidelines which designate limits on the notional value of off-balance sheet transactions and require periodic evaluation of risks associated with these transactions, including counterparty credit risk.
During 1995, the Corporation entered into interest rate floor contracts with a notional principal amount of $50 million and a five-year term maturing in February 2000. During 1998, the Corporation entered into additional floor contracts with a notional principal amount of $20 million and a five-year term maturing in March 2003. These contracts are intended to function as a hedge against reductions in interest income realized from prime-based loans. These contracts were purchased for a total premium of $1.2 million, which is being amortized over the life of the contracts. The Corporation receives payment for these contracts if certain interest rates fall below specified levels. During 1998, the Corporation recorded income, net of premium amortization, of $67 thousand on its floor contracts. (See Note 7 to the Consolidated Financial Statements for additional information regarding the floor contracts.)
Liquidity is the ability of a financial institution to meet maturing liability obligations and customer loan demand. Washington Trust's primary source of liquidity is customer deposits. Customer deposits (time, savings and demand deposits) funded approximately 63.1% of total average assets in 1998. Other sources of funding include discretionary use of purchased liabilities (i.e., Federal Home Loan Bank term advances, securities sold under agreements to repurchase and federal funds purchased), cash flows from the Corporation's securities portfolios and loan repayments. In addition, securities designated as available for sale may be sold in response to short-term or long-term liquidity needs.
The ALCO establishes and monitors internal liquidity measures to manage liquidity exposure. Liquidity remained well within target ranges established by the ALCO during 1998. Net loans as a percentage of total assets fell to 46.7% at December 31, 1998, compared to 54.9% at December 31, 1997. Total securities as a percentage of total assets rose to 44.0% at December 31, 1998, up from 35.5% at December 31, 1997. These changes resulted primarily from a combination of slower loan growth and planned investment growth.
For the year ended December 31, 1998, net cash provided by financing activities was $109.8 million. Proceeds from FHLB advances totaled $609.3 million, while repayments of FHLB advances totaled $534.2 million in 1998. Additionally, $44.4 million in deposits were generated primarily from branch expansion and growth of larger time deposits. Net cash used in investing activities was $118.3 million in 1998, the majority of which was used to purchase securities. In addition, approximately $3.7 million was used for additions to premises and equipment. While the Corporation does not have any significant capital commitments, it expects to continue to expend funds to upgrade and expand equipment and premises to support its operations. Net cash provided by operating activities amounted to $11.9 million in 1998, $10.0 million of which was generated by net income. (See the Consolidated Statements of Cash Flows for further information about sources and uses of cash.)
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and supplementary data are contained herein.
Page
Independent Auditors' Report Consolidated Balance Sheets Consolidated Statements of Income Consolidated Statements of Changes in Shareholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements
INDEPENDENT AUDITORS' REPORT
[firm logo here][KPMG]
The Board of Directors and Shareholders Washington Trust Bancorp, Inc.:
We have audited the consolidated financial statements of Washington Trust Bancorp, Inc. and Subsidiary (the "Corporation") as listed in the accompanying index. These consolidated financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Washington Trust Bancorp, Inc. and Subsidiary as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the years in the three-year period ending December 31, 1998, in conformity with generally accepted accounting principles.
KPMG LLP
Providence, Rhode Island January 21, 1999
The accompanying notes are an integral part of these consolidated financial statements.
The accompanying notes are an integral part of these consolidated financial statements.
The accompanying notes are an integral part of these consolidated financial statements.
(continued)
The accompanying notes are an integral part of these consolidated financial statements.
WASHINGTON TRUST BANCORP, INC. AND SUBSIDIARY (Dollars in thousands) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
General Washington Trust Bancorp, Inc. (the "Corporation") is a publicly-owned, registered bank holding company, organized under the laws of the State of Rhode Island. The Corporation provides a complete product line of financial services through its wholly-owned subsidiary, The Washington Trust Company (the "Bank"), a Rhode Island chartered commercial bank. The Bank was originally chartered in 1800 and provides a variety of financial services including commercial, residential and consumer lending, retail and commercial deposit products and trust services through its branch offices in Rhode Island and Connecticut. The deposits of the Bank are insured by the Federal Deposit Insurance Corporation ("FDIC"), subject to regulatory limits.
The activities of the Corporation and the Bank are subject to the regulatory supervision of the Federal Reserve Board and the FDIC, respectively. Both companies are subject to various Rhode Island and Connecticut business and banking regulations.
(1) Summary of Significant Accounting Policies Basis of Presentation The consolidated financial statements include the accounts of the Corporation and the Bank. All significant intercompany transactions have been eliminated. Certain prior year amounts have been reclassified to conform to the current year classification.
The accounting and reporting policies of the Corporation conform to generally accepted accounting principles and to general practices of the banking industry. The Corporation has one reportable operating segment. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ from those estimates. A material estimate which is particularly susceptible to change is the determination of the allowance for loan losses.
Securities Securities Available for Sale The Corporation designates securities that it intends to use as part of its asset/liability strategy or that may be sold as a result of changes in market conditions, changes in prepayment risk, rate fluctuations, liquidity or capital requirements as available for sale. The determination to classify such securities as available for sale is made at the time of purchase.
Securities available for sale are reported at fair value, with any unrealized gains and losses excluded from earnings and reported as a separate component of shareholders' equity, net of tax, until realized. Any decline in fair value below the amortized cost basis of an individual security deemed to be other than temporary is recognized as a realized loss in the accounting period in which the determination is made. The fair value of the security at the time of the write-down becomes the new cost basis of the security.
Realized gains or losses from sales of equity securities are determined using the average cost method, while other realized gains and losses are determined using the specific identification method.
Securities Held to Maturity The determination to classify debt securities in the held-to-maturity category is made at the time of purchase and is based on management's intent and ability to hold the securities until maturity. Debt securities in the held-to-maturity portfolio are stated at cost, adjusted for amortization of premium and accretion of discount (calculated on a method that approximates the interest method).
Federal Home Loan Bank Stock The Bank is a member of the Federal Home Loan Bank of Boston ("FHLB"). As a requirement of membership, the Bank must own a minimum amount of FHLB stock, calculated periodically based primarily on its level of borrowings from the FHLB. The Bank may redeem FHLB stock in excess of the minimum required. In addition, the FHLB may require members to redeem stock in excess of the requirement. FHLB stock is redeemable at par, which equals cost. Since no market exists for these shares, they are valued at par.
Mortgage Banking Activities Mortgage Loans Held for Sale Mortgage loans held for sale are carried at the lower of aggregate cost, net of unamortized deferred loan origination fees and costs, or market. Unrealized losses, if any, are charged to current period earnings.
Mortgage Servicing Rights Rights to service mortgage loans for others are recognized as an asset, including rights acquired through both purchases and originations. The total cost of originated mortgage loans that are sold with servicing rights retained is allocated between the mortgage servicing rights and the loans without the mortgage servicing rights based on their relative fair values. Capitalized mortgage servicing rights are included in other assets and are amortized as an offset to other income over the period of estimated net servicing income. They are periodically evaluated for impairment based on their fair value. Impairment is measured on an aggregated basis according to interest rate band and period of origination. The fair value is estimated based on the present value of expected cash flows, incorporating assumptions for discount rate, prepayment speed and servicing cost. Any impairment is recognized as a charge to earnings through a valuation allowance.
Portfolio Loans Loans held in portfolio are stated at the principal amount outstanding, net of unamortized deferred loan origination fees and costs. Interest income is accrued on a level yield basis based on principal amounts outstanding. Deferred loan origination fees and costs are amortized as an adjustment to yield over the life of the related loans.
Nonaccrual Loans Loans, with the exception of credit card loans and certain well-secured residential mortgage loans, are placed on nonaccrual status and interest recognition is suspended when such loans are 90 days or more overdue with respect to principal and/or interest. Well-secured residential mortgage loans are permitted to remain on accrual status provided that full collection of principal and interest is assured. Loans are also placed on nonaccrual status when, in the opinion of management, full collection of principal and interest is doubtful. Interest previously accrued but not collected on such loans is reversed against current period income. Subsequent cash receipts on nonaccrual loans are applied to the outstanding principal balance of the loan or recognized as interest income depending on management's assessment of the ultimate collectibility of the loan. Loans are removed from nonaccrual status when they have been current as to principal and interest for a period of time, the borrower has demonstrated an ability to comply with repayment terms, and when, in management's opinion, the loans are considered to be fully collectible.
Impaired Loans A loan is impaired when it is probable that the creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. The Corporation considers all nonaccrual commercial loans to be impaired. Impairment is measured on a discounted cash flow method, or at the loan's observable market price, or at the fair value of the collateral if the loan is collateral dependent. Impairment is measured based on the fair value of the collateral if it is determined that foreclosure is probable.
Restructured Loans Restructured loans include those for which concessions such as reduction of interest rates other than normal market rate adjustments, or deferral of principal or interest payments have been granted due to a borrower's financial condition. Subsequent cash receipts on restructured loans are applied to the outstanding principal balance of the loan, or recognized as interest income depending on management's assessment of the ultimate collectibility of the loan.
Allowance for Loan Losses The Corporation continually evaluates the allowance for loan losses by performing ongoing reviews of certain individual loans, the size and composition of the loan portfolio, net charge-off experience, current and expected economic conditions, industry concentrations and other pertinent factors. The allowance for loan losses is maintained at levels considered adequate by management to provide for losses inherent in the loan portfolio. The allowance is increased by provisions charged to earnings and by recoveries of amounts previously charged off, and is reduced by charge-offs on loans.
While management believes that the allowance for loan losses is adequate, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies periodically review the Corporation's allowance for loan losses. Such agencies may require additions to the allowance based on their judgments about information available to them at the time of their examination.
Premises and Equipment Premises and equipment are stated at cost less accumulated depreciation. Depreciation for financial reporting purposes is calculated on the straight-line method over the estimated useful lives of assets. Expenditures for major additions and improvements are capitalized while the costs of current maintenance and repairs are charged to operating expenses.
Other Real Estate Owned (OREO) Other real estate owned consists of property acquired through foreclosure and loans determined to be substantively repossessed. Real estate loans that are substantively repossessed include only those loans for which the Corporation has taken possession of the collateral, but has not completed legal foreclosure proceedings.
OREO is stated at the lower of cost or fair value minus estimated costs to sell at the date of acquisition or classification to OREO status. Fair value of such assets is determined based on independent appraisals and other relevant factors. Any write-down to fair value at the time of foreclosure is charged to the allowance for loan losses. A valuation allowance is maintained for known specific and potential market declines and for estimated selling expenses. Increases to the valuation allowance, expenses associated with ownership of these properties, and gains and losses from their sale are included in foreclosed property costs.
Transfers and Servicing of Assets and Extinguishments of Liabilities The Corporation adopted Statement of Financial Accounting Standards ("SFAS") No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities". This Statement provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. Those standards are based on an approach that focuses on control, whereby after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished. This Statement provides consistent standards for distinguishing transfers of financial assets that are sales from transfers that are secured borrowings. SFAS No. 127, "Deferral of the Effective Date of Certain Provisions of SFAS Statement No. 125" deferred certain provisions of SFAS No. 125 due to logistical issues concerning implementation. The adoption of SFAS No. 125 and SFAS No. 127 did not have an effect on the Corporation's financial statements.
Interest Rate Risk Management Agreements The Corporation uses off-balance sheet financial instruments from time to time as part of its interest rate risk management strategy. Interest rate swap and floor agreements are entered into as hedges against future interest rate fluctuations on specifically identified assets or liabilities. The Corporation does not enter into agreements for trading or speculative purposes. Therefore, these agreements are not marked to market.
The net amounts to be paid or received on outstanding interest rate risk management agreements are recognized on the accrual basis as an adjustment to the related interest income or expense over the life of the agreements. Premiums paid for interest rate floor agreements are amortized as an adjustment to interest income over the term of the agreements. Unamortized premiums are included in other assets. Gains or losses resulting from the termination of interest rate swap and floor agreements on qualifying hedges of existing assets or liabilities are deferred and amortized over the remaining lives of the related assets/liabilities as an adjustment to the yield. Unamortized deferred gains/losses on terminated interest rate swap and floor agreements are included in the underlying assets/liabilities hedged.
Deposit Taxes and Assessments Deposit taxes and assessments consist of amounts assessed to members of the Bank Insurance Fund by the FDIC and deposit taxes imposed by the State of Rhode Island. These amounts are calculated based on levels of bank deposits using rates established by the respective regulatory authorities.
Pension Costs Costs associated with defined benefit plans are accounted for in accordance with SFAS No. 87, "Employers' Accounting for Pensions". Effective January 1, 1998, the Corporation adopted SFAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits, an amendment of SFAS Nos. 87, 88 and 106". SFAS No. 132 standardizes the disclosure requirements for pensions and other postretirement benefits to the extent practicable, requires additional information on changes in the benefit obligations and fair values of plan assets that will facilitate financial analysis, and eliminates certain disclosures required by SFAS Nos. 87, 88 and 106. The adoption of this pronouncement requires restatement of disclosures for earlier periods.
Stock-Based Compensation The Corporation measures compensation cost for stock-based compensation plans using the intrinsic value based method prescribed by Accounting Principles Board ("APB") Opinion No. 25. In addition, the Corporation discloses pro forma net income and earnings per share computed using the fair value based method of accounting for these plans as required by SFAS No. 123.
Income Taxes Income tax expense is determined based on the asset and liability method, whereby deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.
Earnings Per Share Earnings per Share (EPS) is determined and disclosed in accordance with SFAS No. 128. Diluted EPS is computed by dividing net income by the average number of common shares and common stock equivalents outstanding. Common stock equivalents arise from the assumed exercise of outstanding stock options, if dilutive. The computation of basic EPS excludes common stock equivalents from the denominator.
Reporting Comprehensive Income Effective January 1, 1998, the Corporation adopted Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive Income". This Statement establishes standards for reporting and display of comprehensive income, which is defined as all changes in equity, except for those resulting from investments by and distribution to shareholders. SFAS No. 130 classifies net income as a component of comprehensive income, with all other components referred to in the aggregate as other comprehensive income. This Statement also requires that comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. The adoption of this pronouncement also requires reclassification of prior year financial statements for comparative purposes. The disclosure of the reclassification amount reported in the Consolidated Statements of Changes in Shareholders' Equity is shown net of tax. The tax effect on the reclassification adjustment for net gains included in net income amounted to $187, $287 and $148 for 1998, 1997 and 1996, respectively.
Cash Flows For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, federal funds sold, and other short-term investments. Generally, federal funds are sold on an overnight basis.
(2) Cash and Due From Banks The Bank is required to maintain certain average reserve balances with the Federal Reserve. Such reserve balances amounted to $3,784 and $5,641 at December 31, 1998 and 1997, respectively.
(3) Securities Securities are summarized as follows:
Included in corporate stocks at December 31, 1998 are preferred stocks, which are callable at the discretion of the issuer, with an amortized cost of $7,929 and a fair value of $8,410. Call features on these stocks range from one month to nine years.
The contractual maturities and weighted average yields of debt securities are summarized below. Weighted average yields are computed on a fully taxable basis. Mortgage-backed securities are included based on weighted average maturities, adjusted for anticipated prepayments.
At December 31, 1998, the Corporation owned debt securities with an aggregate carrying value of $52,250 which are callable at the discretion of the issuers. The majority of these securities are U.S. Treasury and government-sponsored agency obligations, included in the available-for-sale category. Final maturities of these securities range from two to thirty years with call features ranging from one month to eight years.
The following is a summary of amounts relating to sales of securities available for sale:
Years ended December 31, 1998 1997 1996 ------------------------------------------------------------------------- Proceeds from sales $95,416 $63,600 $35,683 ------------------------------------------------------------------------- Realized gains $1,161 $1,252 $626 Realized losses (656) (519) (258) ------------------------------------------------------------------------- Net realized gains $505 $733 $368 -------------------------------------------------------------------------
Securities available for sale with a fair value of $27,800 and $29,127 were pledged to secure public deposits and for other purposes at December 31, 1998 and 1997 respectively.
(4) Loans The following is a summary of loans:
December 31, 1998 1997 ------------------------------------------------------------------------- Commercial and other: Mortgages (1) $70,468 $62,264 Construction and development (2) 612 3,539 Other (3) 111,477 127,956 ------------------------------------------------------------------------- Total commercial and other 182,557 193,759 Residential real estate: Mortgages 179,589 181,790 Homeowner construction 10,046 6,097 ------------------------------------------------------------------------- Total residential real estate 189,635 187,887 Consumer 77,310 74,264 ------------------------------------------------------------------------- Total loans $449,502 $455,910 -------------------------------------------------------------------------
(1) Amortizing mortgages, primarily secured by income producing property (2) Loans for construction of residential and commercial properties and for land development (3) Loans to businesses and individuals, a substantial portion of which are fully or partially collateralized by real estate
Concentrations of Credit Risk The Corporation's lending activities are primarily conducted in southern Rhode Island and southeastern Connecticut. The Corporation grants single family and multi-family residential loans, commercial real estate loans, commercial loans, and a variety of consumer loans. In addition, loans are granted for the construction of residential homes, commercial real estate properties, and for land development. The ability of single family residential and consumer borrowers to honor their repayment commitments is generally dependent on the level of overall economic activity within the market area and real estate values. The ability of commercial borrowers to honor their repayment commitments is dependent on the general economy as well as the health of the real estate economic sector in the Corporation's market area.
Nonaccrual Loans The balance of loans on nonaccrual status as of December 31, 1998 and 1997 was $5,613 and $7,335, respectively. Interest income that would have been recognized had these loans been performing at originally contracted rates was approximately $520 in 1998 and $800 in 1997. Interest income attributable to these loans included in the Consolidated Statements of Income amounted to approximately $149 in 1998 and $552 in 1997. Included in nonaccrual loans at December 31, 1998 and 1997 are loans amounting to $1,122 and $1,041, respectively, whose terms have been restructured.
Impaired Loans Impaired loans consist of all nonaccrual commercial loans. The following is a summary of impaired loans:
December 31, 1998 1997 -------------------------------------------------------------------------
Impaired loans requiring an allowance $3,702 $5,131 Impaired loans not requiring an allowance 98 363 ------------------------------------------------------------------------- Total recorded investment in impaired loans $3,800 $5,494 -------------------------------------------------------------------------
Years ended December 31, 1998 1997 ------------------------------------------------------------------------- Average recorded investment in impaired loans $5,091 $5,436 ------------------------------------------------------------------------- Interest income recognized on impaired loans $443 $399 -------------------------------------------------------------------------
Mortgage Servicing Activities At December 31, 1998 and 1997, mortgage loans sold to others and serviced by the Corporation on a fee basis under various agreements amounted to $174,730 and $119,471, respectively. Loans serviced for others are not included in the Consolidated Balance Sheets.
The following is a summary of capitalized mortgage servicing rights:
December 31, 1998 1997 ------------------------------------------------------------------------- Balance at beginning of year $334 $145 Additions 551 215 Amortization (79) (26) ------------------------------------------------------------------------- Balance at end of year $806 $334 -------------------------------------------------------------------------
Capitalized mortgage servicing rights are periodically evaluated for impairment. As of December 31, 1998 and 1997, the balance of the valuation allowance amounted to $296 and $41, respectively.
Loans to Related Parties The Corporation has made loans in the ordinary course of business to certain directors and executive officers including their immediate families and their affiliated companies. Such loans were made under normal interest rate and collateralization terms. Activity related to these loans in 1998 and 1997 was as follows:
December 31, 1998 1997 ------------------------------------------------------------------------- Balance at beginning of year $1,898 $2,671 Additions 521 716 Reductions (806) (1,489) ------------------------------------------------------------------------- Balance at end of year $1,613 $1,898 -------------------------------------------------------------------------
(5) Allowance for Loan Losses The following is an analysis of the allowance for loan losses:
Years ended December 31, 1998 1997 1996 ------------------------------------------------------------------------- Balance at beginning of year $8,835 $8,495 $7,785 Provision charged to expense 1,800 1,400 1,200 Recoveries of loans previously charged off 399 402 783 Loans charged off (618) (1,462) (1,273) ------------------------------------------------------------------------- Balance at end of year $10,416 $8,835 $8,495 -------------------------------------------------------------------------
Included in the allowance for loan losses at December 31, 1998, 1997 and 1996 was an allowance for impaired loans amounting to $803, $916 and $867, respectively.
(6) Premises and Equipment The following is a summary of premises and equipment:
December 31, 1998 1997 ------------------------------------------------------------------------- Land and improvements $1,934 $1,884 Premises and improvements 22,507 21,122 Furniture, fixtures and equipment 16,630 14,394 ------------------------------------------------------------------------- 41,071 37,400 Less accumulated depreciation 18,086 15,579 ------------------------------------------------------------------------- Total premises and equipment, net $22,985 $21,821 -------------------------------------------------------------------------
(7) Financial Instruments With Off-Balance Sheet Risk and Derivative Financial Instruments The Corporation is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to manage the Corporation's exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit, standby letters of credit, financial guarantees and interest rate swaps and floors. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the Consolidated Balance Sheets. The contract or notional amounts of these instruments reflect the extent of involvement the Corporation has in particular classes of financial instruments. The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. The contractual and notional amounts of financial instruments with off-balance sheet risk are as follows:
Commitments to Extend Credit Commitments to extend credit are agreements to lend to a customer as long as there are no violations of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Each borrower's creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained is based on management's credit evaluation of the borrower.
Standby Letters of Credit Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.
Interest Rate Risk Management Agreements The Corporation uses interest rate swaps and floors from time to time as part of its interest rate risk management strategy. Swaps are agreements in which the Corporation and another party agree to exchange interest payments (e.g. fixed-rate for variable-rate payments) computed on a notional principal amount. A floor is a purchased contract that entitles the Corporation to receive payment from a counterparty if a rate index falls below a contractual rate. The amount of the payment is the difference between the contractual floor rate and the rate index multiplied by the notional principal amount of the contract. If the rate index does not fall below the contractual floor rate, no payment is received. The credit risk associated with swap and floor transactions is the risk of default by the counterparty. To minimize this risk, the Corporation enters into interest rate agreements only with highly rated counterparties that management believes to be creditworthy. The notional amounts of these agreements do not represent amounts exchanged by the parties and thus, are not a measure of the Corporation's potential loss exposure.
In March 1998, the Corporation entered into a five year interest rate floor contract with a notional amount of $20 million which matures in February 2003. The floor contract entitles the Corporation to receive payment from a counterparty if the three-month LIBOR rate falls below 5.50%. During 1995, the Corporation entered into interest rate floor contracts with a total notional amount of $50 million which mature in February 2000. The Corporation receives payment under contracts with a total notional value of $30 million when the prime rate falls below 9.0% and on the remaining $20 million when 3-month LIBOR at quarterly resetting dates is below 6.1875%. The purpose of the floor contracts is to offset the risk of future reductions in interest earned on certain floating rate loans. The prime rate and 3-month LIBOR applicable to the outstanding floor contracts at December 31, 1998 were 7.75% and 5.0656%, respectively. At December 31, 1998, the fair value, or the value to the Corporation of terminating the contracts, was $1,404. The remaining unamortized premium for these contracts, included in other assets, amounted to $469 at December 31, 1998.
The Corporation has not terminated any interest rate swap agreements or floor contracts and there are no unamortized deferred gains or losses.
(8) Other Real Estate Owned An analysis of the composition of OREO follows:
December 31, 1998 1997 ------------------------------------------------------------------------ Residential real estate $204 $492 Commercial real estate 27 - Land 81 81 ------------------------------------------------------------------------ 312 573 Valuation allowance (69) (76) ------------------------------------------------------------------------ Other real estate owned, net $243 $497 ------------------------------------------------------------------------
An analysis of the activity relating to OREO follows:
Years ended December 31, 1998 1997 ------------------------------------------------------------------------ Balance at beginning of year $573 $1,295 Net transfers from loans 789 809 Sales (1,066) (1,553) Other 16 22 ------------------------------------------------------------------------ 312 573 Valuation allowance (69) (76) ------------------------------------------------------------------------ Other real estate owned, net $243 $497 ------------------------------------------------------------------------
The following is an analysis of activity relating to the OREO valuation allowance:
Years ended December 31, 1998 1997 1996 ------------------------------------------------------------------------ Balance at beginning of year $76 $205 $410 Provision charged to expense 14 42 303 Sales (1) (131) (458) Selling expenses incurred (20) (40) (50) ------------------------------------------------------------------------ Balance at end of year $69 $76 $205 ------------------------------------------------------------------------
Net realized gains on dispositions of properties amounted to $59, $69 and $351 in 1998, 1997 and 1996, respectively. These amounts are included in other noninterest expense in the Consolidated Statements of Income.
(9) Time Certificates of Deposit Scheduled maturities of time certificates of deposit at December 31, 1998 were as follows:
Years ending December 31: 1999 $226,112 2000 43,589 2001 4,626 2002 2,042 2003 1,395 2004 and thereafter 83 ------------------------------------------------------------------------ Balance at December 31, 1998 $277,847 ------------------------------------------------------------------------
The aggregate amount of time certificates of deposit in denominations of $100 or more was $78,488 and $59,270 at December 31, 1998 and 1997, respectively.
(10) Borrowings Short-Term Borrowings Short-term borrowings consist primarily of securities sold under repurchase agreements which generally mature within 90 days. The securities underlying the agreements are held in safekeeping by the counterparty in the name of the Corporation and are repurchased when the agreement matures. Accordingly, these underlying securities are included in securities available for sale and the obligation to repurchase such securities are reflected as a liability. The following is a summary of amounts relating to short-term borrowings:
Years ended December 31, 1998 1997 1996 -------------------------------------------------------------------------- Maximum amount outstanding at any month-end $26,767 $26,820 $14,000 -------------------------------------------------------------------------- Average amount outstanding $15,085 $14,773 $3,260 --------------------------------------------------------------------------
Federal Home Loan Bank Advances The following table presents scheduled maturities and weighted average interest rates paid on Federal Home Loan Bank advances outstanding at December 31, 1998:
Weighted Average Rate Amount --------------------------------------------------------------------------- Years ending December 31: 1999 5.42% $169,787 2000 5.03% 25,844 2001 5.60% 21,806 2002 5.67% 7,784 2003 5.12% 12,128 2004 and thereafter 4.55% 24,757 --------------------------------------------------------------------------- Balance at December 31, 1998 $262,106 ---------------------------------------------------------------------------
Included in the outstanding amounts disclosed above, are callable advances totaling $25,000. Call features on these advances range from one to five years. In addition to the outstanding advances, the Bank also has access to an unused line of credit amounting to $13,927 at December 31, 1998. Under agreement with the FHLB, the Bank is required to maintain qualified collateral, free and clear of liens, pledges, or encumbrances that, based on certain percentages of book and market values, has a value equal to the aggregate amount of the line of credit and outstanding advances. Qualified collateral may consist of residential mortgage loans, U.S. government or agency securities, and amounts maintained on deposit at the FHLB. The Bank maintains qualified collateral in excess of the amount required to collateralize the line of credit and outstanding advances at December 31, 1998.
(11) Employee Benefits Defined Benefit Pension Plans The Corporation's noncontributory tax-qualified defined benefit pension plan covers substantially all full-time employees. Benefits are based on an employee's years of service and highest 3-year compensation. The plan is funded on a current basis, in compliance with the requirements of the Employee Retirement Income Security Act. The prepaid benefit costs relating to the defined benefit pension plan amounted to $938 and $807 at December 31, 1998 and 1997, respectively.
The Corporation has a nonqualified retirement plan to provide supplemental retirement benefits to certain employees, as defined in the plan. The accrued pension liability related to this plan amounted to $323 and $270 at December 31, 1998 and 1997, respectively. The actuarial assumptions used for this supplemental plan are the same as those used for the Corporation's tax-qualified pension plan. The accumulated benefit obligation for this plan amounted to $777 and $678 at December 31, 1998 and 1997, respectively.
The following is a reconciliation of the benefit obligation, fair value of plan assets and funded status of the Corporation's defined benefit pension plans:
Years ended December 31, 1998 1997 ------------------------------------------------------------------------- Change in Benefit Obligation: Benefit obligation at beginning of year $12,390 $10,370 Service cost 502 376 Interest cost 915 791 Actuarial gain 1,299 1,352 Benefits paid (627) (500) ------------------------------------------------------------------------- Benefit obligation at end of year $14,479 $12,390 ------------------------------------------------------------------------- Change in Plan Assets: Fair value of plan assets at beginning of year $14,392 $11,494 Actual return on plan assets 2,006 2,824 Employer contribution 578 574 Benefits paid (627) (500) ------------------------------------------------------------------------- Fair value of plan assets at end of year $16,349 $14,392 -------------------------------------------------------------------------
Certain changes in the items shown are not recognized as they occur, but are amortized systematically over subsequent periods. Unrecognized amounts to be amortized and the amounts included in the Consolidated Balance Sheets are as follows:
Years ended December 31, 1998 1997 ------------------------------------------------------------------------- Funded status $1,870 $2,002 Unrecognized transition asset (55) (61) Unrecognized prior service cost 522 597 Unrecognized net actuarial (gain) loss (1,722) (2,001) ------------------------------------------------------------------------- Prepaid benefit cost $615 $537 -------------------------------------------------------------------------
As of December 31, 1998 1997 ------------------------------------------------------------------------- Assumptions Used: Discount rate 6.75% 7.25% Expected return on plan assets 8.50% 8.00% Rate of compensation increase 5.00% 5.00%
The components of net pension cost include the following:
Years ended December 31, 1998 1997 1996 ------------------------------------------------------------------------- Components of Net Periodic Benefit Cost: Service cost $502 $376 $435 Interest cost 915 791 720 Expected return on plan assets (992) (826) (743) Amortization of transition asset (6) (6) (6) Amortization of prior service cost 75 75 73 Recognized net actuarial loss 6 13 9 ------------------------------------------------------------------------- Net periodic benefit cost $500 $423 $488 -------------------------------------------------------------------------
Savings and Profit Sharing Plan The Corporation has a qualified savings and profit sharing plan. The plan provides a specified match of employee contributions for substantially all full-time employees. In addition, full-time employees, excluding those key employees participating in the Short-Term Incentive Plan, are eligible for an annual benefit pursuant to a formula based on return on equity. Total employer matching contributions under this plan amounted to $231, $223 and $198 in 1998, 1997 and 1996, respectively. The amount of the profit sharing benefit was $306, $286 and $245 for 1998, 1997 and 1996, respectively.
Short-Term Incentive Plan The Corporation's nonqualified Short-Term Incentive Plan rewards key employees for their contributions to the Corporation's success. This plan provides for annual payments up to a maximum percentage of each participant's base salary, which percentages vary among participants. Payment amounts are based on the achievement of target levels of return on equity and/or the achievement of individual objectives. Participants in this plan are not eligible to receive benefits provided under the profit sharing component of the Savings and Profit Sharing Plan. The expense of the Short-Term Incentive Plan amounted to $688, $640 and $597 in 1998, 1997 and 1996, respectively.
Directors' Retainer Continuation Plan The Corporation has a nonqualified plan which provides retirement benefits to non-officer directors. On October 1, 1996, the provisions of the plan were terminated for active directors and the accrued benefit was settled through the issuance of common stock (Note 15). The benefits provided under this plan continue for retired directors. The expense of this plan is included in other noninterest expense and amounted to $25, $36 and $63 for 1998, 1997 and 1996, respectively. Accrued and unpaid benefits under this plan are an unfunded obligation of the Bank. The accrued liability related to this plan amounted to $256 and $263 at December 31, 1998 and 1997, respectively.
(12) Income Taxes The components of income tax expense were as follows:
Years ended December 31, 1998 1997 1996 ------------------------------------------------------------------------ Current expense: Federal $4,276 $3,405 $3,322 State 2 237 819 ------------------------------------------------------------------------ Total current expense 4,278 3,642 4,141 ------------------------------------------------------------------------ Deferred expense (benefit): Federal (330) 445 181 State - (445) (24) ------------------------------------------------------------------------ Total deferred expense (330) - 157 ------------------------------------------------------------------------ Total income tax expense $3,948 $3,642 $4,298 ------------------------------------------------------------------------
Total income tax expense varied from the amount determined by applying the Federal income tax rate to income before income taxes. The reasons for the differences were as follows:
Years ended December 31, 1998 1997 1996 --------------------------------------------------------------------------- Tax expense at Federal statutory rate $4,798 $4,328 $4,326 Increase (decrease) in taxes resulting from: Tax-exempt income (401) (282) (237) Dividends received deduction (261) (253) (282) State tax, net of Federal income tax benefit (1) (137) 553 Effect of change in state tax rate - - (43) Other (187) (14) (19) --------------------------------------------------------------------------- Total income tax expense $3,948 $3,642 $4,298 ---------------------------------------------------------------------------
The approximate tax effects of temporary differences that give rise to gross deferred tax assets and gross deferred tax liabilities at December 31, 1998 and 1997 are as follows:
December 31, 1998 1997 ------------------------------------------------------------------------ Gross deferred tax assets: Allowance for loan losses $3,441 $2,890 Deferred loan origination fees 312 249 Interest on nonaccrual loans 198 270 Other 903 838 ------------------------------------------------------------------------ Gross deferred tax assets 4,854 4,247 ------------------------------------------------------------------------ Gross deferred tax liabilities: Securities available for sale (4,157) (3,987) Premises and equipment (1,114) (1,093) Deferred loan origination costs (686) (643) Pension (308) (264) Other (218) (210) ------------------------------------------------------------------------ Gross deferred tax liabilities (6,483) (6,197) ------------------------------------------------------------------------ Net deferred tax liability $(1,629) $(1,950) ------------------------------------------------------------------------
In addition to future taxable income, a primary source of recovery of deferred tax assets is taxes paid in prior years available for carryback.
(13) Operating Leases At December 31, 1998, the Corporation was committed to rent premises used in banking operations under noncancellable operating leases. Rental expense under the operating leases amounted to $334, $131 and $47 for 1998, 1997 and 1996, respectively. The minimum annual lease payments under the terms of these leases, exclusive of renewal provisions, are as follows:
Years ending December 31: 1999 $236 2000 244 2001 247 2002 120 2003 71 Thereafter 42 ------------------------------------------------------------------------ $960 ------------------------------------------------------------------------
At December 31, 1998, the Corporation was committed to exercise a purchase option under a lease relating to certain real estate. This purchase was consummated in January 1999 for $1,077. The lease payments relating to this property has been excluded from the minimum annual lease payments disclosed above.
(14) Litigation On January 28, 1997, a suit was filed against the Bank by a corporate customer and the customer's shareholders for damages which the plaintiffs allegedly incurred as a result of an embezzlement by the customer's former president and treasurer. The suit alleges that the Bank wrongly permitted this individual, while an officer of the customer, to divert funds from the customer's account at the Bank for his personal benefit. The claims against the Bank are based upon theories of breach of fiduciary duties, negligence, breach of contract, unjust enrichment, conversion, failure to act in a commercially reasonable manner, and constituted fraud.
The suit as originally filed sought recovery for losses directly related to the embezzlement of approximately $3,100, as well as consequential damages amounting to approximately $2,600. On March 19, 1998, the plaintiffs amended their claims to seek recovery of an additional $2,600 in losses, plus an unspecified amount of interest thereon, which are alleged to be directly related to the embezzlement. Management believes, based on its review with counsel of the development of this matter to date, that the Bank has asserted meritorious affirmative defenses in this litigation. Additionally, the Bank has filed counterclaims against the customer and its principal shareholder, as well as claims against the officer allegedly responsible for the embezzlement. The Bank intends to vigorously assert its defenses and affirmative claims. The case is in discovery and management and legal counsel are unable to estimate or assess the extent of risk of an adverse result. Consequently, no loss provision for this lawsuit has been recorded.
The Corporation is involved in various other claims and legal proceedings arising out of the ordinary course of business. Management is of the opinion, based on its review with counsel of the development of such matters to date, that the ultimate disposition of such other matters will not materially affect the consolidated financial position or results of operations of the Corporation.
(15) Shareholders' Equity Stock Splits A 3-for-2 stock split, in the form of a stock dividend, was paid on August 3, 1998 to shareholders of record on July 17, 1998. A 3-for-2 stock split on shares of common stock was also paid on November 19, 1997 to shareholders of record on November 5, 1997. The par value of the common stock remained unchanged at $.0625 per share. Cash payments were made in lieu of issuing fractional shares. All share and per share amounts in the consolidated financial statements and related notes have been restated to reflect these stock splits.
Stock Repurchase Plan In December 1997, the Corporation's Board of Directors approved a program to repurchase up to 225,000, or approximately 2.3%, of its outstanding common shares. This plan replaces the June 1996 authorization to repurchase 195,750 shares. The Corporation plans to hold the repurchased shares as treasury stock to be used for general corporate purposes. During the year ended December 31, 1998, approximately 139,274 shares were repurchased under the December 1997 plan at a total cost of $3,005. As of December 31, 1997, there were no shares repurchased under the December 1997 plan.
Rights On August 1996, the Corporation declared a dividend of one common share purchase right (a "Right") for each share of common stock payable on September 3, 1996 to shareholders of record on that date. Such Rights also apply to new issuances of shares after that date. Each Right entitles the registered holder to purchase from the Corporation one share of its common stock at a price of $35.56 per share, subject to adjustment.
The Rights are not exercisable or separable from the common stock until the earlier of 10 days after a person or group (an "Acquiring Person") acquires beneficial ownership of 15% or more of the outstanding common shares or announces a tender offer to do so. The Rights, which expire on August 31, 2006, may be redeemed by the Corporation at any time prior to the acquisition by an Acquiring Person of beneficial ownership of 15% or more of the common stock at a price of $.001 per Right. In the event that any party becomes an Acquiring Person, each holder of a Right, other than Rights owned by the Acquiring Person, will have the right to receive upon exercise that number of common shares having a market value of two times the purchase price of the Right. In the event that, at any time after any party becomes an Acquiring Person, the Corporation is acquired in a merger or other business combination transaction or 50% or more of its assets or earning power are sold, each holder of a Right will have the right to purchase that number of shares of the acquiring company having a market value of two times the purchase price of the Right.
Dividends The primary source of funds for dividends paid by the Corporation is dividends received from the Bank. The Corporation and the Bank are regulated enterprises and their abilities to pay dividends are subject to regulatory review and restriction. Certain regulatory and statutory restrictions exist regarding dividends, loans, and advances from the Bank to the Corporation. Generally the Bank has the ability to pay dividends to the parent subject to minimum regulatory capital requirements. Under the most restrictive of these requirements, the Bank could have declared aggregate additional dividends of $26,795 as of December 31, 1998.
Stock Option Plans The Corporation's 1997 Equity Incentive Plan (the "1997 Plan") permits the granting of options and other equity incentives to key employees, directors, advisors, and consultants. Up to 1,012,500 shares of the Corporation's common stock may be used from authorized but unissued shares, treasury stock, or shares available from expired awards. As of December 31, 1998, only options have been granted under the 1997 Plan and the exercise price of each option is the fair market value on the date of the grant. Options are designated either as non-qualified or as incentive options. In general, the option price is payable in cash, by the delivery of shares of the Corporation's common stock already owned by the grantee, or a combination thereof. Awards may be granted at any time until April 29, 2007.
The 1988 Amended and Restated Stock Option Plan (the "1988 Plan") provided for the granting of options to directors, officers and key employees. The 1988 Plan permitted options to be granted at any time until December 31, 1997. The 1988 Plan provided for shares of the Corporation's common stock to be used from authorized but unissued shares, treasury stock, or shares available from expired options. Options were designated either as non-qualified or as incentive options. The exercise price of options granted was equal to the fair market value on the date of grant. In general, the option price is payable in cash, by the delivery of shares of the Corporation's common stock already owned by the grantee, or a combination thereof. The 1988 Plan permitted options to be granted with stock appreciation rights (SARs), however, no options under the 1988 Plan were granted with SARs.
Options granted under the plans vest according to various terms at the end of ten years. The following table presents changes in options outstanding during 1998, 1997 and 1996:
The weighted average exercise price and remaining contractual life for options outstanding at December 31, 1998 were as follows:
As discussed in Note 1, the Corporation accounts for its stock option plan using the intrinsic value based method prescribed by APB Opinion No. 25, and in addition, is required to disclose pro forma net income and earnings per share using the fair value based method prescribed by SFAS No. 123. Accordingly, no compensation cost for these plans has been recognized in the Consolidated Statements of Income for 1998, 1997 and 1996.
In determining the pro forma disclosures required by SFAS No. 123, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. The following table presents pro forma net income and earnings per share assuming the stock option plan was accounted for using the fair value method prescribed by SFAS No. 123, the weighted average assumptions used and the grant date fair value of options granted in 1998, 1997 and 1996:
Years ended December 31, 1998 1997 1996 - --------------------------------------------------------------------------------
Net income As reported $10,048 $9,087 $8,425 Pro forma $9,696 $8,783 $8,306
Earnings per share - basic As reported $1.01 $.92 $.87 Pro forma $.97 $.89 $.85
Earnings per share - diluted As reported $.97 $.89 $.84 Pro forma $.94 $.86 $.83
Weighted average fair value $5.40 $4.31 $2.59 Expected life 8.6 years 8.4 years 6.3 years Risk-free interest rate 6.04% 6.3% 6.6% Expected volatility 25.9% 21.2% 17.2% Expected dividend yield 4.0% 4.25% 4.0%
The pro forma effect on net income and earnings per share for 1998, 1997 and 1996 is not representative of the pro forma effect on net income and earnings per share for future years because it does not reflect compensation cost for options granted prior to January 1, 1995.
Dividend Reinvestment Under the Amended and Restated Dividend Reinvestment and Stock Purchase Plan, 607,500 shares of common stock were originally reserved to be issued for dividends reinvested and cash payments to the plan.
Reserved Shares As of December 31, 1998, a total of 2,603,797 common stock shares were reserved for issuance under the 1988 Amended and Restated Stock Option Plan, the 1997 Equity Incentive Plan and the Amended and Restated Dividend Reinvestment and Stock Purchase Plan.
Regulatory Capital Requirements The Corporation and the Bank are subject to various regulatory capital requirements administered by the Federal Reserve Board and the FDIC, respectively. These requirements were established to more accurately assess the credit risk inherent in the assets and off-balance sheet activities of financial institutions. 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 consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation and the Bank must meet specific capital guidelines that involve quantitative measures of the assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Corporation and the Bank to maintain minimum amounts and ratios of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital to average assets (as defined). Management believes, as of December 31, 1998, that the Corporation and the Bank meet all capital adequacy requirements to which they are subject.
As of December 31, 1998, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios. There are no conditions or events since that notification that management believes have changed the Bank's category.
The following table presents the Corporation's and the Bank's actual capital amounts and ratios at December 31, 1998 and 1997, as well as the corresponding minimum regulatory amounts and ratios:
(16) Earnings per Share
(17) Fair Value of Financial Instruments SFAS No. 107, "Disclosures about Fair Value of Financial Instruments", requires that the Corporation disclose estimated fair values of its financial instruments. Fair value estimates are made as of a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any pricing adjustments that could result from the sale of the Corporation's entire holding of a particular financial instrument. Because no quoted market exists for a portion of the financial instruments, fair value estimates are based on subjective judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. Changes in assumptions could significantly affect the estimates of fair value. Fair value estimates, methods, and assumptions are set forth as follows:
Cash and Securities The carrying amount of short-term instruments such as cash and federal funds sold is used as an estimate of fair value.
The fair value of securities available for sale and held to maturity is estimated based on bid prices published in financial newspapers or bid quotations received from securities dealers. No market exists for shares of the Federal Home Loan Bank of Boston. Such stock may be redeemed at par upon termination of FHLB membership and is therefore valued at par, which equals cost.
Mortgage Loans Held for Sale The fair value of mortgage loans held for sale is estimated using the quoted market prices for sales of similar loans on the secondary market.
Loans Fair values are estimated for categories of loans with similar financial characteristics. Loans are segregated by type and are then further segmented into fixed rate and adjustable rate interest terms to determine their fair value. The fair value of fixed rate commercial and consumer loans is calculated by discounting scheduled cash flows through the estimated maturity of the loan using interest rates offered at December 31, 1998 and 1997 that reflect the credit and interest rate risk inherent in the loan. The estimate of maturity is based on the Corporation's historical repayment experience. For residential mortgages, fair value is estimated by using quoted market prices for sales of similar loans on the secondary market, adjusted for servicing costs. The fair value of floating rate commercial and consumer loans approximates carrying value. The fair value of nonaccrual loans is calculated by discounting estimated cash flows, using a rate commensurate with the risk associated with the loan type or by other methods that give consideration to the value of the underlying collateral.
Deposit Liabilities The fair value of demand deposits, savings accounts, and certain money market accounts is equal to the amount payable on demand as of December 31, 1998 and 1997. The discounted values of cash flows using the rates currently offered for deposits of similar remaining maturities were used to estimate the fair value of certificates of deposit.
Securities Sold Under Agreements to Repurchase The carrying amount of securities sold under repurchase agreements approximates fair value.
Federal Home Loan Bank Advances Rates currently available to the Corporation for advances with similar terms and remaining maturities are used to estimate fair value of existing advances.
Off-Balance Sheet Instruments The fair values of interest rate swap agreements and floor contracts generally reflect the estimated amounts that the Corporation would receive or pay to terminate the contracts. The fair value of commitments to extend credit is 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. For fixed rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties.
The following table presents the fair values of the Corporation's financial instruments:
Other off-balance sheet financial instruments, consisting largely of loan commitments and letters of credit, contain provisions for fees, conditions and term periods which are consistent with customary market practices. Accordingly, the fair value amounts (considered to be the discounted present value of the remaining contractual fees over the unexpired commitment period) would not be material and therefore are not disclosed.
(18) Parent Company Financial Statements The following are parent company only financial statements of Washington Trust Bancorp, Inc. reflecting the investment in the bank subsidiary on the equity basis of accounting. The Statements of Changes in Shareholders' Equity for the parent company only are identical to the Consolidated Statements of Changes in Shareholders' Equity and are therefore not presented.
(18) Subsequent Event On February 23, 1999, the Corporation announced that it had signed a definitive agreement to acquire PierBank, a Rhode Island-chartered community bank with assets of $59.4 million, which is headquartered in South Kingstown, Rhode Island. Under the terms of the agreement, Washington Trust Bancorp, Inc. will exchange shares of its common stock for shares of PierBank common stock. Each PierBank share will initially be valued at approximately $8.60, for a total transaction value of $13.7 million. The actual number and value of Washington Trust Bancorp, Inc. common shares to be issued to PierBank shareholders will be based on an exchange formula using the average closing price of Washington Trust Bancorp's common stock during the 15 trading days prior to receiving final regulatory approval. Based on the initial exchange ratio, Washington Trust Bancorp will exchange .4517 shares of its common stock for each share of common stock held by a PierBank shareholder. In accordance with the agreement, PierBank granted Washington Trust Bancorp, Inc. an option to acquire under certain terms and conditions up to 319,810 shares at $7.48 per share. The option was granted as an inducement to Washington Trust Bancorp Inc.'s willingness to enter into the agreement. The purchase, which is expected to be completed in the second half of 1999, is subject to approval by PierBank's shareholders as well as State and Federal banking regulators. The transaction is expected to be a tax-free reorganization and accounted for as a pooling of interests.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Required information regarding directors is presented under the caption "Nominee and Director Information" in the Corporation's Proxy Statement dated March 19, 1999 prepared for the Annual Meeting of Shareholders to be held April 27, 1999 and incorporated herein by reference.
Required information regarding executive officers of the Corporation is included in Part I under the caption "Executive Officers of the Registrant".
Information required with respect to compliance with Section 16(a) of the Exchange Act appears under the caption "Section 16(a) Beneficial Ownership Reporting Compliance" in the Corporation's Proxy Statement dated March 19, 1999 prepared for the Annual Meeting of Shareholders to be held April 27, 1999, which is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item appears under the caption "Compensation of Directors and Executive Officers - Executive Compensation" in the Corporation's Proxy Statement dated March 19, 1999 prepared for the Annual Meeting of Shareholders to be held April 27, 1999, which is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item appears under the caption "Nominee and Director Information" in the Corporation's Proxy Statement dated March 19, 1999 prepared for the Annual Meeting of Shareholders to be held April 27, 1999, which is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item is incorporated herein by reference to the caption "Indebtedness and Other Transactions" in the Corporation's Proxy Statement dated March 19, 1999 prepared for the Annual Meeting of Shareholders to be held April 27, 1999.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) 1. The financial statements of the Registrant required in response to this Item are listed in response to Part II, Item 8 of this Report.
2. Financial Statement Schedules. All schedules normally required by Article 9 of Regulation S-K and all other schedules to the consolidated financial statements of the Registrant have been omitted because the required information is either not required, not applicable, or is included in the consolidated financial statements or notes thereto.
(b) There were no reports on Form 8-K filed during the quarter ended December 31, 1998.
(c) Exhibit Index.
Exhibit Number --------------------
3.a Restated Articles of Incorporation of the Registrant - Filed as Exhibit 3.(i) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1994. (1)
3.b Amendment to Restated Articles of Incorporation - Filed as Exhibit 3.i to the Registrant's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1997. (1)
3.c Amended and Restated By-Laws of the Corporation - Filed as Exhibit 3.c to the Registrant's Annual Report on Form 10-K for the fiscal year ended December ,31 1997. (1)
4 Rights Agreement between the Registrant and The Washington Trust Company dated as of August 15, 1996 (including Form of Right Certificate attached thereto as Exhibit A) - Filed as Exhibit 1 to the Registrant's Registration Statement on Form 8-A (File No. 000-13091) filed with the Commission on August 16, 1996. (1)
10.a Supplemental Pension Benefit and Profit Sharing Plan - Filed as Exhibit 10.1 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1994. (1) (2)
10.b Short Term Incentive Plan Description - Filed as Exhibit 10.b to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1997. (1) (2)
10.c Amended and Restated Nonqualified Deferred Compensation Plan - Filed as Exhibit 4.4 to the Registrant's Registration Statement on Form S-8 (File No. 333-72277) filed with the Commission on February 12, 1999. (1) (2)
10.d Amended and Restated 1988 Stock Option Plan - Filed as Exhibit 10.4 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1994. (1) (2)
10.e Vote of the Board of Directors of the Corporation which constitutes the 1996 Directors' Stock Plan - Filed as Exhibit 99.2 to the Registrant's Registration Statement on Form S-8 (File No. 333-13167) filed with the Commission on October 1, 1996. (1) (2)
10.f The Registrant's 1997 Equity Incentive Plan - Filed as Exhibit 10.a to the Registrant's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1997. (1) (2)
10.g Change in Control Agreements with Executive Officers - Filed as Exhibit 10.b to the Registrant's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1997. (1) (2)
10.h Change in Control Agreements with Executive Officers - Filed herewith. (2)
21 Subsidiaries of the Registrant - Filed as Exhibit 21 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1996. (1)
23 Consent of Independent Auditors - Filed herewith.
27 Financial Data Schedules - Filed herewith.
--------------------
(1) Not filed herewith. In accordance with Rule 12b-32 promulgated pursuant to the Securities Exchange Act of 1934, as amended, reference is made to the documents previously filed with the Commission, which are incorporated by reference herein.
(2) Management contract or compensatory plan or arrangement
(d) Financial Statement Schedules. None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
WASHINGTON TRUST BANCORP, INC. ----------------------------------------------- (Registrant)
Date: February 18, 1999 By John C. Warren - ------------------------ ----------------------------------------------- John C. Warren President, Chief Executive Officer and Director (principal executive officer)
Date: February 18, 1999 By David V. Devault - ------------------------ ----------------------------------------------- David V. Devault Executive Vice President, Treasurer and Chief Financial Officer (principal financial and principal accounting officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Date: February 18, 1999 Alcino G. Almeida ---------------------------- ---------------------------------- Alcino G. Almeida, Director
Date: February , 1999 ---------------------------- ---------------------------------- Gary P. Bennett, Director
Date: February 18, 1999 Steven J. Crandall ---------------------------- ---------------------------------- Steven J. Crandall, Director
Date: February 18, 1999 Richard A. Grills ---------------------------- ---------------------------------- Richard A. Grills, Director
Date: February 18, 1999 Larry J. Hirsch ---------------------------- ---------------------------------- Larry J. Hirsch, Director
Date: February 18, 1999 Katherine W. Hoxsie ---------------------------- ---------------------------------- Katherine W. Hoxsie, Director
Date: February , 1999 ---------------------------- ---------------------------------- Mary E. Kennard, Director
Date: February 18, 1999 Joseph J. Kirby ---------------------------- ---------------------------------- Joseph J. Kirby, Director
Date: February 18, 1999 James W. McCormick, Jr. ---------------------------- ---------------------------------- James W. McCormick, Jr., Director
Date: February , 1999 ---------------------------- ---------------------------------- Brendan P. O'Donnell, Director
Date: February 18, 1999 Victor J. Orsinger ---------------------------- ---------------------------------- Victor J. Orsinger II, Director
Date: February 18, 1999 Anthony J. Rose, Jr. ---------------------------- ---------------------------------- Anthony J. Rose, Jr., Director
Date: February 18, 1999 James P. Sullivan ---------------------------- ---------------------------------- James P. Sullivan, Director
Date: February 18, 1999 Neil H. Thorp ---------------------------- ---------------------------------- Neil H. Thorp, Director
Date: February 18, 1999 John C. Warren ---------------------------- ---------------------------------- John C. Warren, Director