Cautionary Statement Regarding Forward-Looking Information
This Quarterly Report on Form 10-Q, including Management's Discussion and Analysis of Financial Condition and Results of Operations, contains certain forward-looking statements that are provided to assist in the understanding of anticipated future financial performance. Forward-looking statements provide current expectations or forecasts of future events and are not guarantees of future performance. Examples of forward-looking statements include: (a) projections of income or expense, earnings per share, the payments or non-payments of dividends, capital structure and other financial items; (b) statements of plans and objectives of the Company or our management or Board of Directors, including those relating to products or services; (c) statements of future economic performance; (d) statements of future customer attraction or retention; and (e) statements of assumptions underlying such statements. Words such as "anticipates", "believes", "plans", "intends", "expects", "projects", "estimates", "should", "may", "would be", "will allow", "will likely result", "will continue", "will remain", or other similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying those statements. Forward-looking statements are based on management's expectations and are subject to a number of risks and uncertainties. Although management believes that the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially from those expressed or implied in such statements. Risks and uncertainties that could cause actual results to differ materially include, without limitation, risks and uncertainties inherent in the national and regional banking industry, changes in economic conditions in the market areas in which the Company and its subsidiaries operate, changes in policies by regulatory agencies, changes in accounting standards and policies, changes in tax laws, fluctuations in interest rates, demand for loans in the market areas in which the Company and its subsidiaries operate, increases in
FDICinsurance premiums, changes in the competitive environment, losses of significant customers, geopolitical events and the loss of key personnel. Additional detailed information concerning a number of important factors which could cause actual results to differ materially from the forward-looking statements contained in Management's Discussion and Analysis of Financial Condition and Results of Operations is available in the Company's filings with the Securities and Exchange Commission, including the risks identified under the heading "Item 1A. Risk Factors" of Part I of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2013. Undue reliance should not be placed on the forward-looking statements, which speak only as of the date hereof. Except as may be required by law, the Company undertakes no obligation to update any forward-looking statement to reflect unanticipated events or circumstances after the date on which the statement is made.
SB Financial Group, Inc.("SB Financial" or the "Company") is a bank holding company registered with the Federal Reserve Board. SB Financial'swholly-owned subsidiary, The State Bankand Trust Company(" State Bank"), is an Ohio-chartered bank engaged in commercial banking. SB Financial'stechnology subsidiary, Rurbanc Data Services, Inc.dba RDSI Banking Systems ("RDSI"), provides item processing services to community banks and businesses. Rurban Statutory Trust I ("RST I") was established in August 2000. In September 2000, RST I completed a pooled private offering of 10,000 Trust Preferred Securities with a liquidation amount of $1,000per security. The proceeds of the offering were loaned to the Company in exchange for junior subordinated debentures of the Company with terms substantially similar to the Trust Preferred Securities. The sole assets of RST I are the junior subordinated debentures, and the back-up obligations, in the aggregate, constitute a full and unconditional guarantee by the Company of the obligations of RST I. 28 -------------------------------------------------------------------------------- Rurban Statutory Trust II ("RST II") was established in August 2005. In September 2005, RST II completed a pooled private offering of 10,000 Trust Preferred Securities with a liquidation amount of $1,000per security. The proceeds of the offering were loaned to the Company in exchange for junior subordinated debentures of the Company with terms substantially similar to the Trust Preferred Securities. The sole assets of RST II are the junior subordinated debentures, and the back-up obligations, in the aggregate, constitute a full and unconditional guarantee by the Company of the obligations of RST II.
Unless the context indicates otherwise, all references herein to "we", "us", "our", or the "Company" refer to
SB Financial Group, Inc.and its consolidated subsidiaries.
Recent Regulatory Developments
The Dodd-Frank Act was enacted into law on
July 21, 2010. The Dodd-Frank Act is significantly changing the regulation of financial institutions and the financial services industry. Among the provisions already implemented pursuant to the Dodd-Frank Act, the following provisions have or may have an effect on the business of the Company and its subsidiaries:
· the federal law prohibiting the payment of interest on commercial demand
deposit accounts was eliminated effective
July 21, 2011;
· the standard maximum amount of deposit insurance per customer was permanently
· the assessment base for determining deposit insurance premiums has been
expanded from domestic deposits to average assets minus average tangible
· public companies in all industries are required to provide shareholders the
opportunity to cast a non-binding advisory vote on executive compensation;
· new capital regulations for bank holding companies have been adopted, which
will impose stricter requirements, and any new trust preferred securities
May 19, 2010will no longer constitute Tier I capital; and
· new corporate governance requirements applicable generally to all public
companies in all industries require new compensation practices and disclosure
requirements, including requiring companies to "claw back" incentive
compensation under certain circumstances, to consider the independence of
compensation advisors and to make additional disclosures in proxy statements
with respect to compensation matters.
Many provisions of the Dodd-Frank Act have not yet been implemented and will require interpretation and rule making by federal regulators. As a result, the ultimate effect of the Dodd-Frank Act on the Company cannot yet be determined. However, it is likely that the implementation of these provisions will increase compliance costs and fees paid to regulators, along with possibly restricting the operations of the Company and its subsidiaries. 29 --------------------------------------------------------------------------------
The Volcker Rule
December 2013, five federal agencies adopted a final regulation implementing the Volcker Rule provision of the Dodd-Frank Act (the "Volcker Rule"). The Volcker Rule places limits on the trading activity of insured depository institutions and entities affiliated with a depository institution, subject to certain exceptions. The trading activity includes a purchase or sale as principal of a security, derivative, commodity future or option on any such instrument in order to benefit from short-term price movements or to realize short-term profits. The Volcker Rule exempts specified U.S. Government, agency and/or municipal obligations, and it exempts trading conducted in certain capacities, including as a broker or other agent, through a deferred compensation or pension plan, as a fiduciary on behalf of customers, to satisfy a debt previously contracted, repurchase and securities lending agreements and risk-mitigating hedging activities. The Volcker Rule also prohibits a banking entity from having an ownership interest in, or certain relationships with, a hedge fund or private equity fund, with a number of exceptions. The Company does not engage in any of the trading activities or have any ownership interest in or relationship with any of the types of funds regulated by the Volcker Rule.
Executive and Incentive Compensation
June 2010, the Federal Reserve Board, the OCC and the FDICissued joint interagency guidance on incentive compensation policies (the "Joint Guidance") intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. This principles-based guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization's incentive compensation arrangements should (a) provide incentives that do not encourage risk-taking beyond the organization's ability to effectively identify and manage risks, (b) be compatible with effective internal controls and risk management and (c) be supported by strong corporate governance, including active and effective oversight by the organization's board of directors. Pursuant to the Joint Guidance, the Federal Reserve Boardwill review as part of a regular, risk-focused examination process, the incentive compensation arrangements of financial institutions such as the Company. Such reviews will be tailored to each organization based on the scope and complexity of the organization's activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination and deficiencies will be incorporated into the institution's supervisory ratings, which can affect the institution's ability to make acquisitions and take other actions. Enforcement actions may be taken against an institution if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization's safety and soundness and prompt and effective measures are not being taken to correct the deficiencies. On February 7, 2011, federal banking regulatory agencies jointly issued proposed rules on incentive-based compensation arrangements under applicable provisions of the Dodd-Frank Act (the "Proposed Rules"). The Proposed Rules generally apply to financial institutions with $1.0 billionor more in assets that maintain incentive-based compensation arrangements for certain covered employees. The Proposed Rules (i) prohibit covered financial institutions from maintaining incentive-based compensation arrangements that encourage covered persons to expose the institution to inappropriate risk by providing the covered person with "excessive" compensation; (ii) prohibit covered financial institutions from establishing or maintaining incentive-based compensation arrangements for covered persons that encourage inappropriate risks that could lead to a material financial loss, (iii) require covered financial institutions to maintain policies and procedures appropriate to their size, complexity and use of incentive-based compensation to help ensure compliance with the Proposed Rules and (iv) require covered financial institutions to provide enhanced disclosure to regulators regarding their incentive-based compensation arrangements for covered person within 90 days following the end of the fiscal year. 30 -------------------------------------------------------------------------------- Pursuant to rules adopted by the stock exchanges and approved by the SECin January 2013under the Dodd-Frank Act, public companies are required to implement "clawback" procedures for incentive compensation payments and to disclose the details of the procedures which allow recovery of incentive compensation that was paid on the basis of erroneous financial information necessitating a restatement due to material noncompliance with financial reporting requirements. This clawback policy is intended to apply to compensation paid within a three-year look-back window of the restatement and would cover all executives who received incentive awards. Public company compensation committee members are also required to meet heightened independence requirements and to consider the independence of compensation consultants, legal counsel and other advisors to the compensation committee. The compensation committees must have the authority to hire advisors and to have the company fund reasonable compensation of such advisors.
Effect of Environmental Regulation
Compliance with federal, state and local provisions regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, has not had a material effect upon the capital expenditures, earnings or competitive position of the Company and its subsidiaries. The Company believes that the nature of the operations of its subsidiaries has little, if any, environmental impact. The Company, therefore, anticipates no material capital expenditures for environmental control facilities for its current fiscal year or for the foreseeable future. The Company's subsidiaries may be required to make capital expenditures for environmental control facilities related to properties which they may acquire through foreclosure proceedings in the future; however, the amount of such capital expenditures, if any, is not currently determinable.
The FRB has adopted risk-based capital guidelines for bank holding companies and for state member banks, such as
State Bank. The risk-based capital guidelines include both a definition of capital and a framework for calculating risk weighted assets by assigning assets and off-balance-sheet items to broad risk categories. The minimum ratio of total capital to risk weighted assets (including certain off-balance-sheet items, such as standby letters of credit) is 8%. Of that 8%, at least 4% must be comprised of common shareholders' equity (including retained earnings but excluding treasury stock), non-cumulative perpetual preferred stock, a limited amount of cumulative perpetual preferred stock, and minority interests in equity accounts of consolidated subsidiaries, less goodwill and certain other intangible assets ("Tier 1 capital"). The remainder of total risk-based capital ("Tier 2 capital") may consist, among other things, of certain amounts of mandatory convertible debt securities, subordinated debt, preferred stock not qualifying as Tier 1 capital, allowance for loan and lease losses and net unrealized gains, after applicable taxes, on available-for-sale equity securities with readily determinable fair values, all subject to limitations established by the guidelines. Under the guidelines, capital is compared to the relative risk related to the balance sheet. To derive the risk included in the balance sheet, one of four risk weights (0%, 20%, 50%, and 100%) is applied to different balance sheet and off-balance sheet assets, primarily based on the relative credit risk of the counterparty. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. In July 2013, the FRB and the federal banking agencies published final rules that substantially amend the regulatory risk-based capital rules applicable to the Company and State Bank. These rules implement the "Basel III" regulatory capital reforms and changes required by the Dodd-Frank Act. "Basel III" refers to various documents released by the Basel Committee on Banking Supervision. Effective in 2015, State Bankand the Company will be subject to new capital regulations (with some provisions transitioned into full effectiveness over two to four years). The new requirements create a new required ratio for common equity Tier 1 ("CET1") capital, increases the leverage and Tier 1 capital ratios, changes the risk-weights of certain assets for purposes of the risk-based capital ratios, creates an additional capital conservation buffer over the required capital ratios and changes what qualifies as capital for purposes of meeting these various capital requirements. Beginning in 2016, failure to maintain the required capital conservation buffer will limit the ability of the Company to pay dividends, repurchase shares or pay discretionary bonuses. 31
-------------------------------------------------------------------------------- When these new requirements become effective, certain of the minimum capital requirements for
State Bankwill change. The minimum leverage ratio of 4% of adjusted total assets and total capital ratio of 8% of risk-weighted assets will remain the same; however, the Tier 1 capital ratio will increase from 4.0% to 6.5% of risk-weighted assets. In addition, the Company will have to meet the new minimum CET1 capital ratio of 4.5% of risk-weighted assets. CET1 consists generally of common stock, retained earnings and accumulated other comprehensive income (AOCI), subject to certain adjustments. Mortgage servicing rights, certain deferred tax assets and investments in unconsolidated subsidiaries over designated percentages of common stock will be deducted from capital, subject to a two-year transition period. In addition, Tier 1 capital will include AOCI, which includes all unrealized gains and losses on available for sale debt and equity securities, subject to a two-year transition period. Because of its asset size, State Bankhas the one-time option of deciding in the first quarter of 2015 whether to permanently opt-out of the inclusion of AOCI in its capital calculations. State Bankis considering whether to take advantage of this opt-out to reduce the impact of market volatility on its regulatory capital levels. The new requirements also include changes in the risk-weights of certain assets to better reflect credit risk and other risk exposures. These include a 150% risk weight (up from 100%) for certain high volatility commercial real estate acquisition, development and construction loans and for non-residential mortgage loans that are 90 days past due or otherwise in nonaccrual status; a 20% (up from 0%) credit conversion factor for the unused portion of a commitment with an original maturity of one year or less; a 250% risk weight (up from 100%) for mortgage servicing and deferred tax assets that are not deducted from capital; and increased risk-weights (0% to 600%) for equity exposures. In addition to the minimum CET1, Tier 1 and total capital ratios, State Bankwill have to maintain a capital conservation buffer consisting of additional CET1 capital equal to 2.5% of risk-weighted assets above each of the required minimum capital levels in order to avoid limitations on paying dividends, engaging in share repurchases and paying certain discretionary bonuses. This new capital conservation buffer requirement is phased in beginning in January 2016at 0.625% of risk-weighted assets and increasing each year until fully implemented in January 2019. The FRB's prompt corrective action standards will change when these new capital ratios become effective. Under the new standards, in order to be considered well-capitalized, State Bankwill be required to have at least a CET1 ratio of 6.5% (new), a Tier 1 ratio of 8% (increased from 6%), a total capital ratio of 10% (unchanged) and a leverage ratio of 5% (unchanged) and not be subject to specified requirements to meet and maintain a specific capital ratio for a capital measure. State Bankconducted a proforma analysis of the application of these new capital requirements as of September 30, 2013. Based on that analysis, State Bankdetermined that as of September 30, 2013it would have met all of the new requirements, including the full 2.5% capital conservation buffer, and would have remained well capitalized if these new requirements had been in effect on that date.
In addition, as noted above, beginning in 2016, if
Critical Accounting Policies
Note 1 to the Consolidated Financial Statements included in the Company's Annual Report on Form 10-K for the fiscal year ended
December 31, 2013describes the significant accounting policies used in the development and presentation of the Company's financial statements. The accounting and reporting policies of the Company are in accordance with accounting principles generally accepted in the United Statesand conform to general practices within the banking industry. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. The Company's financial position and results of operations can be affected by these estimates and assumptions and are integral to the understanding of reported results. Critical accounting policies are those policies that management believes are the most important to the portrayal of the Company's financial condition and results, and they require management to make estimates that are difficult, subjective, or complex. 32 -------------------------------------------------------------------------------- Allowance for Loan Losses - The allowance for loan losses provides coverage for probable losses inherent in the Company's loan portfolio. Management evaluates the adequacy of the allowance for loan losses each quarter based on changes, if any, in underwriting activities, loan portfolio composition (including product mix and geographic, industry or customer-specific concentrations), trends in loan performance, regulatory guidance and economic factors. This evaluation is inherently subjective, as it requires the use of significant management estimates. Many factors can affect management's estimates of specific and expected losses, including volatility of default probabilities, rating migrations, loss severity and economic and political conditions. The allowance is increased through provisions charged to operating earnings and reduced by net charge-offs. The Company determines the amount of the allowance based on relative risk characteristics of the loan portfolio. The allowance recorded for commercial loans is based on reviews of individual credit relationships and an analysis of the migration of commercial loans and actual loss experience. The allowance recorded for homogeneous consumer loans is based on an analysis of loan mix, risk characteristics of the portfolio, fraud loss and bankruptcy experiences, and historical losses, adjusted for current trends, for each homogeneous category or group of loans. The allowance for credit losses relating to impaired loans is based on the loan's observable market price, the collateral for certain collateral-dependent loans, or the discounted cash flows using the loan's effective interest rate. Regardless of the extent of the Company's analysis of customer performance, portfolio trends or risk management processes, certain inherent but undetected losses are probable within the loan portfolio. This is due to several factors, including inherent delays in obtaining information regarding a customer's financial condition or changes in their unique business conditions, the subjective nature of individual loan evaluations, collateral assessments and the interpretation of economic trends. Volatility of economic or customer-specific conditions affecting the identification and estimation of losses for larger non-homogeneous credits and the sensitivity of assumptions utilized to establish allowances for homogenous groups of loans are also factors. The Company estimates a range of inherent losses related to the existence of these exposures. The estimates are based upon the Company's evaluation of imprecise risk associated with the commercial and consumer allowance levels and the estimated impact of the current economic environment. To the extent that actual results differ from management's estimates, additional loan loss provisions may be required that could adversely impact earnings for future periods. Goodwill and Other Intangibles - The Company records all assets and liabilities acquired in purchase acquisitions, including goodwill and other intangibles, at fair value as required. Goodwill is subject, at a minimum, to annual tests for impairment. Other intangible assets are amortized over their estimated useful lives using straight-line or accelerated methods, and are subject to impairment if events or circumstances indicate a possible inability to realize the carrying amount. The initial goodwill and other intangibles recorded and subsequent impairment analysis requires management to make subjective judgments concerning estimates of how the acquired asset will perform in the future. Events and factors that may significantly affect the estimates include, among others, customer attrition, changes in revenue growth trends, specific industry conditions and changes in competition. A decrease in earnings resulting from these or other factors could lead to an impairment of goodwill that could adversely impact earnings for future periods.
Three Months Ended
Net Income: Net income for the second quarter of 2014 was
$1.2 million, or $0.25per diluted share, compared to net income of $1.3 million, or $0.27per diluted share, for the second quarter of 2013. For the quarter, the Banking Group (consisting primarily of State Bank), had net income of $1.7 million, which is down 6.4 percent compared to the net income of $1.8 millionfrom the year-ago second quarter. RDSI reported a net loss of $40 thousandcompared to a net loss of $10 thousandfrom the year-ago second quarter. 33 -------------------------------------------------------------------------------- Provision for Loan Losses: The second quarter provision for loan losses was $0.15 millioncompared to $0.20 millionfor the year-ago quarter. Charge-offs for the quarter were $0.31 millioncompared to $0.18 millionfor the year-ago quarter. Total delinquent loans ended the quarter at $3.0 million, which is even to the prior year. Net charge-offs for the quarter exceed provision due to the partial charge-off of a commercial loan, which has an existing allowance allocation. Asset Quality Review - For the Period Ended June 30, December 31, June 30, ($'s in Thousands) 2014 2013 2013 Net charge-offs $ 309$ 747 $ 179Nonaccruing loans 4,006 4,844 4,386 Accruing Trouble Debt Restructures 1,665 1,739 1,262 Nonaccruing and restructured loans 5,671 6,583 5,648 OREO / OAO 516 651 1,955 Nonperforming assets 6,187 7,233 7,603 Nonperforming assets/Total assets 0.93 % 1.14 % 1.20 % Allowance for loan losses/Total loans 1.30 % 1.46 % 1.51 % Allowance for loan losses/Nonperforming loans 115.8 %
105.8 % 124.2 %
Consolidated Revenue: Total revenue, consisting of net interest income fully taxable equivalent (FTE) and noninterest income, was
$8.6 millionfor the second quarter of 2014, a decrease of $0.6 million, or 6.8 percent, from the $9.3 milliongenerated during the 2013 second quarter. Net interest income (FTE) was $5.3 million, which is down $0.1 millionfrom the prior year second quarter's $5.4 million. The Company's earning assets increased $30.2 million, but this was offset by a 37 basis point decrease in the yield on earning assets. The net interest margin for the second quarter of 2014 was 3.60 percent compared to 3.86 percent for the second quarter of 2013.
Noninterest income was
State Bankoriginated $67.1 millionof mortgage loans compared to $81.9 millionfor the second quarter of 2013. These second quarter 2014 originations and subsequent sales resulted in $1.2 millionof gains, which compares to gains of $1.5 millionfor the second quarter of 2013. Net mortgage banking revenue was $1.4 millioncompared to $1.9 millionfor the second quarter of 2013 due to the lowered volumes and no recapture of OMSR impairment. Consolidated Noninterest Expense: Noninterest expense for the second quarter of 2014 was $6.6 million, compared to $7.1 millionin the prior-year second quarter. The decrease in noninterest expenses compared to the prior year was volume related (mortgage commission and balance growth incentive). In addition, the Company reduced costs for employee benefits and realized reductions in state tax expense, due to the change in the financial institutions tax.
Income Taxes: Income taxes for the second quarter of 2014 were
Six Months Ended
Net Income: Net income for the six months ended
June 30, 2014was $2.2 million, or $0.46per diluted share, compared to net income of $2.6 million, or $0.54per diluted share, for the six months ended June 30, 2013. The Banking Group(consisting primarily of State Bank), had net income of $3.0 millionfor the first six months of 2014, which is down 13.8 percent compared to the net income of $3.5 millionfrom the first six months of 2013. RDSI reported a net loss of $108 thousandfor the first six months of 2014 compared to net income of $15 thousandfrom the year-ago first six months. 34 -------------------------------------------------------------------------------- Provision for Loan Losses: The first six months of 2014 provision for loan losses was $0.2 millioncompared to $0.5 millionfor the year-ago first six months. Charge-offs for the first six months of 2014 were $0.6 millioncompared to $0.3 millionfor the year-ago first six months. Net charge-offs for the six months exceed provision due to the partial charge-off of an existing allowance allocation. Consolidated Revenue: Total revenue, consisting of net interest income fully taxable equivalent (FTE) and noninterest income, was $16.1 millionfor the first six months of 2014, a decrease of $2.1 million, or 11.5 percent, from the $18.2 milliongenerated during the 2013 first six months. Net interest income (FTE) was $10.3 millionfor the first six months of 2014, which is down $0.5 millionfrom the prior year first six months $10.8 million. The Company's earning assets increased $22.9 million, but this was offset by a 48 basis point decrease in the yield on earning assets. The net interest margin for the first six months of 2014 was 3.57 percent compared to 3.86 percent for the first six months of 2013. Noninterest income was $5.9 millionfor the 2014 first six months compared to $7.4 millionfor the prior year six month period. Excluding data service fees, which are contributed by RDSI, the remaining noninterest income is generated by the Banking Group. RDSI fees continue to trail the prior year due to client losses. State Bankoriginated $100.3 millionof mortgage loans in the first six months of 2014 compared to $153.9 millionfor the comparable period of 2013. These originations and subsequent sales from the first six months of 2014 resulted in $1.8 millionof gains, which compares to gains of $2.9 millionfor the first six months of 2013. Net mortgage banking revenue for the first six months of 2014 was $2.2 milliondue to the lowered volumes and no recapture of OMSR impairment. Consolidated Noninterest Expense: Noninterest expense for the first six months of 2014 was $12.7 million, compared to $13.8 millionin the prior-year first six months. The decrease in noninterest expenses compared to the prior year was volume related (mortgage commission and balance growth incentive) which offset higher weather related costs. Also impacting the reduction was lower state tax due to the financial institutions tax change. Income Taxes: Income taxes for the first six months of 2014 were $0.8 millioncompared to $1.1 millionfor the first six months of 2013. The decrease was due primarily to the decrease in pre-tax income compared to the prior year.
Changes in Financial Condition
Total assets at
June 30, 2014were $662.5 million, an increase of $30.7 millionor 4.9 percent since 2013 year end. Total loans, net of unearned income, were $506.1 millionas of June 30, 2014, up $28.8 millionfrom year end, an increase of 6.0 percent. Total deposits at June 30, 2014were $524.1 million, an increase of $5.8 millionas compared to December 2013balances. Borrowed funds (consisting of notes payable, FHLB advances, and REPOs) totaled $54.2 millionat June 30, 2014. This is up from year end when borrowed funds totaled $31.3 million. Total equity for the Company of $59.0 millionnow stands at 8.9 percent of total assets, which is flat from the December 31, 2013level of 8.9 percent. The allowance for loan loss of $6.6 millionis down from the prior year by 6.4 percent. This reduction combined with the loan growth of 9.1 percent has reduced the allowance to loans to 1.3 percent. The 1.3 percent level is considered appropriate given the risk profile of the portfolio. 35
Minimum Required Minimum Required To Be Well Capitalized For Capital Under Prompt Corrective Actual Adequacy Purposes Action Regulations Amount Ratio Amount Ratio Amount Ratio Total capital (to risk- weighted assets) Consolidated
$ 67,41813.1 % $ 41,3348.0 % $ - N/A State Bank $ 62,01712.0 % 41,511 8.0 % $ 51,88910.0 %
Both the Company and
Liquidity relates primarily to the Company's ability to fund loan demand, meet deposit customers' withdrawal requirements and provide for operating expenses. Assets used to satisfy these needs consist of cash and due from banks, federal funds sold, interest-earning deposits in other financial institutions, securities available-for-sale and loans held for sale. These assets are commonly referred to as liquid assets. Liquid assets were
$107.7 millionat June 30, 2014, compared to $106.3 millionat December 31, 2013. Liquidity risk arises from the possibility that the Company may not be able to meet the Company's financial obligations and operating cash needs or may become overly reliant upon external funding sources. In order to manage this risk, the Board of Directors of the Company has established a Liquidity Policy that identifies primary sources of liquidity, establishes procedures for monitoring and measuring liquidity and quantifies minimum liquidity requirements. This policy designates the Asset/Liability Committee ("ALCO") as the body responsible for meeting these objectives. The ALCO reviews liquidity regularly and evaluates significant changes in strategies that affect balance sheet or cash flow positions. Liquidity is centrally managed on a daily basis by the Company's Chief Financial Officer and Asset Liability Manager. The Company's commercial real estate, first mortgage residential and multi-family mortgage portfolio of $320.9 millionat June 30, 2014and $304.9 millionat December 31, 2013, which can and has been used to collateralize borrowings, is an additional source of liquidity. Management believes the Company's current liquidity level, without these borrowings, is sufficient to meet its liquidity needs. At June 30, 2014, all eligible commercial real estate, first mortgage residential and multi-family mortgage loans were pledged under an FHLB blanket lien. The cash flow statements for the periods presented provide an indication of the Company's sources and uses of cash, as well as an indication of the ability of the Company to maintain an adequate level of liquidity. A discussion of the cash flow statements for the six months ended June 30, 2014and 2013 follows. The Company experienced negative cash flows from operating activities for the six months ended June 30, 2014and June 30, 2013. Net cash used in operating activities was $2.3 millionfor the six months ended June 30, 2014and $1.0 millionfor the six months ended June 30, 2013. Highlights for the current year include $100.3 millionin proceeds from the sale of loans, which is down $50.0 millionfrom the prior year. Originations of loans held for sale was a use of cash of $100.2 million, which is also down from the prior year, by $53.7 million. For the six months ended June 30, 2014, there was a net increase of Origination Mortgage Servicing Rights (OMSR) impairment of $0.1 million, and gain on sale of loans of $2.5 million. The Company experienced negative cash flows from investing activities for the six months ended June 30, 2014and positive cash flows from investing activities for the six months ended June 30, 2013. Net cash flows used in investing activities was $25.5 millionfor the six months ended June 30, 2014and cash flows provided by investing activities was $1.1 millionfor the six months ended June 30, 2013. Highlights for the six months ended June 30, 2014include $9.7 millionin purchases of available-for-sale securities. These cash payments were offset by $16.4 millionin proceeds from maturities of securities, which is down $6.0 millionfrom the prior six month period. The Company experienced a $29.5 millionincrease in loans, which is up $29.2 millionfrom the prior year six month period. Sales of foreclosed assets provided cash of $0.02 millionfor the six months ended June 30, 2014. 36 -------------------------------------------------------------------------------- The Company experienced positive cash flows from financing activities for the six months ended June 30, 2014and negative cash flows from financing activities for the six months ended June 30, 2013. Net cash flow provided by financing activities was $28.4 millionfor the six months ended June 30, 2014and cash flow used in financing activities of $8.4 millionfor the six months ended June 30, 2013. Highlights for the current period include a $5.3 millionincrease in transaction deposits for the six months ended June 30, 2014, which is up from the $2.4 millionincrease in transaction deposits for the six months ended June 30, 2013. Certificates of deposit increased by $0.6 millionin the current year compared to a decline of $18.0 millionfor the prior year. FHLB advances were increased by $21.0 millionfor the six months ended June 30, 2014. ALCO uses an economic value of equity ("EVE") analysis to measure risk in the balance sheet incorporating all cash flows over the estimated remaining life of all balance sheet positions. The EVE analysis calculates the net present value of the Company's assets and liabilities in rate shock environments that range from -400 basis points to +400 basis points. The likelihood of a decrease in rates as of June 30, 2014and December 31, 2013was considered unlikely given the current interest rate environment and therefore, only the minus 100 basis point rate change was included in this analysis. The results of this analysis are reflected in the following tables for June 30, 2014and December 31, 2013. June 30, 2014 Economic Value of Equity ($'s in thousands) Change in Rates $ Amount $ Change % Change +400 basis points 108,375 16,793 18.34 +300 basis points 105,835 14,253 15.56 +200 basis points 102,329 10,746 11.73 +100 basis points 97,729 6,146 6.71 Base Case 91,582 - - -100 basis points 84,018 (7,565 ) (8.26 ) December 31, 2013 Economic Value of Equity ($'s in thousands) Change in Rates $ Amount $ Change % Change +400 basis points 105,687 13,393 14.51 % +300 basis points 103,812 11,517 12.48 % +200 basis points 101,018 8,724 9.45 % +100 basis points 97,311 5,017 5.44 % Base Case 92,294 - - -100 basis points 86,266 (6,029 ) (6.53 %)
Off-Balance-Sheet Borrowing Arrangements:
Significant additional off-balance-sheet liquidity is available in the form of FHLB advances and unused federal funds lines from correspondent banks. Management expects the risk of changes in off-balance-sheet arrangements to be immaterial to earnings. The Company's commercial real estate, first mortgage residential and multi-family mortgage portfolios of
$320.9 millionhave been pledged to meet FHLB collateralization requirements as of June 30, 2014. Based on the current collateralization requirements of the FHLB, the Company had approximately $12.7 millionof additional borrowing capacity at June 30, 2014. The Company also had $20.1 millionin unpledged securities that may be used to pledge for additional borrowings. 37
The Company's contractual obligations as of
June 30, 2014were comprised of long-term debt obligations, other debt obligations, operating lease obligations and other long-term liabilities. Long-term debt obligations are comprised of FHLB Advances of $37.0 million, and Trust Preferred securities of $20.6. The operating lease obligations consist of a lease on the RDSI-North building of $162 thousandper year and a lease on the DCM-Lansing facility of $105 thousandper year. Total time deposits at June 30, 2014were $176.6 million, of which $82.2 millionmatures beyond one year. Also, as of June 30, 2014, the Company had commitments to sell mortgage loans totaling $19.8 million. The Company believes that it has adequate resources to fund commitments as they arise and that it can adjust the rate on savings certificates to retain deposits in changing interest rate environments. If the Company requires funds beyond its internal funding capabilities, advances from the FHLB of Cincinnatiand other financial institutions are available.
ASSET LIABILITY MANAGEMENT
Asset liability management involves developing, executing and monitoring strategies to maintain appropriate liquidity, maximize net interest income and minimize the impact that significant fluctuations in market interest rates would have on current and future earnings. The business of the Company and the composition of its balance sheet consist of investments in interest-earning assets (primarily loans, mortgage-backed securities, and securities available for sale) which are primarily funded by interest-bearing liabilities (deposits and borrowings). With the exception of specific loans which are originated and held for sale, all of the financial instruments of the Company are for other than trading purposes. All of the Company's transactions are denominated in U.S. dollars with no specific foreign exchange exposure. In addition, the Company has limited exposure to commodity prices related to agricultural loans. The impact of changes in foreign exchange rates and commodity prices on interest rates are assumed to be insignificant. The Company's financial instruments have varying levels of sensitivity to changes in market interest rates resulting in market risk. Interest rate risk is the Company's primary market risk exposure; to a lesser extent, liquidity risk also impacts market risk exposure. Interest rate risk is the exposure of a banking institution's financial condition to adverse movements in interest rates. Accepting this risk can be an important source of profitability and shareholder value; however, excessive levels of interest rate risk could pose a significant threat to the Company's earnings and capital base. Accordingly, effective risk management that maintains interest rate risks at prudent levels is essential to the Company's safety and soundness. Evaluating a financial institution's exposure to changes in interest rates includes assessing both the adequacy of the management process used to control interest rate risk and the organization's quantitative level of exposure. When assessing the interest rate risk management process, the Company seeks to ensure that appropriate policies, procedures, management information systems and internal controls are in place to maintain interest rate risks at prudent levels of consistency and continuity. Evaluating the quantitative level of interest rate risk exposure requires the Company to assess the existing and potential future effects of changes in interest rates on its consolidated financial condition, including capital adequacy, earnings, liquidity and asset quality (when appropriate). The
Federal Reserve Boardtogether with the Office of the Comptroller of the Currencyand the Federal Deposit Insurance Companyadopted a Joint Agency Policy Statement on interest rate risk effective June 26, 1996. The policy statement provides guidance to examiners and bankers on sound practices for managing interest rate risk, which will form the basis for ongoing evaluation of the adequacy of interest rate risk management at supervised institutions. The policy statement also outlines fundamental elements of sound management that have been identified in prior Federal Reserve guidance and discusses the importance of these elements in the context of managing interest rate risk. Specifically, the guidance emphasizes the need for active board of director and senior management oversight and a comprehensive risk management process that effectively identifies, measures and controls interest rate risk. 38
Financial institutions derive their income primarily from the excess of interest collected over interest paid. The rates of interest an institution earns on its assets and owes on its liabilities generally are established contractually for a period of time. Since market interest rates change over time, an institution is exposed to lower profit margins (or losses) if it cannot adapt to interest rate changes. For example, assume that an institution's assets carry intermediate or long-term fixed rates and that those assets are funded with short-term liabilities. If market interest rates rise by the time the short-term liabilities must be refinanced, the increase in the institution's interest expense on its liabilities may not be sufficiently offset if assets continue to earn at the long-term fixed rates. Accordingly, an institution's profits could decrease on existing assets because the institution will either have lower net interest income or possibly, net interest expense. Similar risks exist when assets are subject to contractual interest rate ceilings, or rate-sensitive assets are funded by longer-term, fixed-rate liabilities in a declining rate environment. There are several ways an institution can manage interest rate risk including: 1) matching repricing periods for new assets and liabilities, for example, by shortening or lengthening terms of new loans, investments, or liabilities; 2) selling existing assets or repaying certain liabilities; and 3) hedging existing assets, liabilities, or anticipated transactions. An institution might also invest in more complex financial instruments intended to hedge or otherwise change interest rate risk. Interest rate swaps, futures contracts, options on futures contracts, and other such derivative financial instruments can be used for this purpose. Because these instruments are sensitive to interest rate changes, they require management's expertise to be effective. The Company has not purchased derivative financial instruments in the past but may purchase such instruments in the future if market conditions are favorable.