SECURITIES AND EXCHANGE COMMISSION Washington D.C. 20549 FORM 10-K Annual Report Pursuant to Section 13 or 15(d) of The Securities Exchange Act of 1934 For the fiscal year ended December 31, 1996 Commission file number 0-12507 ARROW FINANCIAL CORPORATION (Exact name of registrant as specified in its charter) NEW YORK (State or Other Jurisdiction of Incorporation or Organization) 22-2448962 (I.R.S. Employer Identification No.) 250 GLEN STREET, GLENS FALLS, NEW YORK 12801 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (518) 745-1000 SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT - NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT Common stock, Par Value $1.00 (Title of Class) Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. Indicate by checkmark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date. Class Common stock, Par Value $1.00 Per Share Outstanding at March 13, 1997 5,659,840 State the aggregate market value of the voting stock held by non-affiliates of registrant. Aggregate market value of voting stock $137,251,000 Based upon the average of the closing bid and closing asked prices on the NASDAQ Exchange March 13, 1997 DOCUMENTS INCORPORATED BY REFERENCE Portions of Registrant's Proxy Statement for the Annual Meeting of Shareholders to be held April 30, 1997 (Part III) and the Annual Report to Shareholders (Part II, Item 8) ARROW FINANCIAL CORPORATION FORM 10-K INDEX Cautionary Statement under Federal Securities Laws PART I Item 1. Business A. General B. Lending Activities C. Supervision and Regulation D. Competition E. Statistical Disclosure (Guide 3) F. Legislative Developments G. Executive Officers of the Registrant Item 2. Properties Item 3. Legal Proceedings Item 4. Submission of Matters to a Vote of Security Holders PART II Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters Item 6. Selected Financial Data Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations A. Overview B. Results of Operations I. Net Interest Income II. Provision for Loan Losses and Allowance for Loan Losses III. Other Income IV. Other Expense V. Income Taxes C. Financial Condition I. Investment Portfolio II. Loan Portfolio a. Distribution of Loans and Leases b. Risk Elements III. Summary of Loan Loss Experience IV. Deposits ` V. Time Certificates of $100,000 or More D. Liquidity E. Interest Rate Risk F. Capital Resources and Dividends G. Fourth Quarter Results Item 8. Financial Statements and Supplementary Data Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure PART III Item 10. Directors and Executive Officers of the Registrant Item 11. Executive Compensation Item 12. Security Ownership of Certain Beneficial Owners and Management Item 13. Certain Relationships and Related Transactions PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K Signatures Exhibits Index Cautionary Statement under Federal Securities Laws: The information contained in this Annual Report on Form 10-K contains forward-looking statements that are based on management's beliefs, certain assumptions made by management and current expectations, estimates and projections about the Company's financial condition and results of operations. Words such as "expects," "believes," "should," "plans," "will," "estimates," and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks and uncertainties that are difficult to quantify or, in some cases, to identify. Therefore, actual outcomes and results may differ materially from what is expected or forecasted in such forward- looking statements. Factors that could cause or contribute to such differences include, but are not limited to, changes in economic and market conditions, including unanticipated fluctuations in interest rates, effects of state and federal regulation and risks inherent in banking operations. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Company undertakes no obligation to revise or update these forward-looking statements to reflect the occurrence of unanticipated events. PART I Item 1: Business A. GENERAL Arrow Financial Corporation (the "Company"), a New York corporation, was incorporated on March 21, 1983 and is registered as a bank holding company within the meaning of the Bank Holding Company Act of 1956. The Company owns two nationally chartered banks in New York, as well as several non-bank subsidiaries, the operations of which are not significant. The Company also owns an inactive bank charter in Vermont (the former Green Mountain Bank) as well as a second- tier bank holding company, also inactive, in Vermont (Arrow Vermont Corporation), both of which are in the process of being liquidated. The Company sold all of its banking operations in Vermont in 1996 in three separate transactions, the last of which was completed in September 1996. The Company owns directly or indirectly all voting stock of all its subsidiaries. The business of the Company consists primarily of the ownership, supervision and control of its bank subsidiaries. The Company provides its subsidiaries with various advisory and administrative services and coordinates the general policies and operation of the subsidiary banks. There were 302 full-time equivalent employees of the Company and the subsidiary banks at December 31, 1996. <TABLE> <CAPTION> SUBSIDIARY BANKS: GLENS (Dollars in Thousands) FALLS SARATOGA NATIONAL NATIONAL BANK & BANK & TRUST CO. TRUST CO. ("GFNB") ("SNB") <S> <C> <C> Total Assets at Year-End $550,706 $76,115 Trust Assets Under Management at Year-End (Not Included in Total Assets) $432,143 $ 2,420 Date Organized 1851 1988 Employees 170 20 State of Headquarters New York New York Offices 15 2 Counties of Operation Warren Saratoga Washington Saratoga Essex Main Office 50 Glen St. 137 So. Broadway Glens Falls, Saratoga, New York New York </TABLE> Each subsidiary bank offers a full range of commercial and consumer financial products. The banks' deposit base consists of core deposits derived principally from the communities which the banks serve. The banks target their lending activities to consumers and small and mid-sized companies in the banks' immediate geographic areas. In addition to traditional banking services, the Company offers credit card processing services for other financial institutions and, through its banks' trust departments, provides retirement planning, trust and estate administration services for individuals and pension, profit-sharing and employee benefit plan administration for corporations. B. LENDING ACTIVITIES The Company's subsidiary banks engage in a wide range of lending activities, including commercial and industrial lending primarily to small and mid-sized companies; mortgage lending for the purchase of residential and commercial properties; and consumer installment, credit card and home equity financing. Historically, the Company has sold a portion of its residential real estate loan originations into the secondary market, primarily to Freddie Mac and state housing agencies, while retaining the servicing rights. Loan sales into the secondary market, have diminished in the past three years, however, as the banks have sought to increase their own portfolios. In addition to interest earned on loans, the banks receive facility fees for various types of commercial and industrial credits, and commitment fees for extension of letters of credit and certain types of loans. Generally, the Company continues to implement conservative lending strategies, policies and procedures which are intended to protect the quality of the loan portfolio. These include stringent underwriting and collateral control procedures and credit review systems through which intensive reviews are conducted. It is the Company's policy to discontinue the accrual of interest on loans when the payment of interest and/or principal is due and unpaid for a designated period (generally 90 days) or when the likelihood of repayment is, in the opinion of management, uncertain. Income on such loans is thereafter recognized only upon receipt (see Item 7.C.II.b. "Risk Elements"). The banks lend primarily to borrowers within the geographic areas served by the banks. The banks' combined loan portfolios do not include any foreign loans or any significant industry concentrations except as described in Note 19 to the Consolidated Financial Statements in Part II Item 8 of this report. Except for credit card loans, the portfolios are substantially secured, and many commercial loans are further secured by personal guarantees. C. SUPERVISION AND REGULATION The following generally describes the regulation to which the Company and its banks are subject. Bank holding companies and banks are extensively regulated under both federal and state law. To the extent that the following information summarizes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular law or regulation. Any change in applicable law or regulation may have a material effect on the business and prospects of the Company and the banks. The Company is a legal entity separate and distinct from its subsidiaries. Most of the Company's revenues, on a parent company-only basis, result from management fees, dividends and undistributed earnings from the subsidiary banks. The right of the Company, and consequently the right of creditors and shareholders of the Company, to participate in any distribution of the assets or earnings of the banks through the payment of such dividends or otherwise is necessarily subject to the prior claims of creditors of the banks, except to the extent that claims of the Company in its capacity as a creditor of the banks also may be recognized. Moreover, there are various legal and regulatory limitations applicable to the payment of dividends to the Company by its subsidiaries as well as the payment of dividends by the Company to its shareholders. The ability of the Company and the banks to pay dividends in the future is, and is expected to continue to be, influenced by regulatory policies and capital guidelines. The Company is a registered bank holding company within the meaning of the Bank Holding Company Act of 1956 (BHC Act) and is subject to regulation by the Board of Governors of the Federal Reserve System (Federal Reserve Board). Additionally, as a "bank holding company" under New York State Law, the Company is subject to regulation by the New York State Banking Department. The subsidiary banks are nationally chartered banks and are subject to the supervision of and examination by the Office of the Comptroller of the Currency ("OCC"). The banks are members of the Federal Reserve System and the deposits of each subsidiary bank are insured by the Federal Deposit Insurance Corporation ("FDIC"). The BHC Act prohibits the Company, with certain exceptions, from engaging, directly or indirectly, in non-bank activities and restricts loans by the banks to the Company or other affiliates. Under the BHC Act, a bank holding company must obtain Federal Reserve Board approval before acquiring, directly or indirectly, 5% or more of the voting shares of another bank or bank holding company (unless it already owns a majority of such shares) or acquiring all or substantially all of the assets of another bank or bank holding company. Under the 1994 Riegle-Neal Act, bank holding companies are now able to acquire banks located in all 50 states (see Item 1.F. "Legislative Developments".) The Federal Reserve Board has adopted various "capital adequacy guidelines" for use in the examination and supervision of bank holding companies. One set of guidelines is the risk-based capital guidelines, which assign risk weightings to all assets and certain off-balance sheet items and establish an 8% minimum ratio of qualified total capital to the aggregate dollar amount of risk-weighted assets (which is almost always less than the dollar amount of such assets without risk weighting). At least half of total capital must consist of "Tier 1" capital, which comprises common equity, retained earnings and a limited amount of permanent preferred stock, less goodwill. Up to half of total capital may consist of so-called "Tier 2" capital, comprising a limited amount of subordinated debt, other preferred stock, certain other instruments and a limited amount of the allowance for loan losses. The Federal Reserve Board's other capital guideline is the leverage ratio standard, which establishes minimum limits on the ratio of a bank holding company's "Tier 1" capital to total tangible assets (not risk-weighted). For top-rated holding companies, the minimum leverage ratio is 3%, but lower-rated companies may be required to meet substantially greater minimum ratios. Each subsidiary bank is subject to similar capital requirements adopted by its primary federal regulator. The year-end 1996 capital ratios of the Company and the banks are set forth in Part II, Item 7.F. "Capital Resources and Dividends." A holding company's ability to pay dividends and expand its business through acquisitions of new subsidiaries can be restricted if capital falls below these capital adequacy guidelines. Neither the Company nor any of its subsidiaries is now, or has been within the past year, subject to any formal or informal regulatory enforcement order. D. COMPETITION The Company and its subsidiaries face intense competition in all markets that they serve. Traditional competitors are other local commercial banks, savings banks, savings and loan institutions and credit unions, as well as local offices of major regional and money center banks. Also, non-banking organizations, such as consumer finance companies, insurance companies, securities firms, money market and mutual funds and credit card companies, which are not subject to the same array of regulatory restrictions and capital requirements as the Company and its subsidiary banks, offer substantive equivalents of transaction accounts, credit cards and various other loan and financial products. E. STATISTICAL DISCLOSURE Statistical disclosure required by Securities Act Guide 3 to be set forth herein is found in Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Item 8 "Financial Statements and Supplementary Data." <TABLE> <CAPTION> INDEX TO SECURITIES ACT GUIDE 3, STATISTICAL DISCLOSURE BY BANK HOLDING COMPANIES Required Information Location <S> <C> Distribution of Assets, Liabilities and Stockholders' Equity; Interest Rates and Interest Differential Part II, Item 7.B.I. Investment Portfolio Part II, Item 7.C.I. Loan Portfolio Part II, Item 7.C.II. Summary of Loan Loss Experience Part II, Item 7.C.III. Deposits Part II, Item 7.C.IV. Return on Equity and Assets Part II, Item 6. Short-Term Borrowings Part II, Item 8. Note 9. </TABLE> F. LEGISLATIVE DEVELOPMENTS In 1994, Congress enacted the Riegle-Neal Interstate Banking and Branching Efficiency Act. Under the Act, as of September 29, 1995, bank holding companies were authorized as a matter of federal law to acquire banks located in any of the 50 states, notwithstanding any state laws to the contrary, provided all required regulatory and other approvals are obtained. Also, under the Act, effective June 1, 1997, banks headquartered in any state will be permitted to branch into any other state, except for those states which may enact legislation prior to June 1, 1997 "opting out" of interstate branching. States may "opt in" to interstate branching prior to June 1, 1997, by affirmatively adopting legislation to that effect. The Act also permitted commonly controlled banks to act as agents for one another, effective September 29, 1995, by accepting deposits or loan payments or closing or servicing loans for one another, regardless of any branching laws to the contrary. In 1995, the federal bank regulatory authorities promulgated a set of revised regulations addressing the responsibilities of banking organizations under the Community Reinvestment Act ("CRA"). The revised regulations place additional emphasis on the actual experience of a bank in making loans in low- and moderate-income areas within its service area as a key determinant in evaluation of the bank's compliance with the statute. As in the prior regulations, bank regulators are authorized to bring enforcement actions against banks under the CRA only in the context of bank expansion or acquisition transactions. In 1991, the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") was enacted. 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 classifications for banking institutions, the highest being "well capitalized." Under regulations adopted by the federal bank regulators, a banking institution is considered "well capitalized" if it has a total risk-adjusted capital ratio of 10% or greater, a Tier 1 risk-adjusted capital ratio of 6% or greater and a leverage ratio of 5% or greater and is not subject to any regulatory order or written directive regarding capital maintenance. The Company and its subsidiary banks are all well capitalized. FDICIA also imposed expanded accounting and audit reporting requirements for depository institutions whose total assets exceed $500 million. For the Company, these requirements became effective for Glens Falls National Bank and Trust Company beginning in 1996. The FDIC levies assessments on various deposit obligations of the Company's banking subsidiaries. During 1995, the FDIC reduced the premium paid by the best-rated banks (including all the Company's subsidiary banks) from $.23 per $100 of insured deposits to $.04. In 1996, the FDIC insurance premium was further reduced to a flat charge of $2 thousand per year for the highest-rated banks, including all the Company's subsidiary banks. In 1996, Congress enacted the Deposit Insurance Funds Act, under which deposits insured by the Bank Insurance Fund ("BIF") are subject to assessment for payment on the Financing Corporation ("FICO") bond obligation at 1/5 the rate of the Savings Association Insurance Fund ("SAIF") assessable deposits. Accordingly, for 1997, BIF-assessable deposits (like the Company's) will be assessed an additional 1.3 cents per $100 of insured deposits. Banks and bank holding companies were also significantly affected by the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA"). FIRREA mandated public disclosure by commercial banks of their Community Reinvestment Act ratings and mortgage lending records and imposed cross-liability on any insured financial institution which is affiliated with any other insured institution to which the FDIC gives financial assistance. Various other banking legislation, including proposals to permit banks to affiliate with full-service securities underwriting firms or non-financial organizations (Glass-Steagall Reform) have been introduced in Congress from time to time. The Company cannot determine the ultimate effect that any such potential legislation, if enacted, would have upon its financial condition or operations. G. EXECUTIVE OFFICERS OF THE REGISTRANT The names and ages of the principal executive officers of the Company and positions held are presented in the following table. The officers are elected annually by the Board of Directors. <TABLE> <CAPTION> Name Age Positions Held and Years from Which Held <S> <C> <C> Michael F. Massiano 62 Chairman and CEO since 1990. Mr. Massiano retired as CEO on January 1, 1997. Mr. Massiano has been with the Company since 1956. Thomas L. Hoy 48 President and CEO since January 1, 1997 and President and COO of Glens Falls National Bank since 1995. Mr. Hoy was Executive Vice President of Glens Falls National Bank prior to 1995. Mr. Hoy has been with the Company since 1974. John J. Murphy 45 Executive Vice President, Treasurer and CFO since 1993. Mr. Murphy has served as Senior Vice President, Treasurer and CFO of the Company since 1983. Mr. Murphy has been with the Company since 1973. Gerard R. Bilodeau 49 Senior Vice President and Secretary since 1994. Mr. Bilodeau was Vice President and Secretary from 1993 to 1994 and was Director of Personnel prior to 1993. Mr. Bilodeau has been with the Company since 1969. </TABLE> Item 2: Properties The Company is headquartered at 250 Glen Street, Glens Falls, New York. The building is owned by Glens Falls National Bank and serves as its main office. Glens Falls National Bank owns thirteen additional offices and leases one, at market rates. Saratoga National Bank owns both of its offices. The Company continues to own the building in Rutland, Vermont, that served as headquarters for the Company's Vermont operations prior to the divestiture of those operations in 1996. The building was held for sale at December 31, 1996. Rental costs of premises did not exceed 5% of operating costs in 1996. In the opinion of management of the Company, the physical properties of the Company and the subsidiary banks are suitable and adequate. Item 3: Legal Proceedings The Company is not the subject of any material pending legal proceedings, other than ordinary routine litigation occurring in the normal course of its business. The Company's subsidiary banks are the subjects of or parties to various legal claims which arise in the normal course of their business. For example, from time to time, the banks encounter claims against them grounded in lender liability, of the sort often asserted against financial institutions. These lender liability claims normally take the form of counterclaims to lawsuits filed by the banks for collection of past due loans. The various pending legal claims against the subsidiary banks, including lender liability claims, will not, in the opinion of management, result in any material liability to the banks or the Company. Item 4: Submission of Matters to a Vote of Security Holders None in the fourth quarter of 1996. PART II Item 5: Market for the Registrant's Common Equity and Related Stockholder Matters The common stock of Arrow Financial Corporation is traded over-the-counter. It is registered with and its price is quoted by the National Association of Securities Dealers, Inc., through its national quotation system (NASDAQ). The price ranges listed below represent actual transactions rounded to the nearest 1/8 point. Although there may have been isolated sales at prices outside the parameters shown, the Company believes that the price ranges fairly represent the trading ranges. Per share amounts and market prices have been adjusted for a 1996 ten percent stock dividend and a 1995 four percent stock dividend. <TABLE> <CAPTION> Market Price Cash (Bid) Dividends High Low Declared <S> <C> <C> <C> 1995 1st Quarter $14.375 $13.500 $.114 2nd Quarter 14.000 12.750 .123 3rd Quarter 15.625 13.125 .131 4th Quarter 17.250 15.375 .145 1996 1st Quarter $18.375 $15.000 $.155 2nd Quarter 21.000 18.625 .155 3rd Quarter 20.750 17.750 .155 4th Quarter 23.750 20.750 .200 </TABLE> The payment of dividends by the Company is at the discretion of the Board of Directors and is dependent upon, among other things, the Company's earnings, financial condition and other factors, including applicable governmental regulations and restrictions. See "Capital Resources and Dividends" in Part II, Item 7.F. of this report. There were approximately 2,653 holders of record of common stock at December 31, 1996. Item 6: Selected Financial Data <TABLE> <CAPTION> FIVE YEAR SUMMARY OF SELECTED DATA Arrow Financial Corporation and Subsidiaries (Dollars In Thousands, Except Per Share Data) 1996 1995 1994 1993 1992 Consolidated Statements of Income Data: <S> <C> <C> <C> <C> <C> Interest and Dividend Income $54,875 $60,718 $52,514 $51,836 $57,829 Less: Interest Expense 21,826 24,865 18,202 19,583 28,399 Net Interest Income 33,049 35,853 34,312 32,253 29,430 Less: Provision for Loan Losses 896 1,170 (950) 690 1,677 Net Interest Income After Provision for Loan Losses 32,153 34,683 35,262 31,563 27,753 Other Income 23,804 14,473 9,049 9,086 8,606 Net Gains (Losses) on Securities Transactions (101) 23 (481) 26 15 Less: Other Expense 24,774 29,769 31,374 32,118 32,153 Income Before Income Taxes, Extra- ordinary Item and Cumulative Effect of Accounting Change 31,082 19,410 12,456 8,557 4,221 Provision for Income Taxes 10,822 6,986 1,131 381 1,331 Income Before Extraordinary Item & Cumulative Effect of Accounting Change 20,260 12,424 11,325 8,176 2,890 Extraordinary Item: Utilization of Net Operating Loss Carryforward --- --- --- --- 811 Cumulative Effect of a Change in Accounting for Income Taxes --- --- --- 1,457 --- Net Income $20,260 $12,424 $11,325 $ 9,633 $ 3,701 Primary Earnings Per Share: Income Before Extraordinary Item and Accounting Change $ 3.40 $ 1.98 $ 1.79 $ 1.31 $ .48 Extraordinary Item and Accounting Change --- --- --- .23 .12 Net Income $ 3.40 $ 1.98 $ 1.79 $ 1.54 $ .60 Fully Diluted Earnings Per Share: Income Before Extraordinary Item and Accounting Change $ 3.39 $ 1.97 $ 1.73 $ 1.31 $ .48 Extraordinary Item and Accounting Change --- --- --- .23 .12 Net Income $ 3.39 $ 1.97 $ 1.73 $ 1.54 $ .60 Cash Dividends $ .66 $ .51 $ .33 $ .09 $ --- Book Value 12.90 10.91 9.27 7.95 6.43 Consolidated Balance Sheet Data: Total Assets $652,603 $789,790 $746,431 $733,442 $722,415 Securities Available-for-Sale 171,743 178,645 53,868 55,892 55,598 Securities Held-to-Maturity 30,876 13,921 129,735 125,832 97,305 Loans and Leases, Net of Unearned Income 393,511 517,787 507,553 502,784 492,916 Nonperforming Assets 2,754 6,765 7,825 20,136 29,669 Deposits 541,747 694,453 650,485 659,427 657,875 Other Borrowed Funds 22,706 15,297 24,865 12,487 15,162 Long-Term Debt --- --- 5,007 5,289 5,371 Shareholders' Equity 74,296 67,504 58,405 50,069 39,735 Selected Key Ratios: Return on Average Assets 2.86% 1.60% 1.52% 1.33% .50% Return on Average Equity 28.78 19.45 20.79 21.03 10.10 Dividend Payout 19.47 25.89 19.08 5.84 --- Average Equity to Average Assets 9.95 8.22 7.34 6.32 4.97 Per share amounts have been adjusted for the 1996 ten percent and the 1995, 1994, and 1993 four percent stock dividends. </TABLE> Item 7: Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis focuses on and reviews the Company's results of operations for each of the years in the three-year period ended December 31, 1996 and the financial condition of the Company as of December 31, 1996 and 1995. Per share amounts have been restated to reflect the ten percent stock dividend paid in November 1996 and the four percent stock dividend paid in November 1995. The discussion below should be read in conjunction with the consolidated financial statements and other financial data presented elsewhere herein. A. OVERVIEW The Company reported net income of $20.3 million for 1996, compared to net income of $12.4 million for 1995. Primary earnings per share were $3.40 and $1.98 for 1996 and 1995, respectively. Book value per share was $12.90 at December 31, 1996, an increase of $1.99, or 18.2%, from December 31, 1995. For 1996, cash dividends per share amounted to 66.4 cents, an increase of 15.1 cents or 29.4%, from cash dividends paid in 1995. The following analysis adjusts net income for nonrecurring items to arrive at a comparative presentation of the Company's core earnings: <TABLE> <CAPTION> SUMMARY OF CORE EARNINGS (In Thousands, Except Per Share Data) 1996 1995 <S> <C> <C> Net Income, as Reported $20,260 $12,424 Adjustments, Net of Tax: Divestiture of Vermont Banking Operations (10,267) --- Insurance Settlement --- (3,250) OREO Transactions 174 136 Severance Benefits --- 388 Net Securities Transactions 57 (12) Other (323) (218) Core Net Income $ 9,901 $ 9,468 Core Primary Earnings per Share $ 1.66 $ 1.51 </TABLE> The company's core earnings for 1996 amounted to $9.9 million, an increase of $433 thousand from core earnings of $9.5 million for 1995. As thus adjusted, core earnings per share were $1.66 and $1.51, for the two respective years, representing an increase of 9.9%. During 1996, in three separate transactions, the Company completed the divestiture of its Vermont banking operations realizing an after tax gain of $10.3 million. The other major nonrecurring income item in the past two years was the Company's receipt in May of 1995 of a $5.0 million pre-tax settlement from its financial institution bond company on a claim for losses suffered in earlier periods. The core earnings analysis has also been adjusted for securities sale transactions, severance benefits for senior officers of Green Mountain Bank, sales of other real estate owned, and other nonrecurring items. Nonperforming assets amounted to $2.8 million at December 31, 1996, down from $6.8 million at December 31, 1995. The reduction was primarily attributable to the disposition of OREO and nonperforming loans as part of the sale of the Vermont banking operations in 1996. The allowance for loan losses was $5.6 million at December 31, 1996, which represented 213% of the amount of nonperforming loans. Divestiture of Vermont Operations During 1996, in three separate transactions, the Company completed the divestiture of its Vermont subsidiary, Green Mountain Bank ("GMB"). In January, the Company sold eight branches of GMB, with related deposits and loans, to Mascoma Savings Bank, Lebanon, NH. In August, the Company sold GMB's trust business to Vermont National Bank, Brattleboro, VT. In September, the Company sold the remaining branches of GMB, with related deposits and loans, to ALBANK, FSB, Albany, NY. The Company did not sell the building which served as GMB's main office in Rutland, Vermont, which was being held for sale at December 31, 1996. Total loans and deposits transferred in these sales amounted to approximately $148 million and $208 million, respectively. These and other changes are more fully described in the following analysis of the results of operations and changes in financial condition. B. RESULTS OF OPERATIONS The following analysis of net interest income, the provision for loan losses, noninterest income, noninterest expense and income taxes, presents the factors that are primarily responsible for the Company's results of operations for 1996 and the prior two years. I. NET INTEREST INCOME (Fully Taxable Basis) Net interest income represents the difference between interest earned on loans securities and other interest-earning assets and interest paid on deposits and other sources of funds. Changes in net interest income result from changes in the level and mix of earning assets and sources of funds (volume) and changes in the yields earned and costs paid (rate). Net interest margin is the ratio of net interest income to average earning assets. Net interest income may also be described as the product of earning assets and the net interest margin. <TABLE> <CAPTION> COMPARISON OF NET INTEREST INCOME (Dollars In Thousands) (Fully Taxable Basis) Years Ended December 31, Change From Prior Year 1996 1995 1994 1996 1995 Amount Percent Amount Percent <S> <C> <C> <C. <C> <C> <C> <C> Interest Income $55,517 $61,411 $52,985 $(5,894) (9.6)% $ 8,426 15.9% Interest Expense 21,826 24,865 18,202 (3,039) (12.2) 6,663 36.6 Net Interest Income $33,691 $36,546 $34,783 $(2,855) (7.8) $ 1,763 5.1 </TABLE> On a tax-equivalent basis, net interest income was $33.7 million in 1996, a decrease of $2.9 million or, 7.8%, from $36.5 million in 1995. The $2.9 million decrease in net interest income was, for the most part, attributable to the decrease in average earning assets resulting from divestiture during the year of the Vermont operations. ANALYSIS OF CHANGES IN NET INTEREST INCOME The following table presents net interest income components on a tax-equivalent basis and reflects changes between periods attributable to movement in either the average daily balances or average rates for both earning assets and interest-bearing liabilities. Changes attributable to both volume and rate have been allocated proportionately between the categories. <TABLE> <CAPTION> CHANGE IN NET INTEREST INCOME (In Thousands) (Fully Taxable Basis)(Unaudited) 1996 to 1995 Change in Net Interest Income Due to: Volume Rate Total Interest and Dividend Income: <S> <C> <C> <C> Federal Funds Sold $ (560) $ (105) $ (665) Securities Available-for-Sale 6,882 199 7,081 Securities Held-to-Maturity: U.S. Treasury and Other Governmental Agencies (3,108) --- (3,108) State and Municipal Obligations 279 (38) 241 Mortgage-Backed Securities (3,366) 306 (3,060) Other Securities (486) --- (486) Total Securities Held-to-Maturity (6,681) 268 (6,413) Loans (4,928) (969) (5,897) Total Interest and Dividend Income (5,287) (607) (5,894) Interest Expense: Deposits: N.O.W./Super N.O.W. (244) 56 (188) Regular Savings and M.M.D.A. (1,298) (272) (1,570) Time Certificates of $100,000 or More 657 (220) 437 Other Time Deposits (1,543) (17) (1,560) Total Deposits (2,428) (453) (2,881) Short-Term Borrowings 122 (50) 72 Long-Term Debt (230) --- (230) Total Interest Expense (2,536) (503) (3,039) Net Interest Income $(2,751) $ (104) $(2,855) </TABLE> <TABLE> <CAPTION> 1995 to 1994 Change in Net Interest Income Due to: Volume Rate Total Interest and Dividend Income: <S> <C> <C> <C> Federal Funds Sold $ 521 $ 285 $ 806 Securities Available-for-Sale 334 823 1,157 Securities Held-to-Maturity: U.S. Treasury and Other Governmental Agencies (372) 75 (297) State and Municipal Obligations 548 45 593 Mortgage-Backed Securities 233 87 320 Other Securities 282 11 293 Total Securities Held-to-Maturity 691 218 909 Loans 956 4,598 5,554 Total Interest and Dividend Income 2,502 5,924 8,426 Interest Expense: Deposits: N.O.W./Super N.O.W. 202 1,279 1,481 Regular Savings and M.M.D.A. (1,917) 847 (1,070) Time Certificates of $100,000 or More 2,158 442 2,600 Other Time Deposits 1,121 2,319 3,440 Total Deposits 1,564 4,887 6,451 Short-Term Borrowings 288 137 425 Long-Term Debt (230) 17 (213) Total Interest Expense 1,622 5,041 6,663 Net Interest Income $ 880 $ 883 $1,763 </TABLE> The following table reflects the components of the Company's net interest income, setting forth, for years ended December 31, 1996, 1995 and 1994 (I) average balances of assets, liabilities and shareholders' equity, (II) interest income earned on earning assets and interest expense incurred on interest-bearing liabilities, (III) average yields earned on earning assets and average rates paid on interest-bearing liabilities, (IV) the net interest spread (average yield less average cost) and (V) the net interest margin (yield) on earning assets. Rates are computed on a tax-equivalent basis. Nonaccrual loans are included in average loans and leases, while unearned income has been eliminated. AVERAGE CONSOLIDATED BALANCE SHEETS AND NET INTEREST INCOME ANALYSIS Arrow Financial Corporation and Subsidiaries (Fully Taxable Basis using a marginal tax rate of 35% for 1996 and 1995 and 34% for 1994) (Dollars In Thousands) (Unaudited) <TABLE> <CAPTION> Years Ended December 31, 1996 Interest Rate Average Income/ Earned/ Balance Expense Paid <S> <C> <C> <C> Federal Funds Sold $ 12,150 $ 642 5.28% Securities Available- for-Sale (1) 173,783 11,105 6.39 Securities Held-to-Maturity: U.S. Treasury and Governmental Agencies --- --- --- State and Municipal 16,700 1,365 8.17 Mortgage-Backed Securities 575 40 6.96 Other Securities --- --- --- Total Securities Held- to-Maturity 17,275 1,405 8.13 Loans & Leases (Net of Unearned Income) 459,946 42,365 9.21 Total Earning Assets 663,154 55,517 8.37 Allowance For Loan Losses (10,102) Cash and Due From Banks 25,303 Other Assets 28,975 Total Assets $707,330 Deposits: N.O.W./Super N.O.W. $131,438 3,787 2.88 Savings/M.M.D.A. 157,892 4,617 2.92 Time Certificates of $100,000 or More 79,996 4,198 5.25 Other Time Deposits 156,236 8,333 5.33 Total Interest-Bearing Deposits 525,562 20,935 3.98 Short-Term Borrowings 18,524 891 4.81 Long-Term Debt. --- --- --- Total Interest- Bearing Funds 544,086 21,826 4.01 Demand Deposits 77,479 Other Liabilities 15,374 Total Liabilities 636,939 Shareholders' Equity 70,391 Total Liabilities and Shareholders' Equity $707,330 Net Interest Income (Fully Taxable Basis) 33,691 Reversal of Tax Equivalent Adjustment (642) Net Interest Income $33,049 Net Interest Spread 4.36% Net Interest Margin 5.08% (1) Yields do not give effect to changes in fair value that are reflected as a component of shareholders' equity. </TABLE> <TABLE> <CAPTION> Years Ended December 31, 1995 Interest Rate Average Income/ Earned/ Balance Expense Paid <S> <C> <C> <C> Federal Funds Sold $ 22,596 $ 1,307 5.78% Securities Available- for-Sale (1) 66,075 4,024 6.09 Securities Held-to-Maturity: U.S. Treasury and Governmental Agencies 57,993 3,108 5.36 State and Municipal 13,271 1,124 8.47 Mortgage-Backed Securities 48,933 3,100 6.34 Other Securities 6,573 486 7.39 Total Securities Held- to-Maturity 126,770 7,818 6.17 Loans & Leases (Net of Unearned Income) 513,266 48,262 9.40 Total Earning Assets 728,707 61,411 8.43 Allowance For Loan Losses (12,288) Cash and Due From Banks 28,081 Other Assets 32,929 Total Assets $777,429 Deposits: N.O.W./Super N.O.W. $139,879 3,975 2.84 Savings/M.M.D.A. 201,932 6,187 3.06 Time Certificates of $100,000 or More 67,029 3,761 5.61 Other Time Deposits 185,166 9,893 5.34 Total Interest-Bearing Deposits 594,006 23,816 4.01 Short-Term Borrowings 15,855 819 5.17 Long-Term Debt. 2,619 230 8.78 Total Interest- Bearing Funds 612,480 24,865 4.06 Demand Deposits 88,961 Other Liabilities 12,097 Total Liabilities 713,538 Shareholders' Equity 63,891 Total Liabilities and Shareholders' Equity $777,429 Net Interest Income (Fully Taxable Basis) 36,546 Reversal of Tax Equivalent Adjustment (693) Net Interest Income $35,853 Net Interest Spread 4.37% Net Interest Margin 5.02% (1) Yields do not give effect to changes in fair value that are reflected as a component of shareholders' equity. </TABLE> <TABLE> <CAPTION> Years Ended December 31, 1994 Interest Rate Average Income/ Earned/ Balance Expense Paid <S> <C> <C> <C> Federal Funds Sold $ 12,490 $ 501 4.01% Securities Available- for-Sale (1) 60,591 2,867 4.73 Securities Held-to-Maturity: U.S. Treasury and Governmental Agencies 64,908 3,405 5.25 State and Municipal 6,761 531 7.85 Mortgage-Backed Securities 45,221 2,780 6.15 Other Securities 2,751 193 7.02 Total Securities Held- to-Maturity 119,641 6,909 5.77 Loans & Leases (Net of Unearned Income) 502,224 42,708 8.50 Total Earning Assets 694,946 52,985 7.62 Allowance For Loan Losses (16,954) Cash and Due From Banks 27,009 Other Assets 37,635 Total Assets $742,636 Deposits: N.O.W./Super N.O.W. $129,999 2,494 1.92 Savings/M.M.D.A. 260,336 7,257 2.79 Time Certificates of $100,000 or More 26,980 1,161 4.30 Other Time Deposits 160,035 6,453 4.03 Total Interest-Bearing Deposits 577,350 17,365 3.01 Short-Term Borrowings 9,838 394 4.00 Long-Term Debt. 5,226 443 8.48 Total Interest- Bearing Funds 592,414 18,202 3.07 Demand Deposits 87,715 Other Liabilities 8,028 Total Liabilities 688,157 Shareholders' Equity 54,479 Total Liabilities and Shareholders' Equity $742,636 Net Interest Income (Fully Taxable Basis) 34,783 Reversal of Tax Equivalent Adjustment (471) Net Interest Income $34,312 Net Interest Spread 4.55% Net Interest Margin 5.01% (1) Yields do not give effect to changes in fair value that are reflected as a component of shareholders' equity. </TABLE> <TABLE> <CAPTION> CHANGES IN NET INTEREST INCOME DUE TO RATE YIELD ANALYSIS December 31, 1996 1995 1994 <S> <C> <C> <C> Yield on Earning Assets 8.37% 8.43% 7.62% Cost of Interest-Bearing Liabilities 4.01 4.06 3.07 Net Interest Spread 4.36% 4.37% 4.55% Net Interest Margin 5.08% 5.02% 5.01% </TABLE> The following items have a major impact on changes in net interest income due to rate: general interest rate changes, the ratio of the Company's rate sensitive assets to rate sensitive liabilities (interest rate sensitive gap) during periods of interest rate changes and the performance of nonperforming loans. The Federal Reserve Board attempts to influence prevailing federal funds and prime interest rates by changing the Federal Reserve Bank discount rate. The following chart presents recent changes to the discount rate: <TABLE> <CAPTION> Federal Reserve Bank's Discount Rate Changes 1992 - 1996 Date New Rate Old Rate <S> <C> <C> January 31, 1996 5.00% 5.25% February 1, 1995 5.25 4.75 November 15, 1994 4.75 4.00 August 16, 1994 4.00 3.50 May 17, 1994 3.50 3.00 July 2, 1992 3.00 3.50 </TABLE> During 1996, the Company experienced minimal impact on net interest income resulting from changes in interest rates. Throughout 1996, interest rates remained quite stable, largely due to the influence of the Federal Reserve Board's control of the federal discount rate, which changed only once at the beginning of the year. At that time the discount rate decreased 25 basis points to 5.00%. In 1995, the change in net interest income attributable to changes in interest rates had an $883 thousand positive impact on net interest income. During the first half of the year, the Company was still experiencing the effect from rising interest rates which had begun in the second half of 1994. Various loan and deposit products react to interest rate changes at different rates and the pricing on some products does not change to the full extent of changes in the prime rate. During 1994, assets in general repriced more quickly than time deposits. Repricing of short-term deposit products also tended to lag behind prime rate changes and did not change to the full extent of prime rate changes. Consequently, the spread between the yield on earning assets and the cost of interest paying liabilities increased from 1993 to 1994 by 13 basis points, while decreasing by 18 basis points from 1994 to 1995. Notwithstanding the decrease in the net interest spread in 1995, the Company experienced an overall beneficial impact from generally rising interest rates due to the fact that average interest-earning assets increased more rapidly than average interest-paying liabilities, as discussed more fully in the following section on changes in net interest income due to volume. As a result, the net interest margin increased from 1994 to 1995, albeit by only one basis point. A discussion of the impact on net interest income resulting from changes in interest rates vis a vis the repricing patterns of the Company's interest-bearing assets and liabilities is included later in this report under Item 7.E. "Interest Rate Risk." During 1996 and 1995, the Company received certain payments on restructured loans in the Vermont portfolio that had not been factored into the effective rate on those loans. The payments, which were recorded as interest income, have been included in the yields in the table above. These payments increased the loan yields by seven and four basis points for the two respective years.
CHANGES IN NET INTEREST INCOME DUE TO VOLUME <TABLE> <CAPTION> AVERAGE BALANCES (Dollars in Thousands) $ Change % Change 1996 1995 1994 1996 1995 1996 1995 <S> <C> <C> <C> <C> <C> <C> <C> Earning Assets $663,154 $728,707 $694,946 $(65,553) $33,761 (9.0)% 4.9% Interest-Bearing Liabilities 544,086 612,480 592,414 (68,394) 20,066 (11.2) 3.4 Demand Deposits 77,479 88,961 87,715 (11,482) 1,246 (12.9) 1.4 Total Assets 707,330 777,429 742,636 (70,099) 34,793 (9.0) 4.7 Earning Assets to Total Assets 93.75% 93.73% 93.58% .02% .15% 0.0 0.2 </TABLE> In general, changes in the volume of earning assets or paying liabilities will result in corresponding changes in net interest income. However, changes due to volume can be enhanced or restricted by shifts in the relative mix between instruments of different rates. In 1996, nearly all of the $2.9 million decrease in net interest income was attributable to the change in volume. The decrease was attributable to the divestiture of the Vermont banking operations during 1996. Increases in the volume of loans and deposits, as well as yields and costs by type, for the New York banks are discussed later in this report under Item 7.C. "Financial Condition." In summary, the New York banks experienced significant growth during 1996, with some shifting of emphasis in the loan portfolio from commercial to consumer loans. There was relatively little change in the mix of deposit products from 1995 to 1996. In 1995, the change in volume had an $880 thousand positive impact on net interest income. Of the $33.8 million increase in average earning assets from 1994 to 1995, average loan balances accounted for $11.0 million. The Company used the remaining funds to increase its liquid assets. Only $20.1 million of the $33.8 million increase in average earning assets was funded by paying liabilities. The primary sources of funds for the remainder came from retained earnings ($9.4 million) and proceeds from the sale of OREO ($1.5 million). II. PROVISION FOR LOAN LOSSES AND ALLOWANCE FOR LOAN LOSSES Through the provision for loan losses, an allowance (reserve) is maintained for estimated loan losses. Actual loan losses are charged against this allowance when they are identified. In evaluating the adequacy of the allowance for loan losses, management considers various risk factors influencing asset quality. The analysis is performed on a loan by loan basis for impaired and large balance loans, and by portfolio type for smaller balance homogeneous loans. This analysis is based on judgments and estimates and may change in response to economic developments or other conditions that may influence borrowers' economic outlook. The provision for loan losses is largely influenced by the level of nonperforming loans, the expected future levels of nonperforming loans and by the level of loans actually charged-off against the allowance for loan losses during the year. At December 31, 1996, nonperforming loans amounted to $2.6 million, a decrease of 39.9% from the balance at December 31, 1995. The decrease is primarily attributable to nonperforming loans transferred in the divestiture of the Vermont banking operations during 1996. The level of nonperforming loans for the New York based banks was virtually unchanged from 1995 to 1996. During 1996, loan losses charged against the reserve, net of recoveries, were $580 thousand, or .13% of average loans for the period. However, the most significant reduction to the allowance for loan losses was the amount of the reserve attributable to loans transferred in the divestiture of the Vermont banking operations of $6.8 million. These reductions in the allowance for loan losses were offset in part by a provision for loan losses of $896 thousand, or .19% of average loans for the year. At December 31, 1996 the allowance for loan losses was $5.6 million. The allowance for loan losses was 213% of the amount of nonperforming loans at that date. During 1995, nonperforming assets continued the steady decline begun in 1991. The primary portion of the decrease in nonperforming assets in 1995 came from the sale of OREO. Nonaccrual loans increased $626 thousand or 17.3% from the year-end 1994 balance. The increase in nonaccrual loans was due primarily to the aggregate borrowing of one large commercial borrower, which was placed on nonaccrual status in 1995. That loan was accounted for under SFAS No. 114 and was being carried at its estimated fair value. Loans reported as troubled debt restructures at December 31, 1994, were classified as performing in 1995. Net loan losses for 1995 were $1.4 million. These losses compare to net loan losses of $2.8 million, $1.9 million and $4.7 million for the years ended December 31, 1994, 1993 and 1992, respectively. As a ratio to average loans, the net loan losses were .27%, .56%, .40% and .92% for the same respective periods. The provision for loan losses in 1994 was actually a credit to the consolidated statement of income resulting in a reduction in the allowance for loan losses. During the second quarter of 1994, with nonperforming assets at significantly reduced levels and a substantial sale of OREO having been completed, the Company reduced the allowance for loan losses by $1.5 million. This reduction was effected by means of a credit to the provision for loan losses. As a result, for the twelve month period ended December 31, 1994, the Company's net provision for loan losses was a benefit $950 thousand, compared to a provision of $690 thousand in 1993 and $1.7 million in 1992. As a ratio of average loans, the provisions were (.19)% in 1994 and .14% and .32% for 1993 and 1992, respectively. <TABLE> <CAPTION> SUMMARY OF THE ALLOWANCE AND PROVISION FOR LOAN LOSSES (Dollars In Thousands) (Loans and Leases, Net of Unearned Income) Years-Ended December 31, 1996 1995 1994 1993 1992 <S> <C> <C> <C> <C> <C> Loans and Leases at End of Period $393,511 $517,787 $507,553 $502,784 $492,916 Average Loans and Leases 459,946 513,266 502,224 489,326 516,711 Total Assets at End of Period 652,603 789,790 746,431 733,442 722,415 Nonperforming Assets: Nonaccrual Loans: Construction and Land Development $ --- $ 104 $ 327 $ 2,534 $ 6,149 Commercial Real Estate 83 1,299 1,050 2,649 7,986 Commercial Loans 1,487 1,979 1,017 2,596 4,168 Other 727 862 1,224 2,082 3,171 Total Nonaccrual Loans 2,297 4,244 3,618 9,861 21,474 Loans Past Due 90 or More Days and Still Accruing Interest 321 111 231 364 1,486 Restructured Loans in Compliance with Modified Terms --- --- 580 2,405 1,161 Total Nonperforming Loans 2,618 4,355 4,429 12,630 24,121 Other Real Estate Owned 136 2,410 3,396 7,506 5,548 Total Nonperforming Assets $ 2,754 $ 6,765 $ 7,825 $ 20,136 $ 29,669 Allowance for Loan Losses: Balance at Beginning of Period $ 12,106 $ 12,338 $ 16,078 $ 17,328 $ 20,387 Transfer with Loan Sales (6,841) --- --- --- --- Loans Charged-off: Commercial, Financial and Agricultural (185) (579) (997) (973) (2,283) Real Estate - Commercial (104) (369) (689) (1,106) (645) Real Estate - Construction (2) (101) (1,181) (377) (2,015) Real Estate - Residential (57) (160) (143) (151) (323) Installment Loans to Individuals (598) (562) (476) (480) (820) Lease Financing Receivables -- -- -- -- (9) Total Loans Charged-off (946) (1,771) (3,486) (3,087) (6,095) Recoveries of Loans Previously Charged-off: Commercial, Financial and Agricultural 84 76 260 694 724 Real Estate - Commercial 48 104 35 75 48 Real Estate - Construction --- 10 68 55 327 Real Estate - Residential 12 8 143 37 22 Installment Loans to Individuals 222 171 188 285 232 Lease Financing Receivables -- -- 2 1 6 Total Recoveries of Loans Previously Charged-off 366 369 696 1,147 1,359 Net Loans Charged-off (580) (1,402) (2,790) (1,940) (4,736) Provision for Loan Losses Charged to Expense 896 1,170 (950) 690 1,677 Balance at End of Period $ 5,581 $ 12,106 $ 12,338 $ 16,078 $ 17,328 Nonperforming Asset Ratio Analysis: Net Loans Charged-off as a Percentage of Average Loans .13% .27% .56 % .40% .92% Provision for Loan Losses as a Percentage of Average Loans .19 .23 (.19) .14 .32 Allowance for Loan Losses as a Percentage of Period-end Loans 1.42 2.34 2.43 3.20 3.52 Allowance for Loan Losses as a Percentage of Nonperforming Loans 213.18 277.98 278.57 127.30 71.84 Nonperforming Loans as a Percentage of Period-end Loans .67 .84 .87 2.51 4.89 Nonperforming Assets as a Percentage of Period-end Total Assets .42 .86 1.05 2.75 4.11 </TABLE> III. OTHER INCOME The majority of other (i.e., noninterest) income is derived from fees and commissions from fiduciary services, deposit account service charges, computer processing fees to correspondents and other "core" or recurring sources. Additionally, other income is influenced by transactions involving the sale of securities available-for-sale. <TABLE> <CAPTION> ANALYSIS OF OTHER INCOME (Dollars In Thousands) Change December 31, Amount Percent 1996 1995 1994 1996 1995 1996 1995 <S> <C> <C> <C> <C> <C> <C> <C> Income from Fiduciary Activities $ 3,458 $ 3,752 $3,657 $ (294) $ 95 (7.8)% 2.6% Fees for Other Services 3,959 4,669 4,345 (710) 324 (15.2) 7.5 Net Securities Gains (Losses) (101) 23 (481) (124) 504 --- --- Net Gain on Divestiture of Vermont Operations 15,330 --- --- 15,330 --- --- --- Other Operating Income 1,057 6,052 1,047 (4,995) 5,005 (82.5) 478.0 Total Other Income $23,703 $14,496 $8,568 $ 9,207 $5,928 63.5 69.2 </TABLE> Total other income for 1996 was $23.7 million as compared to $14.5 million for 1995. Without regard to nonrecurring items included in other income for the two years, specifically the divestiture of Vermont operations in 1996, the financial institution bond recovery in 1995 and securities sale transactions for both years, other income was $8.5 million for 1996, compared to $9.5 million in 1995, a decrease of 10.5%. As thus adjusted, other income as a percentage of average assets was 1.20% in 1996, virtually the same as in 1995. During 1996, the Company completed the divestiture of its Vermont banking operations. The pre-tax gain of $15.3 million is net of recording the remaining assets and liabilities at fair value less estimated costs to sell. The major remaining asset, which at December 31, 1996, was held for sale, was the building in Rutland, Vermont, which was the former main office of GMB. Principal remaining liabilities included pension and post-retirement obligations of GMB and amounts reserved for costs and expenses of liquidating GMB's charter. In 1995, the Company received a $5.0 million payment from the Company's financial institution bond carrier, in settlement of a lawsuit filed in 1994 for losses suffered in earlier periods, covered under the Company's policy. During 1996, the Company recognized net losses of $101 thousand on the sale of $51.1 million of securities classified as available-for-sale. Most of the sales were made for the purpose of extending the term of the securities at higher yields. During 1995, the Company recognized net gains of $23 thousand on the sale of $4.2 million of available-for-sale securities. During 1994, the Company recognized net securities losses of $481 thousand on the sale of $16.5 million of available-for-sale securities. Income from fiduciary activities for 1996 was $3.5 million, a decrease of $294 thousand, or 7.8% from 1995. On August 31, 1996, the Company sold its Vermont trust business as part of the divestiture of Vermont operations. In 1995, the Vermont trust business represented approximately 42% of the Company's fiduciary income for the year of $3.8 million. During 1996, the New York based trust business generated $2.4 million in income, an increase of $232 thousand, or 10.6%, from 1995. The increase was attributable to a $35.3 million increase in assets under management, which were $434.6 million at December 31, 1996. Fees for other services include deposit service charges, safe deposit box fees, credit card merchant processing fees, and servicing fees on loans sold with servicing retained by the Company. These fees amounted to $4.0 million for 1996, a decrease of $710 thousand, or 15.2% from 1995, again reflecting the disposition of the Vermont operations during 1996. For the New York based operations, these fees amounted to $3.4 million for both years. Other operating income includes, as a primary component, fees earned on servicing credit card portfolios for correspondent banks. This category of noninterest income also includes gains on the sale of loans, other real estate owned and other assets. Without regard to the bond recovery, other operating income amounted to $1.1 million for both 1996 and 1995. Total other income for 1995 amounted to $14.5 million, a $5.9 million increase from 1994. The increase was primarily attributable to a $5.0 million payment received from the Company's financial institution bond carrier. Exclusive of the bond recovery and net securities transactions, total other income in 1995 increased $424 thousand, or 4.7%, above the 1994 level. As adjusted, the ratio of total other income to average assets was 1.22% for both years. Fees for other services to customers amounted to $4.7 million in 1995, compared to $4.3 million in 1994, a 7.5% increase. The increase was primarily attributable to increases in service charges on deposit accounts and credit card merchant processing income. Other operating income in 1995 was virtually unchanged from 1994. IV. OTHER EXPENSE Other (i.e., noninterest) expense is a means of measuring the delivery cost of services, products and business activities of the Company. The key components of other expense are presented in the following table. <TABLE> <CAPTION> ANALYSIS OF OTHER EXPENSE (Dollars In Thousands) Change December 31, Amount Percent 1996 1995 1994 1996 1995 1996 1995 <S> <C> <C> <C> <C> <C> <C> <C> Salaries and Benefits $14,971 $16,710 $16,204 $(1,739) $ 506 (10.4)% 3.1 % Net Occupancy Expense 1,790 2,040 2,168 (250) (128) (12.3) (5.9) Furniture and Equipment 1,677 1,930 2,076 (253) (146) (13.1) (7.0) Other Operating Expense 6,336 9,089 10,926 (2,753) (1,837) (30.3) (16.8) Total Other Expense $24,774 $29,769 $31,374$ (4,995) $(1,605) (16.8) (5.1) </TABLE> Other expense for 1996 was $24.8 million, a decrease of $5.0 million, or 16.8%, from 1995. All four major categories of other expense decreased as a result of the divestiture of the Vermont banking operations. Salaries and benefits for 1996 was $15.0 million, a decrease of $1.7 million, or 10.4%, from 1995. Net occupancy expense and furniture and equipment expense both decreased approximately $250 thousand from 1995, or 12.3% and 13.1%, respectively. ` Other operating expense for 1996 was $6.3 million, a decrease of $2.8 million, or 30.3%, from 1995. In addition to the savings resulting from the divestiture of the Vermont operations, the Company experienced decreased costs for FDIC insurance premiums, legal expenses, expenses related to problem loans and in costs to maintain and dispose of OREO. In mid-1995, the FDIC reduced the insurance premiums for well- capitalized banks, such as the Company's subsidiary banks, from 23 cents per $100 of insured deposits to a flat fee of two thousand dollars per year. Other expense for 1995 amounted to $29.8 million, which compared to $31.4 million for 1994, a decrease of $1.6 million, or 5.1%. An increase in salaries and benefits in 1995 was more than offset by reduced expenses for net occupancy expense, furniture and equipment expense and other operating expenses. Total salaries of $11.1 million for 1995 decreased $284 thousand from the 1994 level. The effect of fewer employees was only partially offset by general salary increases. Between 1994 and 1995, employee benefits increased by $790 thousand, of which $652 thousand represented severance costs incurred the latter year. Otherwise, a slight decrease in payroll taxes was offset by increased expenses for pension plans and health insurance. From 1995 to 1994, net occupancy expense and furniture and equipment expense decreased by $128 thousand and $146 thousand, respectively. The decreases were primarily attributable to reduced depreciation expenses. Other operating expense was $9.1 million for 1995, a decrease of $1.8 million, or 16.8%, from 1994. The decrease was primarily attributable to a reduction in FDIC and other insurance premiums, as well as to a large reduction in losses on the sale of OREO. V. INCOME TAXES The following table sets forth the Company's income tax expense and effective tax rates for the periods presented herein. <TABLE> <CAPTION> INCOME TAXES AND EFFECTIVE RATES (Dollars in Thousands) Years Ended December 31, 1996 1995 1994 <S> <C> <C> <C> Provision for Income Taxes $10,822 $6,986 $1,131 Effective Tax Rate 34.8% 36.0% 9.1% </TABLE> The provisions for federal and state income taxes amounted to $10.8 million, $7.0 million and $1.1 million for 1996, 1995 and 1994, respectively. The 1994 provision was relatively small as a result of a net operating loss carryforward tracing from 1991 and changes in the valuation allowance for deferred tax assets. Eliminating the effect of these two benefits in 1994, the effective income tax rates for 1996, 1995 and 1994 were 34.8%, 36.0% and 38.1%, respectively. The decrease in the effective tax rate in each of the past two years primarily reflected a relative increase in the Company's tax exempt loan and securities portfolios. C. FINANCIAL CONDITION I. INVESTMENT PORTFOLIO The Company adopted SFAS No. 115 "Accounting for Certain Investments in Debt and Equity Securities" at December 31, 1993. Under SFAS No. 115, investment securities must be classified as held- to-maturity, trading, or available-for-sale, depending on the purposes for which such securities were acquired or are being held. Securities held-to-maturity are debt securities that the Company has both the positive intent and ability to hold to maturity; such securities are stated at amortized cost. Debt and equity securities that are bought and held principally for the purpose of sale in the near term are classified as trading securities and are reported at fair value with unrealized gains and losses included in earnings. Debt and equity securities not classified as either held-to-maturity or trading securities are classified as available- for-sale and are reported at fair value with unrealized gains and losses excluded from earnings and reported net of taxes in a separate component of shareholders' equity. At December 31, 1996, the Company held no trading securities. In November 1995, the FASB issued "A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities." The Guide allowed a one-time reclassification of held-to-maturity securities before December 31, 1995. Acting under this provision of the Guide, the Company reclassified $118.2 million of held-to-maturity securities to available-for-sale in December of 1995. The Company took advantage of this one-time provision as a means to improve liquidity and to gain some additional flexibility in the management of the Company's interest rate risk. See the following sections D. on "Liquidity" and E. on "Interest Rate Risk." Securities Available-for-Sale: The following table sets forth the book value of the Company's securities available-for-sale portfolio, at year-end 1996, 1995 and 1994. <TABLE> <CAPTION> SECURITIES AVAILABLE-FOR-SALE (In Thousands) December 31, 1996 1995 1994 <S> <C> <C> <C> U.S. Treasury and Agency Obligations $ 95,733 $114,502 $49,063 State and Municipal Obligations --- 338 2,180 Collateralized Mortgage Obligations 42,894 44,173 475 Other Mortgage-Backed Securities 21,732 10,478 --- Corporate and Other Debt Securities 9,184 7,300 --- Mutual Funds and Equity Securities 2,200 1,854 2,150 Total $171,743 $178,645 $53,868 </TABLE> Other mortgage-backed securities principally included agency mortgage pass-through securities. Pass-through securities provide to the investor monthly portions of principal and interest pursuant to the contractual obligations of the underlying mortgages. Collateralized mortgage obligations ("CMO's") separate the repayments into two or more components (tranches), where each tranche has a separate estimated life and yield. The Company's practice is to purchase pass-through securities guaranteed by federal agencies and tranches of CMO's with shorter maturities. Regulatory agencies have devised a high-risk test for mortgage-backed securities. The test evaluates the following: (I) Average Life Test - the product has an average life of less than 10 years; (II) Average Life Sensitivity Test - an immediate and sustained change in interest rates of 300 basis points will not extend the expected life by more than four years; and (III) Price Sensitivity Test - an immediate and sustained change in interest rates of 300 basis points will not change the price by more than 17%. The Company evaluates each mortgage-backed security at the time of purchase and quarterly thereafter. Although none of the Company's investments have failed to pass the high-risk test subsequent to acquisition, it is the Company's policy to analyze the appropriateness of divesting high-risk securities. Included in corporate and other debt securities are highly rated corporate bonds. The following table sets forth the maturities of the Company's securities available-for-sale portfolio as of December 31, 1996. CMO's are included in the table based on their expected average life and other mortgage-backed securities by final maturity date. <TABLE> <CAPTION> MATURITIES OF SECURITIES AVAILABLE-FOR-SALE (In Thousands) After After Within 1 But 5 But After One Within Within 10 Year 5 Years 10 Years Years Total <S> <C> <C> <C> <C> <C> U.S. Treasury and Agency Obligations $34,141 $ 50,767 $10,825 $ -- $ 95,733 Collateralized Mortgage Obligations 1,536 32,230 8,110 1,018 42,894 Other Mortgage-Backed Securities 335 4,195 1,581 15,621 21,732 Corporate and Other Debt Securities 1,010 8,174 --- -- 9,184 Mutual Funds and Equity Securities --- --- --- 2,200 2,200 Total $37,022 $ 95,366 $20,516 $18,839 $171,743 </TABLE> The following table sets forth the tax-equivalent yields of the Company's securities available-for-sale portfolio at December 31, 1996. <TABLE> <CAPTION> YIELDS ON SECURITIES AVAILABLE-FOR-SALE (Fully Tax-Equivalent Basis) After After Within 1 But 5 But After One Within Within 10 Year 5 Years 10 Years Years Total <S> <C> <C> <C> <C> <C> U.S. Treasury and Agency Obligations 6.68% 6.36% 6.83% --% 6.53% Collateralized Mortgage Obligations 9.82 6.71 6.48 7.48 6.79 Other Mortgage-Backed Securities 5.33 7.00 7.14 7.00 6.98 Corporate and Other Debt Securities 7.01 7.30 -- -- 7.26 Mutual Funds and Equity Securities -- -- -- 6.60 6.60 Total 6.80 6.58 6.72 6.98 6.69 </TABLE> The yields for debt securities shown in the table above are calculated by dividing annual interest, including accretion of discounts and amortization of premiums, by the carrying value of the securities at December 31, 1996. Yields on obligations of states and municipalities were computed on a fully tax-equivalent basis using a marginal tax rate of 35%. Dividend earnings derived from equity securities were adjusted to reflect applicable federal income tax exclusions. During 1996 the Company recognized net losses of $101 thousand on the sale of $51.1 million from securities within the available-for-sale portfolio. Proceeds from sales early in the year were used to provide funds in completing the branch sale to Mascoma Savings Bank, a transaction in which the deposit liabilities assumed by the purchaser substantially exceeded the purchase price of the loans and other assets acquired and the deposit premium. Other sales of securities from the available-for-sale portfolio were used to extend the maturity dates and increase the yield on the portfolio. During the last quarter of 1995, the Company recognized net gains of $23 thousand on sales of $4.2 million from the available-for-sale portfolio. The proceeds were used to fund the deposits transferred with the sale of eight branches of Green Mountain Bank to Mascoma Savings Bank in January 1996. At December 31, 1996 and 1995, the weighted average maturity was 2.71 and 2.03 years, respectively, for debt securities in the available-for-sale portfolio. During the last quarter of 1994, the Company recognized net losses of $481 thousand on sales of $16.5 million from the available-for-sale portfolio. The proceeds were reinvested in higher yielding securities. At December 31, 1996, unrealized gains on securities available-for-sale amounted to $208 thousand, net of tax. Unrealized gains or losses, net of tax, are reflected as a separate component of shareholders' equity. Securities Held-to-Maturity: The following table sets forth the book value of the Company's portfolio of securities held-to- maturity for each of the last three years. Year-end amounts and data in the following tables do not include the securities available-for-sale portfolio discussed previously. The substantial reduction in the held-to-maturity portfolio between year-end 1994 and year-end 1995 reflects the one-time reclassification in November 1995 discussed previously in the introduction to the investment portfolio discussion. <TABLE> <CAPTION> SECURITIES HELD-TO-MATURITY (In Thousands) December 31, 1996 1995 1994 <S> <C> <C> <C> U.S. Treasury and Agency Obligations $ --- $ --- $ 61,390 State and Municipal Obligations 19,765 13,921 10,409 Other Mortgage-Backed Securities 11,111 --- 51,904 Other Securities --- --- 6,032 Total $30,876 $13,921 $129,735 </TABLE> For information regarding the fair value of the Company's portfolio of securities held-to-maturity, see Note 3 to the Consolidated Financial Statements in Part II, Item 8 of this report. The following table sets forth the maturities of the Company's portfolio of securities held-to- maturity, as of December 31, 1996. Other mortgage-backed securities are allocated to maturity periods based on final maturity date. <TABLE> <CAPTION> MATURITIES OF SECURITIES HELD-TO-MATURITY (In Thousands) After After Within 1 But 5 But After One Within Within 10 Year 5 Years 10 Years Years Total <S> <C> <C> <C> <C> <C> State and Municipal Obligations $1,888 $2,784 $5,417 $ 9,676 $19,765 Other Mortgage-Backed Securities --- --- --- 11,111 11,111 Total Securities Held-to- Maturity $1,888 $2,784 $5,417 $20,787 $30,876 </TABLE> The following table sets forth the tax-equivalent yields of the Company's portfolio of securities held-to-maturity at December 31, 1996. <TABLE> <CAPTION> YIELDS ON SECURITIES HELD-TO-MATURITY (Fully Tax-Equivalent Basis) After After Within 1 But 5 But After One Within Within 10 Year 5 Years 10 Years Years Total <S> <C> <C> <C> <C> <C> State and Municipal Obligations 7.07% 8.18% 7.93% 7.97% 7.90% Other Mortgage-Backed Securities --- --- --- 7.13 7.13 Total Securities Held-to- Maturity 7.07 8.18 7.93 7.53 7.63 </TABLE> The yields for debt securities shown in the tables above are calculated by dividing annual interest, including accretion of discounts and amortization of premiums, by the carrying value of the securities at December 31, 1996. Yields on obligations of states and municipalities were computed on a fully tax-equivalent basis using a marginal tax rate of 35%. During 1996 and 1995, the Company sold no securities from the held-to-maturity portfolio. The weighted-average maturity of the held-to- maturity portfolio was 7.5 years and 8.8 years at December 31, 1996 and 1995, respectively. II. LOAN PORTFOLIO The amounts and respective percentages of loans and leases outstanding represented by each principal category on the dates indicated were as follows: <TABLE> <CAPTION> a. DISTRIBUTION OF LOANS AND LEASES (Dollars In Thousands) December 31, 1996 1995 1994 1993 1992 Amount % Amount % Amount % Amount % Amount % <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> Commercial, Financial and Agricultural $ 48,372 12 $ 79,993 15 $ 74,455 15 $ 82,317 16 $ 85,428 17 Real Estate - Commercial 36,302 9 71,622 14 81,704 16 95,981 19 110,702 22 Real Estate - Construction 971 1 2,051 1 5,136 1 8,702 2 12,167 2 Real Estate - Residential 168,429 43 238,298 46 230,943 45 221,066 44 198,165 40 Installment Loans to Individuals 139,395 35 125,762 24 115,291 23 94,656 19 86,323 19 Lease Financing Receivables 42 -- 61 -- 24 -- 62 -- 131 -- Total Loans and Leases 393,511 100 517,787 100 507,553 100 502,784 100 492,916 100 Allowance for Loan Losses (5,581) (12,106) (12,338) (16,078) (17,328) Total Loans and Leases, Net $387,930 $505,681 $495,215 $486,706 $475,588 </TABLE> During 1996, the Company transferred substantially all of the loans in its Vermont banking operation in two branch sale transactions, to Mascoma Savings Bank in January 1996 and to ALBANK in September 1996. The Vermont loan portfolio had a higher percentage of commercial loans than the loan portfolios of the Company's New York banks. Consequently, the divestiture of the Vermont banking operations is largely responsible for the shift in the mix of the loan portfolio from commercial to consumer loans between year-end 1995 and year-end 1996. Also, the Company concentrated its lending efforts in 1996, in the area of residential real estate loans and installment loans to individuals (primarily automobile loans). Within the installment loan portfolio, the Company has focused on growth in its indirect lending program. Indirect loans are vehicle acquisition loans to consumers financed through local dealerships where, by prior arrangement, the Company acquires the dealer paper. At year- end 1992, indirect loans amounted to $42.1 million or 49% of installment loans. By December 31, 1996, indirect loans amounted to $107.2 million, or 77% of installment loans. While the yields on the consumer portfolios (other than credit card loans) typically are lower than on the commercial portfolios, the Company has historically experienced fewer loan losses in consumer loans than commercial loans, in proportion to outstanding average loan balances. Since 1990, the Company has concentrated its lending efforts in the area of residential real estate loans and installment loans to individuals, while de-emphasizing commercial and commercial real estate loans. Consequently, each of the years preceding 1996, both the dollar amount of loans for commercial and commercial real estate loans and the percentage of such loans to total loans decreased from the prior year, while residential real estate and installment loans to individuals increased each year since 1990, both in dollar amount and in percentage to total loans. The following table indicates the changing mix in the Company's New York loan portfolio by presenting the quarterly average balance for the Company's significant loan products for the past five quarters. In addition, the table presents the percentage of total loans represented by each category as well as the annualized tax-equivalent yield. <TABLE> <CAPTION> NEW YORK LOAN PORTFOLIO Quarterly Average Loan Balances (Dollars In Thousands) Quarter Ending Dec 1996 Sep 1996 Jun 1996 Mar 1996 Dec 1995 <S> <C> <C> <C> <C> <C> Commercial and Commercial Real Estate $ 84,059 $ 84,789 $ 87,304 $ 87,073 $ 87,388 Residential Real Estate 125,897 123,884 122,858 120,010 119,157 Home Equity 29,863 29,109 28,804 29,226 29,364 Indirect Consumer Loans 105,227 99,059 92,757 82,446 78,823 Direct Consumer Loans 32,013 30,634 31,627 31,555 30,022 Credit Card Loans 8,514 8,733 8,967 9,310 9,413 Total Loans $385,573 $376,208 $372,317 $359,620 $354,167 </TABLE Percentage of Total Quarterly Average Loans Commercial and Commercial Real Estate 21.8% 22.6% 23.5% 24.2% 24.7% Residential Real Estate 32.7 32.9 33.0 33.4 33.6 Home Equity 7.7 7.7 7.7 8.1 8.3 Indirect Consumer Loans 27.3 26.4 24.9 22.9 22.2 Direct Consumer Loans 8.3 8.1 8.5 8.8 8.5 Credit Card Loans 2.2 2.3 2.4 2.6 2.7 Total Loans 100.0% 100.0% 100.0% 100.0% 100.0% Quarterly Taxable Equivalent Yield on Loans Commercial and Commercial Real Estate 9.36% 9.76% 9.22% 9.98% 10.07% Residential Real Estate 8.30 8.26 8.42 8.55 8.47 Home Equity 9.08 9.10 9.03 9.40 9.76 Indirect Consumer Loans 8.35 8.43 8.52 8.62 8.56 Direct Consumer Loans 10.73 9.45 9.44 9.43 9.90 Credit Card Loans 16.46 16.66 16.55 16.45 15.64 Total Loans 8.99 9.00 9.12 9.26 9.30 </TABLE> The following table indicates the respective maturities and repricing structure of the Company's commercial, financial and agricultural loans and its real estate - construction loans at December 31, 1996. For purposes of determining relevant maturities, loans are assumed to mature at (but not before) their scheduled repayment dates as required by contractual terms. Demand loans and overdrafts are included in the "Within 1 Year" maturity category. <TABLE> <CAPTION> MATURITY AND REPRICING OF COMMERCIAL LOANS (In Thousands) After 1 After WithinBut Within Five 1 Year 5 Years Years Total <S> <C> <C> <C> <C> Commercial, Financial and Agricultural $24,559 $16,395 $ 7,418 $48,372 Real Estate - Construction 340 74 557 971 Total $24,899 $16,469 $ 7,975 $49,343 Fixed Interest Rates $ 2,963 $ 8,678 $ 6,669 $18,310 Variable Interest Rates 21,936 7,791 1,306 31,033 Total $24,899 $16,469 $ 7,975 $49,343 </TABLE> COMMITMENTS AND LINES OF CREDIT Letters of credit represent extensions of credit granted in the normal course of business which are not reflected in the accompanying consolidated financial statements because they are not yet funded. As of December 31, 1996, the total contingent liability for standby letters of credit amounted to $1.2 million. In addition to these instruments, the Banks have issued lines of credit to customers, including home equity lines of credit, credit card lines of credit, commitments for residential and commercial construction and other personal and commercial lines of credit, which also may be unfunded or only partially funded from time to time. Commercial lines, generally issued for a period of one year, are usually extended to provide for the working capital requirements of the borrower. At December 31, 1996, the Banks had outstanding loan unfunded commitments in the aggregate amount of approximately $60.9 million. b. RISK ELEMENTS NONACCRUAL, PAST DUE AND RESTRUCTURED LOANS The Company designates loans as impaired when the payment of interest and/or principal is due and unpaid for a designated period (generally 90 days) or when the likelihood of the full repayment of principal and interest is, in the opinion of management, uncertain. Loans are written off against the allowance for loan losses for amounts in excess of the fair value of collateral less estimated costs to sell upon reaching 120 days delinquent. There were no material commitments to lend additional funds on outstanding impaired loans at December 31, 1996. Loans and leases past due 90 days or more and still accruing interest, as identified in the following table, are those loans and leases which were contractually past due 90 days or more but because of expected repayments were still accruing interest. For years prior to 1995, loans were classified as "restructured" in accordance with SFAS No. 15, "Accounting by Debtors and Creditors for Troubled Debt Restructurings." On January 1, 1995, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 114, "Accounting by Creditors for Impairment of a Loan." SFAS No. 114, as amended, requires that impaired loans, except for large groups of smaller-balance homogeneous loans, be measured based on (I) the present value of expected future cash flows discounted at the loan's effective interest rate, (II) the loan's observable market price or (III) the fair value of the collateral if the loan is collateral dependent. The Company applies the provisions of SFAS No. 114 to all impaired commercial and commercial real estate loans over $250,000, and to all loans restructured subsequent to adoption. Reserves for losses for the remaining smaller-balance loans are evaluated under SFAS No. 5. Under the provisions of SFAS No. 114, the Company determines impairment for collateralized loans based on fair value of the collateral less estimated cost to sell. For other loans, impairment is determined by comparing the recorded value of the loan to the present value of the expected cash flows, discounted at the loan's effective interest rate. The Company determines the interest income recognition method on a loan by loan basis. Based upon the borrowers' payment histories and cash flow projections, interest recognition methods include full accrual, cash basis and cost recovery. Loans accounted for under SFAS No. 114 may be reported as either nonaccrual, restructured or performing. Those loans recognizing interest income on a cash or cost recovery basis are reported as nonaccrual. Loans restructured under SFAS No. 15 are reported as restructured if the loan is in compliance with the modified terms. Under SFAS No. 15, as amended, loans bearing a market rate at the time of restructure and in compliance with modified terms are not subject to the disclosure requirements of SFAS No. 114 in years subsequent to the year of restructure, and thus would be included in performing loans. The Company's nonaccrual, past due and restructured loans and leases were as follows: <TABLE> <CAPTION> SCHEDULE OF NONPERFORMING LOANS (Dollars In Thousands) December 31, 1996 1995 1994 1993 1992 Nonaccrual Loans: <S> <C> <C> <C> <C> <C> Construction and Land Development $ --- $ 104 $ 327 $ 2,534 $ 6,149 Commercial Real Estate 83 1,299 1,050 2,649 7,986 Commercial Loans 1,487 1,979 1,017 2,596 4,168 Other 727 862 1,224 2,082 3,171 Total Nonaccrual Loans 2,297 4,244 3,618 9,861 21,474 Loans Past Due 90 Days or More and Still Accruing Interest 321 111 231 364 1,486 Restructured Loans in Compliance with Modified Terms --- --- 580 2,405 1,161 Total Nonperforming Loans $2,618 $4,355 $4,429 $12,630 $24,121 Total Nonperforming Loans as a Percentage of Total Loans .67% .84% .87% 2.51% 4.89% </TABLE> The following table presents additional disclosures required by SFAS No. 114 and by the Securities and Exchange Commission's Industry Guide 3 relating to impaired loans accounted for under SFAS No. 114. All loans reported in the schedule below are included in nonaccrual loans in the schedule of nonperforming loans above. The reserves for loans accounted for under SFAS No. 114 in the schedule below are a component of the allowance for loan losses discussed earlier in this report under Item 7.B.II., "Provision for Loan Losses and Allowance for Loan Losses." <TABLE> <CAPTION> SCHEDULE OF IMPAIRED LOANS ACCOUNTED FOR UNDER SFAS NO. 114 (In Thousands) December 31, 1996 Recorded Allowance for Carrying Investment Loan Losses Amount Measured at the Present Value of Expected Cash Flows: <S> <C> <C> <C> Commercial Loans $1,301 $ 195 $1,106 </TABLE> <TABLE> <CAPTION> December 31, 1995 Recorded Allowance for Carrying Investment Loan Losses Amount Measured at the Present Value of Expected Cash Flows: <S> <C> <C> <C> Commercial Loans $1,405 $ 211 $1,194 Measured at the Fair Value of Collateral: Commercial Real Estate 258 129 129 Other 444 --- 444 Total $2,107 $ 340 $1,767 </TABLE> At December 31, 1996, nonaccrual loans amounted to $2.3 million. Nearly all of the nonaccrual loans in the Vermont portfolio were transferred in the 1996 branch sales. The New York based nonaccrual loans at December 31, 1996 were virtually unchanged from the level at the prior year-end. Over one-half of the nonaccrual balances at December 31, 1996 was attributable to one borrower whose loan was restructured in 1996. Payments on that loan were current in accordance with the restructured terms as of December 31, 1996 and all payments in 1996 were used to reduce the carrying amount of the loan. During 1996, income recognized on year-end balances of nonaccrual loans was $48 thousand. Income that would have been recognized during that period on nonaccrual loans if such had been current in accordance with their original terms and had been outstanding throughout the period (or since origination if held for part of the period) was $232 thousand. Nonperforming loans amounted to $4.4 million at December 31, 1995, $74 thousand below the balance at year-end 1994. The increase in nonaccrual commercial loans between year-end 1994 and 1995 was primarily attributable to the aggregate borrowing of one commercial borrower, which was placed on nonaccrual status during 1995. Otherwise, nonaccrual loans at December 31, 1995 would have decreased from the prior year-end balance. All loans reported as restructured and in compliance with modified terms at December 31, 1994 were still in compliance with modified terms at year-end 1995 and thus classified as performing at that date. During 1995, income recognized on year-end balances of nonaccrual loans was $116 thousand. Income that would have been recognized during that period on nonaccrual loans if such had been current in accordance with their original terms and had been outstanding throughout the period (or since origination if held for part of the period) was $435 thousand. Nonperforming loans amounted to $4.4 million at December 31, 1994, a decrease of $8.2 million or 64.9% from the prior year-end. Of the $12.6 million in nonperforming loans at December 31, 1993, $2.5 million was transferred to OREO in 1994, $2.4 million of loans reported as restructured at year-end 1993 was returned to performing status in 1994 in accordance with SFAS No. 15, and another $3.5 million was charged, during 1994, against the allowance for loan losses. The small remaining difference represented the improvement in nonaccrual loans, net of loans newly classified as nonperforming. During 1993, nonperforming loans decreased $11.5 million, or 47.6%. During the year $7.8 million of nonaccrual loans and leases was acquired through foreclosure and transferred to OREO. Much of the $3.1 million of loan charge-offs during the year was also attributable to prior year-end nonaccrual loans. The remaining difference represented a net improvement in the amount of nonaccrual loans and included the return to performing status of certain nonaccrual loans. The balance of $2.4 million of restructured loans in compliance with modified terms as of December 31, 1993 represented three commercial loans restructured during the year. POTENTIAL PROBLEM LOANS While levels of nonperforming loans and delinquency trends have generally fallen since 1991, the Company expects that there will be continued exposure in the commercial real estate portfolio in forthcoming periods and until the regional economy shows substantial strengthening. FOREIGN OUTSTANDINGS - None LOAN CONCENTRATIONS The loan portfolio is well diversified. There are no concentrations of credit that exceed 10% of the portfolio, other than the general categories reported in the previous section of this report. For a further discussion, see Note 19 to the Consolidated Financial Statements in Part II, Item 8 of this report. OTHER REAL ESTATE OWNED Other real estate owned (OREO) consists of real property acquired in foreclosure. OREO is carried at the lower of fair value less estimated cost to sell or cost in accordance with Statement of Position (SOP) 92-3 "Accounting for Foreclosed Assets." Also, in compliance with SOP 92-3, the Company's subsidiary banks have established allowances for OREO losses. The allowances are established and monitored on a property by property basis and reflect management's ongoing estimate of the difference between the property's carrying amount and cost, when the carrying amount is less than cost. For all periods, all OREO was held for sale. <TABLE> <CAPTION> DISTRIBUTION OF OTHER REAL ESTATE OWNED (Net of Allowance) (In Thousands) December 31, 1996 1995 1994 1993 1992 <S> <C> <C> <C> <C> <C> Single Family 1 - 4 Units $ --- $ 82 $1,073 $1,189 $ 892 Commercial Real Estate 86 2,328 2,128 3,418 1,536 Construction & Land Development 50 --- 195 2,899 3,120 Other Real Estate Owned, Net $ 136 $2,410 $3,396 $7,506 $5,548 </TABLE> The following table summarizes changes in the net carrying amount of other real estate owned at December 31 for each of the periods presented. <TABLE> <CAPTION> SCHEDULE OF CHANGES IN OTHER REAL ESTATE OWNED (Net of Allowance) (In Thousands) 1996 1995 1994 1993 1992 <S> <C> <C> <C> <C> <C> Balance at Beginning of Year $2,410 $ 3,396 $ 7,506 $ 5,548 $ 6,145 Properties Acquired Through Foreclosure 302 642 2,493 7,804 6,446 Adjustment for Change in Fair Value (85) (161) (398) (638) (1,160) Sale (2,491) (1,467) (6,205) (5,208) (5,883) Balance at End of Year $ 136 $ 2,410 $ 3,396 $ 7,506 $ 5,548 </TABLE> The following is a summary of changes in the allowance for OREO losses: <TABLE> <CAPTION> ALLOWANCE FOR OTHER REAL ESTATE OWNED LOSSES (In Thousands) 1996 1995 1994 1993 1992 <S> <C> <C> <C> <C> <C> Balance at Beginning of Year $ 370 $ 369 $ 1,150 $1,120 $ -- Additions 85 161 398 638 1,160 Charge-Offs (347) (160) (1,179) (608) (40) Balance at End of Year $ 108 $ 370 $ 369 $1,150 $1,120 </TABLE> During 1996, the Company acquired five properties totaling $302 thousand through foreclosure. Also during the year, the Company recognized losses of $330 thousand on the sale of OREO properties with a carrying amount of $2.5 million, including OREO disposed of in the Vermont branch sale transactions described under "Overview", earlier in this report, and reduced the carrying amount of the two properties remaining in OREO at December 31, 1996 by $85 thousand. During 1995, the Company acquired $642 thousand of OREO through foreclosure. The Company recognized losses of $48 thousand on the sale of OREO properties carried on the books at $1.5 million. During 1994, the Company acquired $2.5 million of OREO through foreclosure. The Company recognized losses of $1.4 million on the sale of OREO properties carried on the books at $6.2 million. Approximately 65% of the sales took place at an auction of OREO properties held during the second quarter of 1994. During 1993, the Company acquired $7.8 million in OREO through foreclosure, of which $3.6 million was formerly classified as in-substance foreclosed property. The Company's net increase in OREO during the year of $2.0 million was primarily attributable to commercial real estate properties, in OREO, which increased by more than $2.0 million during the period, whereas construction and land development properties held in OREO decreased $221 thousand during 1993. For the year, the Company recognized net gains of $366 thousand on the sale of $5.2 million of OREO properties. These net gains partially offset the $638 thousand provision for estimated OREO losses taken during the year. During 1992, the Company acquired $6.4 million in OREO through foreclosure. The provision for estimated OREO losses of $1.2 million in 1992 reflects the SOP 92-3 adjustment for estimated selling costs as well as adjustments for declines in fair value. During the year, the Company disposed of $5.9 million of OREO properties, upon which the Company recognized net gains of $257 thousand. III. SUMMARY OF LOAN LOSS EXPERIENCE The Company monitors credit quality through a continuous review of the entire loan portfolio. All significant loans (primarily commercial and commercial real estate) and leases are reviewed at least semi-annually, and those under special supervision are reviewed at least quarterly. The boards of directors of the Company's subsidiary banks, upon recommendations from management, determine the extent of charge-offs and have the final decision-making responsibility in authorizing charge-offs. Additionally, regulatory examiners perform periodic examinations of the banks' loan and lease portfolios and report on these examinations to the boards of directors. Provisions for loan losses are determined by the managements of the subsidiary banks, and are based upon an overall evaluation of the appropriate levels of the allowances for loan losses. Factors incorporated in such determination include the existing risk characteristics of the portfolio, prevailing national and local economic conditions, historical loss experience and expected performance within a range of anticipated future economic conditions. The Company's management believes that the banks' allowances for loan losses are adequate to absorb reasonably foreseeable loan losses. The table in Part II, Item 7.B.II. "Provision for Loan Losses and Allowance for Loan Losses" presents a summary of the activity in the Company's allowance for loan losses. ALLOCATION OF THE ALLOWANCE FOR LOAN AND LEASE LOSSES The allowance for loan losses is a general allowance applicable to estimated future losses. For internal operating purposes, the allowance is not allocated among loan categories. In the following table, the allowance has been allocated solely for purposes of complying with disclosure requirements of the Securities and Exchange Commission. However, this allocation should not be interpreted as a projection of (I) likely sources of future losses, (II) likely proportional distribution of future losses among loan categories or (III) likely amounts of future losses. Since management regards the allowance as a general balance and has assigned an unallocated value to the schedule, the amounts presented do not represent the total balance available to absorb future losses that might occur within the principal categories. Subject to the qualifications noted above, an allocation of the allowance for loan losses by principal classification and the proportion of the related loan balance is presented below as of December 31 for each of the years indicated. <TABLE> <CAPTION> ALLOCATION OF THE ALLOWANCE FOR LOAN AND LEASE LOSSES (Dollars in Thousands) 1996 1995 1994 1993 1992 <S> <C> <C> <C> <C> <C> Commercial, Financial and Agricultural $1,946 $ 2,913 $ 2,329 $ 3,908 $ 5,518 Real Estate-Commercial 353 1,755 1,841 3,324 3,626 Real Estate-Construction 49 305 1,994 2,027 2,525 Real Estate-Residential Mortgage 890 1,616 2,098 1,893 1,803 Installment Loans to Individuals 1,959 2,365 1,363 2,032 1,770 Lease Financing Receivables -- -- -- -- 15 Unallocated 384 3,152 2,713 2,894 2,071 Total Loans and Leases $5,581 $12,106 $12,338 $16,078 $17,328 PERCENT OF LOANS IN EACH CATEGORY TO TOTAL LOANS Commercial, Financial and Agricultural 12% 15% 15% 16% 17% Real Estate-Commercial 9 14 16 19 22 Real Estate-Construction 1 1 1 2 2 Real Estate-Residential Mortgage 43 46 45 44 40 Installment Loans to Individuals 35 24 23 19 19 Lease Financing Receivables -- -- -- -- -- Total Loans and Leases 100% 100% 100% 100% 100% </TABLE> At December 31, 1996, the allocated reserve for each indicated classification of loans exceeded 100% of the dollar amount of loans in such classification that were then reported as nonperforming. IV. DEPOSITS The following table sets forth the average balances of and average rates paid on deposits for the periods indicated. <TABLE> <CAPTION> AVERAGE DEPOSIT BALANCES Years Ended December 31, (Dollars In Thousands) 1996 1995 1994 Average Average Average Balance Rate Balance Rate Balance Rate <S> <C> <C> <C> <C> <C> <C> Demand Deposits $ 77,479 --% $ 88,961 --% $ 87,715 --% N.O.W./Super N.O.W. 131,438 2.88 139,879 2.84 129,999 1.92 Savings/M.M.D.A. 157,892 2.92 201,932 3.06 260,336 2.79 Time Certificates of $100,000 or More 79,996 5.25 67,029 5.61 26,980 4.30 Other Time Deposits 156,236 5.33 185,166 5.34 160,035 4.03 Total Deposits $603,041 3.47 $682,967 3.49 $665,065 2.61 </TABLE> During 1996, average deposits of $85.4 million were attributable to the Vermont banking operations. All Vermont deposits were transferred during the year in connection with the branch sales to Mascoma Savings Bank in January 1996 and ALBANK in September 1996. The following table presents the quarterly average balance by deposit type and the percentage of total deposits represented by each deposit type for each of the most recent five quarters for the Company's New York banks exclusively, i.e. deposits of the Vermont operations have been eliminated from the presentation. <TABLE> <CAPTION> NEW YORK DEPOSIT PORTFOLIO Quarterly Average Deposit Balances (Dollars In Thousands) Quarter Ending Dec 1996 Sep 1996 Jun 1996 Mar 1996 Dec 1995 <S> <C> <C> <C> <C> <C> Demand Deposits $ 67,240 $ 69,216 $ 66,299 $ 63,156 $ 66,437 N.O.W/Super N.O.W 125,559 111,052 104,768 99,004 103,881 Savings and Money Market 133,974 137,768 142,916 145,094 142,582 Time Deposits of $100,000 or More 80,462 84,707 78,063 66,755 67,141 Other Time Deposits 133,041 127,933 120,397 117,682 116,703 Total Deposits $540,276 $530,676 $512,443 $491,691 $496,744 Percentage of Total Quarterly Average Deposits Demand Deposits 12.4% 13.0% 12.9% 12.8% 13.4% N.O.W/Super N.O.W 23.3 20.9 20.4 20.1 20.9 Savings and Money Market 24.7 26.0 27.9 29.5 28.7 Time Deposits of $100,000 or More 14.9 16.0 15.2 13.7 13.5 Other Time Deposits 24.7 24.1 23.6 23.9 23.5 Total Deposits 100.0% 100.0% 100.0% 100.0% 100.0% </TABLE> During 1996, the Company experienced nominal shifts in the mix of deposit products as decreases in the percentage of demand, savings and money market savings accounts to total deposits were offset by increases in the percentage of N.O.W. and time deposits accounts to total deposits. The Federal Reserve Board attempts to influence prevailing federal funds and prime interest rates by changing the Federal Reserve Bank discount rate. Over the past two years, changes in the discount rate have directly influenced federal funds rates and prime rates, which in turn have had an impact upon the Company's cost of funds. The charts below, demonstrate the positive correlation between changes in the federal discount rate and changes in the Company's cost of funds for its New York operations. <TABLE> <CAPTION> Quarterly Cost of New York Deposits Quarter Ending Dec 1996 Sep 1996 Jun 1996 Mar 1996 Dec 1995 <S> <C> <C> <C> <C> <C> N.O.W/Super N.O.W 3.04% 2.86% 2.69% 2.58% 2.87% Savings and Money Market 2.93 2.92 2.92 3.00 3.08 Time Deposits of $100,000 or More 5.21 5.25 5.15 5.37 5.59 Other Time Deposits 5.34 5.23 5.23 5.49 5.64 Total Deposits 3.52 3.45 3.38 3.45 3.57 </TABLE> <TABLE> <CAPTION> Federal Reserve Bank Discount Rate Changes 1992 - 1996 Date New Rate Old Rate <S> <C> <C> January 31, 1996 5.00% 5.25% February 1, 1995 5.25 4.75 November 15, 1994 4.75 4.00 August 16, 1994 4.00 3.50 May 17, 1994 3.50 3.00 July 2, 1992 3.00 3.50 </TABLE> The increase in the discount rate on February 1, 1995 marked the last in a series of interest rate increases by the Federal Reserve Board beginning in May of 1994. After February 1, 1995, rates held steady for twelve months until the Reserve Board lowered rates by twenty five basis points on January 31, 1996. The Company's cost of funds rose throughout 1994 and into 1995 as a result of these changes. Correspondingly, the cost of deposits reached a plateau for the last two quarters of 1995, and as a result of the January 31, 1996 decrease in the federal discount rate, the cost of interest-bearing deposits decreased twelve basis points in the first quarter of 1996, and decreased an additional seven basis points for the second quarter of 1996. The cost of funds for the last two quarters of 1996, however, increased 7 basis points in each quarter as the Company responded to competitive pricing for NOW accounts, large municipal time deposit accounts and other time deposits. The average cost of funds for savings and money market accounts in the last two quarters of the year remained substantially unchanged from the second quarter average. V. TIME CERTIFICATES OF $100,000 OR MORE <TABLE> <CAPTION> The maturities of time certificates of $100,000 or more at December 31, 1996 are presented below. (In Thousands) Maturing in: <S> <C> Under Three Months $60,922 Three to Six Months 12,583 Six to Twelve Months 6,256 1998 1,546 1999 428 2000 1,463 2001 604 Total $83,802 </TABLE> D. LIQUIDITY The objective of liquidity management is to satisfy cash flow requirements, principally the needs of depositors and borrowers to access funds. Liquidity is provided through assumption or "purchase" of liabilities, the maturity of asset balances and the sale of assets. Liability liquidity arises primarily from the significant base of "core" and other deposits gathered through a branch network operating over a dispersed geographical area. These "core" balances consist of demand deposits, savings, N.O.W. and money market savings account balances and small denomination time deposits. Core deposits are considered to be less volatile in their movement into and out of financial institutions, as compared to large denomination time deposits, brokered time deposits and repurchase agreements, which are perceived as more sensitive to changes in interest rates than core deposits. Historically, the Company has sought to maintain a high ratio of core deposits to total assets. At year-end 1996, core deposits exceeded 70% of the Company's total assets and shareholders' equity represented an additional 11.4% of total assets. Large denomination time deposits, repurchase agreements and other borrowed funds represented 16.3% of total assets at December 31, 1996. Federal funds sold are overnight sales of the Company's surplus funds to correspondent banks, while federal funds purchased represent overnight borrowings. The Company's practice is to be a net seller of federal funds on average, and to avoid extended periods of purchasing federal funds. During 1996, average federal funds sold amounted to $12.2 million and federal funds purchased averaged $1.1 million. On December 31, 1993, the Company, upon adoption of SFAS No. 115, segregated its investment portfolio into securities available-for-sale and those held-to-maturity. In November 1995, the FASB issued "A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities." The Guide allowed a one-time reclassification of held-to-maturity securities before December 31, 1995. Acting under those provisions, in December 1995 the Company reclassified $118.2 million of held-to-maturity securities into its available- for-sale portfolio. Apart from federal funds, securities available- for-sale represent the Company's primary source of liquidity. This liquidity arises both from an ability to quickly sell the securities, as well as from the ability to use the securities as collateral for borrowing. Other sources of funds include term federal funds arrangements with correspondent banks and a borrowing arrangement with the Federal Home Loan Bank. The Company experienced no liquidity pressures in completing the sale transactions for its Vermont banking operations in 1996. The Company is not aware of any known trends, events or uncertainties that will have or that are reasonably likely to have a material effect or make material demands on the Company's liquidity, capital resources or results of operations. E. INTEREST RATE RISK While managing liquidity, the Company must monitor and control interest rate risk. Interest rate risk is the exposure of the Company's net interest income to changes in interest rates. Interest rate risk is directly related to the different maturities and repricing characteristics of interest-bearing assets and liabilities, as well as to prepayment risks for mortgage-backed assets, early withdrawal of time deposits, and the fact that the speed and magnitude of responses to interest rate changes varies by product. While many of the Company's loan products are indexed to independent rates, such as prime or treasury notes, the rates on most deposit products are set by management pricing committees. The Company's primary short-term measure of interest rate risk projects net interest income for the ensuing twelve-month period based on the maturity, prepayment assumption and repricing characteristic of each individual interest- bearing asset and liability under a variety of interest rate projections. The Company obtains interest rate projections from a third party provider of economic data. These projections are applied to existing interest sensitive assets and liabilities and to expected new and rollover amounts. As a base, the Company projects net interest income for the ensuing twelve months for the most likely projection and for a no-change scenario. Exposure to rising or falling rates are calculated to cover a high distribution of the perceived probable interest rate scenarios. At December 31, 1996, for purposes of projecting net interest income over the ensuing year, the Company assumed that short-term interest rates would rise by fifty basis points over the following year. For a long-term measure of interest rate risk, the Company measures the economic value of equity for immediate and sustained changes in interest rates. At December 31, 1996, the Company was operating within established internal policy limits for both the short-term and long-term measures of interest rate risk. The Company is able to reduce interest rate risk by adjusting the mix of loan products as well as the balance of fixed and variable rate products within the various loan categories. To a lesser extent, the Company manages interest rate risk through selection of investments for the securities portfolios. The Company does not, and in the foreseeable future, will not use derivative financial instruments to manage interest rate risk. The Company prepares an interest rate gap analysis to identify the repricing pattern of interest-bearing assets and liabilities. The interest rate sensitive gap is the difference between interest rate sensitive assets and interest rate sensitive liabilities. The interest rate sensitive gap ratio is the ratio of interest rate sensitive assets to interest rate sensitive liabilities. When the interest rate sensitive gap ratio exceeds the balanced position of 1.0, the Company is susceptible to falling interest rates over the time horizon indicated, as assets may reprice downward more rapidly than liabilities. Conversely, the Company is susceptible to rising rates when the gap ratio for a particular time horizon falls below the balanced position of 1.0. While the static gap analysis will reveal mismatches in the repricing patterns of assets and liabilities, the dynamic modeling of projected net interest income, as described above, provides a much more reliable tool for assessing the Company's net interest income exposure to changes in interest rates. The following table "Interest Rate Sensitive Gap Analysis" presents the Company's interest rate sensitive position at December 31, 1996. For purposes of the table, an asset or liability is considered rate sensitive within a specified period when it matures or could be repriced within such period in accordance with its contractual terms except for certain deposit balances without specific maturities. These deposit balances have been allocated to various time horizons in accordance with the Company's internal projections on their likely repricing behavior in the light of historical trends, since these deposits are not apt to reprice to the full extent of prime rate changes and reprice over a period of time after changes to the prime rate. Nearly all of the Company's time deposits are fixed rate, and therefore, reprice upon maturity. Money market deposit accounts are immediately repriceable and often fluctuate with the frequency of prime rate changes, but rarely to the magnitude of changes in the prime rate. N.O.W. accounts are also subject to immediate rate changes, but again, rates tend to move more slowly than prime rate changes and to a smaller degree. Savings accounts, which remained stable for an extended period of time after deregulation, have been the least sensitive of deposit balances to interest rate changes. Certain other assets and liabilities lacking specific maturities are classified in the "Over Five Years" category. Nonaccrual loans and overdrafts are excluded from the loan balances. Securities available-for-sale are presented at amortized cost. Various assets and liabilities that reprice before maturity demonstrate different repricing patterns. Nearly three-fourths of the Company's commercial loans are prime based, and consequently, reprice immediately, or in some cases monthly, upon changes in the prime rate. The greater portion of variable rate residential real estate loans reprice annually and are often tied to an average short-term treasury rate, with the repricing date lagging behind changes in the indexed rate. Rates on credit card lines are largely variable at management's discretion and in general reprice more slowly than prime based loans. The cumulative gap ratio at December 31, 1996 was .87 for both the ensuing cumulative six month and twelve month repricing periods. These ratios were within the range of ratios the Company seeks to maintain. <TABLE> <CAPTION> INTEREST RATE SENSITIVE GAP ANALYSIS (Dollars In Thousands) Within Three Six to One to Over Three to Six Twelve Five Five Months Months Months Years Years Total Earning Assets: <S> <C> <C> <C> <C> <C> <C> Federal Funds Sold $ 17,925 $ --- $ --- $ --- $ --- $ 17,925 Securities Available-for-Sale 63,759 1,763 3,677 70,003 32,180 171,382 Securities Held-to-Maturity 609 516 1,513 5,783 22,455 30,876 Loans and Leases, Net of Unearned Income & Nonaccrual Loans 100,408 25,125 50,315 153,128 61,916 390,892 Total Interest Rate Sensitive Assets 182,701 27,404 55,505 228,914 116,551 611,075 Interest Paying Liabilities: Regular Savings Accounts 4,513 --- 4,513 81,233 --- 90,259 N.O.W. Accounts 53,431 --- 3,469 65,063 --- 121,963 Money Market Savings Accounts 40,341 --- --- 1,749 --- 42,090 Time Deposits of $100,000 or More 60,922 12,583 6,256 4,041 --- 83,802 Other Time Deposits 27,191 22,623 46,860 39,082 --- 135,756 Short-Term Borrowings 19,462 244 3,000 --- --- 22,706 Long-Term Debt --- --- --- --- --- --- Total Interest Rate Sensitive Liabilities 205,860 35,450 64,098 191,168 --- 496,576 Interest Rate Sensitive Gap $(23,159) $ (8,046) $ (8,593)$ 37,746 $116,551 $114,499 Cumulative Interest Rate Sensitive Gap $(23,159) $(31,205) $(39,798)$ (2,052) $114,499 Interest Rate Sensitive Gap Ratio .89 .77 .87 1.20 --- 1.23 Cumulative Interest Rate Sensitive Gap Ratio .89 .87 .87 1.00 1.23 N/A </TABLE> F. CAPITAL RESOURCES AND DIVIDENDS Shareholders' equity was $74.3 million at December 31, 1996, as compared to $67.5 million at December 31, 1995. Changes in shareholders' equity during 1996 included $16.4 million of retained earnings which was partially offset by treasury stock purchases of $10.1. Most of the treasury stock purchases were acquired under two initiatives undertaken by the Company's Board of Directors during the year, each of which authorized management to repurchase from time to time, at its discretion, up to $10 million of the Company's common stock in the open market or privately negotiated transactions. The maintenance of appropriate capital levels is a management priority. Overall capital adequacy is monitored on an ongoing basis by management and reviewed regularly by the Board of Directors. The Company's principal capital planning goal is to provide an adequate return to shareholders while retaining a sufficient base to provide for future expansion and comply with all regulatory standards. Under regulatory capital guidelines, the Company and the subsidiary banks are required to satisfy certain risk-based capital measures. The minimum ratio of "Tier 1" capital to risk-weighted assets is 4.0% and the minimum ratio of total capital to risk-weighted assets is 8.0%. For the Company, Tier 1 capital is comprised of shareholders' equity less intangible assets. Total capital includes a portion of the allowance for loan losses. In addition to the risk-based capital measures, the federal bank regulatory agencies require banks and bank holding companies to satisfy another capital guideline, the Tier 1 leverage ratio (Tier 1 capital to total assets less goodwill). The minimum Tier 1 leverage ratio is 3.0% for the most highly rated institutions. The guidelines provide that other institutions should maintain a Tier 1 leverage ratio that is at least 1.0% to 2.0% higher than the 3.0% minimum level for top-rated institutions. <TABLE> <CAPTION> The table below sets forth the capital ratios of the Company and its subsidiary banks as of December 31, 1996: Risk-Based Capital Ratios: Arrow GFNB SNB <S> <C> <C> <C> Tier 1 19.3% 14.3% 9.5% Total Capital 20.6 15.6 10.7 Tier 1 Leverage Ratio 11.2 7.9 7.6 </TABLE> At December 31, 1996, all subsidiary banks and the Company exceeded the minimum capital ratios established by these guidelines, as well as the "well-capitalized" thresholds set by federal bank regulatory agencies pursuant to FDICIA (see the disclosure under "Legislative Developments" in Part I, Item 1.F. of this report). The principal source of funds for the payment of shareholder dividends by the Company has been dividends declared and paid to the Company by its bank subsidiaries. As of December 31, 1996, only the Company's principal bank subsidiary, Glens Falls National Bank and Trust Company ("GFNB") was in a position to pay any material amount of dividends without prior regulatory approval. At that time, the maximum amount that could have been paid by GFNB to the Company was approximately $8.6 million. See Part II, Item 5 "Market for the Registrant's Common Equity and Related Stockholder Matters" for a recent history of the Company's cash dividend payments. G. FOURTH QUARTER RESULTS The Company reported earnings of $2.4 million for the fourth quarter of 1996, a decrease of $176 thousand or 6.7% from the fourth quarter of 1995. Earnings per share for both periods was $.42. The decrease in earnings was primarily attributable to the decrease in earning assets resulting from the completion of the divestiture of the Vermont banking operations in the first three quarters. Average earning assets for the fourth quarter of 1996 were $606.4 million, a decrease of $134.8 million or 18.2% from average earning assets of $741.2 million for the fourth quarter of 1995. Accordingly, the Company also experienced a proportional decrease in net interest income, to $7.3 million in 1996 (stated on a tax-equivalent basis) down $1.8 million or 19.8% from the fourth quarter of 1995. The Company also experienced a decrease in net interest margin (net interest income to average earning assets), which was 4.78% and 5.00% for the two respective quarters. Noninterest income of $2.2 million for the fourth quarter of 1996 included securities losses of $183 thousand and income of $570 thousand from a post-closing upward price adjustment in the sale of the Vermont trust business upon satisfaction of a contingency condition. On a comparable basis, noninterest income decreased $550 thousand, or 23.7% from the fourth quarter of 1995. The decrease was attributable to the sale of the Vermont trust business and to decreased deposit servicing fee income resulting from the transfer of deposits in the sale of branches in Vermont. Noninterest expense of $5.3 million for the fourth quarter of 1996 decreased $1.8 million, or 25.0%, from the fourth quarter of 1995, again, primarily attributable to the sale of the Vermont operations. <TABLE> <CAPTION> SELECTED FOURTH QUARTER FINANCIAL INFORMATION (Dollars In Thousands) For the Quarter Ended December 31, 1996 1995 <S> <C> <C> Interest Income $12,153 $15,846 Interest Expense 5,025 6,577 Net Interest Income 7,128 9,269 Provision for Loan Losses 224 530 Net Interest Income after Provision for Loan Losses 6,904 8,739 Other Income 2,155 2,342 Other Expense 5,255 7,009 Income Before Income Taxes 3,804 4,072 Provision for Income Taxes 1,370 1,462 Net Income $ 2,434 $ 2,610 Weighted Average Number of Shares and Equivalents Outstanding Primary 5,847 6,239 Fully Diluted 5,850 6,244 Primary Earnings Per Share $ .42 $ .42 Fully Diluted Earnings Per Share .42 .42 SELECTED RATIOS: Return on Average Assets 1.49% 1.30% Return on Average Equity 13.04% 15.58% Per share amounts have been adjusted for the 1996 ten percent stock dividend. </TABLE> Item 8: Financial Statements and Supplementary Data The following audited financial statements and supplementary data are incorporated herein by reference to the Company's Annual Report to Shareholders for December 31, 1996, which Annual Report is attached as Exhibit 13 to this Report: Independent Auditors' Report Financial Statements: Consolidated Balance Sheets as of December 31, 1996 and 1995 Consolidated Statements of Income for the Years Ended December 31, 1996, 1995 and 1994 Consolidated Statements of Changes in Shareholders' Equity for the Years Ended December 31, 1996, 1995 and 1994 Consolidated Statements of Cash Flows for the Years Ended December 31, 1996, 1995 and 1994 Notes to Consolidated Financial Statements Supplementary Data: (Unaudited) Quarterly Financial Data for the Years Ended December 31, 1996 and 1995 Item 9: Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. - None. PART III Item 10: Directors and Executive Officers of the Registrant Item 1, "Election of Directors and Information with Respect to Directors and Officers" of the Company's Proxy Statement for its Annual Meeting of Shareholders to be held April 30, 1997 is incorporated herein by reference. Required information regarding the Company's Executive Officers is contained in Part I, Item 1.E., "Executive Officers of the Registrant." Item 11: Executive Compensation Item 1, "Election of Directors and Information with Respect to Directors and Officers" of the Company's Proxy Statement for its Annual Meeting of Shareholders to be held April 30, 1997 is incorporated herein by reference. Item 12: Security Ownership of Certain Beneficial Owners and Management Item 1, "Election of Directors and Information with Respect to Directors and Officers" of the Company's Proxy Statement for its Annual Meeting of Shareholders to be held April 30, 1997 is incorporated herein by reference. Item 13: Certain Relationships and Related Transactions Item 1, "Election of Directors and Information with Respect to Directors and Officers" of the Company's Proxy Statement for its Annual Meeting of Shareholders to be held April 30, 1997 is incorporated herein by reference. PART IV Item 14: Exhibits, Financial Statement Schedules and Reports on Form 8-K A) Documents filed as part of this report: I Financial Statements: The following financial statements, the notes thereto, and the independent auditors' reports thereon are filed as part of this report, incorporated by reference from Exhibit 13 to this Report, the 1996 Annual Report to Shareholders. See the index to such financial statements in Part II, Item 8 of this report. Independent Auditors' Report Consolidated Balance Sheets as of December 31, 1996 and 1995 Consolidated Statements of Income for the Years Ended December 31, 1996, 1995 and 1994 Consolidated Statements of Changes in Shareholders' Equity for the Years Ended December 31, 1996, 1995 and 1994 Consolidated Statements of Cash Flows for the Years Ended December 31, 1996, 1995 and 1994 Notes to Consolidated Financial Statements II Schedules: All schedules are omitted since the required information is either not applicable or not required or is contained in the respective financial statements or in the notes thereto. III. Exhibits: The following exhibits are incorporated by reference herein. Exhibit Number Exhibit 2.1 Purchase and Assumption Agreement among Arrow Financial Corporation, Arrow Vermont Corporation, Green Mountain Bank and Mascoma Savings Bank, dated June 1, 1995 incorporated herein by reference from the Registrant's Current Report on Form 8-K, filed on August 4, 1995, Exhibit 2.1. 2.2 Supplement to Purchase and Assumption Agreement among Arrow Financial Corporation, Arrow Vermont Corporation, Green Mountain Bank and Mascoma Savings Bank, dated January 12, 1996 incorporated herein by reference from the Registrant's Current Report on Form 8-K, filed January 30, 1996, Exhibit 2.2. 2.3 Purchase and Assumption Agreement among Arrow Financial Corporation, Arrow Vermont Corporation, Green Mountain Bank and ALBANK, FSB, dated February 26, 1996 incorporated herein by reference from the Registrant's Current Report on Form 8-K, filed March 14, 1996, Exhibit 2.1. 2.4 Amendment to Purchase and Assumption Agreement among Arrow Financial Corporation, Arrow Vermont Corporation, Green Mountain Bank and ALBANK, FSB, dated September 26, 1996 incorporated herein by reference from the Registrant's Current Report on Form 8-K filed October 11, 1996, Exhibit 2.3. 2.5 Service Purchasing Agreement among Arrow Financial Corporation, Arrow Vermont Corporation, Green Mountain Bank and ALBANK, FSB, dated February 26, 1996 incorporated herein by reference from the Registrant's Current Report on Form 8-K filed March 14, 1996, Exhibit 2.2. 2.6 Amendment to Service Purchasing Agreement among Arrow Financial Corporation, Arrow Vermont Corporation, Green Mountain Bank and ALBANK, FSB, dated September 26, 1996 incorporated herein by reference from the Registrant's Current Report on Form 8-K, filed October 11, 1996, Exhibit 2.4. 2.7 Stock Purchase Agreement among Arrow Financial Corporation, Arrow Vermont Corporation, Green Mountain Bank and Vermont National Bank, dated February 27, 1996 incorporated herein by reference from the Registrant's Current Report on Form 8-K filed March 14, 1996, Exhibit 2.3. 3.(I) Certificate of Incorporation of the Registrant, as amended, incorporated herein by reference from the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990, Exhibit 3.(a). 10.1 1985 Incentive Stock Option Plan of the Registrant, incorporated herein by reference from Registrant's 1933 Act Registration Statement on Form S-8 (file number 2-98736; filed on July 1, 1985). * 10.2 1985 Non-Qualified Stock Option Plan of the Registrant, incorporated herein by reference from Registrant's 1933 Act Registration Statement on Form S-8 (file number 2-98735; filed July 1, 1985). * 10.3 Short-term Incentive Award Plan of Glens Falls National Bank and Trust Company, incorporated herein by reference from Registrant's 1933 Act Registration Statement on Form S-2 (file number 33-10109; filed December 16, 1986). * 10.4 Employment Agreement between the Registrant and Michael F. Massiano dated December 31, 1990, incorporated herein by reference from Registrant's Annual Report on Form 10-K for the year ended December 31, 1990, Exhibit 10.(k). * 10.5 Employment Agreement between the Registrant and John J. Murphy dated December 31, 1990, incorporated herein by reference from Registrant's Annual Report on Form 10-K for the year ended December 31, 1992, Exhibit 10(g)(1). * 10.6 Employment Agreement between the Registrant, its subsidiary bank, Glens Falls National Bank & Trust Company, and Thomas L. Hoy dated December 31, 1990, incorporated herein by reference from Registrant's Annual Report on Form 10-K for the year ended December 31, 1992, Exhibit 10(j)(1). * 10.7 Select Executive Retirement Plan of the Registrant effective January 1, 1992 incorporated herein by reference from Registrant's Annual Report on Form 10-K for December 31, 1992, Exhibit 10(m). * 10.8 Employee Stock Purchase Plan of the Registrant, incorporated herein by reference from Registrant's 1933 Act Registration Statement on Form S-8 (File number 33-48225; filed May 15, 1992). * 10.9 Long Term Incentive Plan of the Registrant, incorporated herein by reference from Registrant's 1933 Act Registration Statement on Form S-8 (File number 33-66192; filed July 19, 1993). * 10.10 Directors Deferred Compensation Plan of Registrant, incorporated herein by reference from Registrant's Annual Report on Form 10-K for December 31, 1993, Exhibit 10(n). * 10.11 Senior Officers Deferred Compensation Plan of the Registrant, incorporated herein by reference from Registrant's Annual Report on Form 10-K for December 31, 1993, Exhibit 10(o).* 10.12 Automatic Dividend Reinvestment Plan of the Registrant incorporated herein by reference from Registrant's Annual Report on Form 10-K for December 31, 1995, Exhibit 10.11.* * Management contracts or compensation plans required to be filed as an exhibit. The following exhibits are submitted herewith: Exhibit Number Exhibit 3.(ii) By-Laws of the Registrant 11 Computation of Earnings per Share 13 Annual Report to Shareholders 21 Subsidiaries of the Company 23 Consent of Independent Certified Public Accountants 27 Financial Data Schedule (submitted with electronic filing only) (B) The following Current Reports on Form 8-K were filed during the fourth quarter of 1996: Filed October 11, 1996: Amendment to Purchase and Assumption Agreement among Arrow Financial Corporation, Arrow Vermont Corporation, Green Mountain Bank and ALBANK, FSB, dated September 26, 1996. Filed October 11, 1996: Amendment to Service Purchasing Agreement among Arrow Financial Corporation, Arrow Vermont Corporation, Green Mountain Bank and ALBANK, FSB, dated September 26, 1996. 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. ARROW FINANCIAL CORPORATION Date: March 26, 1997 By: /s/ Thomas L. Hoy Thomas L. Hoy President and Chief Executive Officer Date: March 26, 1997 By: /s/ John J. Murphy John J. Murphy Executive Vice President, Treasurer and Chief Financial Officer (Principal Financial and Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on March 26, 1997 by the following persons in the capacities indicated. /s/ John J. Carusone,Jr. John J. Carusone Director /s/ Michael B. Clarke Michael B. Clarke Director /s/ George C. Frost George C. Frost Director /s/ Kenneth C. Hopper, M.D. Kenneth C. Hopper, M.D. Director /s/ Thomas L. Hoy Thomas L. Hoy Director and President /s/ Edward F. Huntington Edward F. Huntington Director /s/ David G. Kruczlnicki David G. Kruczlnicki Director /s/ Michael F. Massiano Michael F. Massiano Director & Chairman /s/ David L. Moynehan David L. Moynehan Director /s/ Doris E. Ornstein Doris E. Ornstein Director /s/ Daniel L. Robertson Daniel L. Robertson Director EXHIBITS INDEX Exhibit Number Exhibit 3.(ii) By-Laws of the Registrant 11 Computation of Earnings per Share 13 Annual Report to Shareholders 21 Subsidiaries of the Company 23 Consent of Independent Certified Public Accountants 27 Financial Data Schedule (submitted with electronic filing only)