SECURITIES AND EXCHANGE COMMISSION Washington, D.C. FORM 10-Q [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarter Ended September 30, 1998 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number: 0-12507 ARROW FINANCIAL CORPORATION (Exact name of registrant as specified in its charter) New York 22-2448962 (State or other jurisdiction of (IRS Employer Identification incorporation or organization) Number) 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 Indicate by check mark 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 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 issuer's classes of common stock, as of the latest practicable date. Class Outstanding as of October 31, 1998 Common Stock, par value $1.00 per share 6,242,984 <TABLE> <CAPTION> INDEX PART I FINANCIAL INFORMATION Page No. <S> <C> Item 1. Consolidated Balance Sheets as of September 30, 1998 and December 31, 1997 3 Consolidated Statements of Income for the Three and Nine Months Ended September 30, 1998 and 1997 4 Consolidated Statements of Changes in Shareholders' Equity for the Nine Months Ended September 30, 1998 and 1997 5 Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 1998 and 1997 6 Notes to Consolidated Interim Financial Statements 7 Independent Auditors' Review Report 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 9 Item 3. Quantitative and Qualitative Disclosures About Market Risk 21 PART II OTHER INFORMATION 22 SIGNATURES 22 </TABLE>
<TABLE> <CAPTION> PART I - FINANCIAL CONDITION ARROW FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in Thousands)(Unaudited) 9/30/98 12/31/97 ASSETS <S> <C> <C> Cash and Due from Banks $ 23,593 $ 23,909 Federal Funds Sold --- 23,000 Cash and Cash Equivalents 23,593 46,909 Securities Available-for-Sale 224,331 221,837 Securities Held-to-Maturity: (Approximate Fair Value of $64,712 in 1998 and $45,562 in 1997) 62,338 44,802 Loans and Leases 527,286 485,810 Less: Allowance for Credit Losses (6,648) (6,191) Net Loans and Leases 520,638 479,619 Premises and Equipment, Net 10,973 10,760 Other Real Estate Owned 619 315 Other Assets 26,507 28,077 Total Assets $868,999 $831,599 LIABILITIES Deposits: Demand $ 95,599 $ 96,482 Interest-Bearing Demand Deposits 178,043 162,016 Regular and Money Market Savings 163,749 158,690 Time Deposits of $100,000 or More 96,193 106,620 Other Time Deposits 197,240 197,107 Total Deposits 730,824 720,915 Short-Term Borrowings: Federal Funds Purchased and Securities Sold Under Agreements to Repurchase 26,216 20,918 Other Short-Term Borrowings 3,496 3,837 Federal Home Loan Bank Advances 15,000 --- Other Liabilities 15,906 12,058 Total Liabilities 791,442 757,728
SHAREHOLDERS' EQUITY Preferred Stock, $5 Par Value; 1,000,000 Shares Authorized --- --- Common Stock, $1 Par Value; 20,000,000 Shares Authorized (7,596,477 Shares Issued in 1998 and 6,905,888 in 1997) 7,596 6,906 Surplus 87,221 65,277 Undivided Profits 4,929 22,531 Accumulated Other Comprehensive Income: Net Unrealized Gain on Securities Available-for-Sale, Net of Tax 1,899 764 Reserve for Unearned ESOP Shares (52,100 Shares in 1998) (1,500) --- Treasury Stock, at Cost (1,286,393 Shares in 1998 and 1,143,553 in 1997) (22,588) (21,607) Total Shareholders' Equity 77,557 73,871 Total Liabilities and Shareholders' Equity $868,999 $831,599 See notes to consolidated interim financial statements. </TABLE> <TABLE> <CAPTION> ARROW FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Dollars in Thousands, Except Per Share Amounts)(Unaudited) Three Months Nine Months Ended Sept 30, Ended Sept 30, 1998 1997 1998 1997 INTEREST AND DIVIDEND INCOME <S> <C> <C> <C> <C> Interest and Fees on Loans and Leases $11,112 $10,473 $32,847 $28,267 Interest on Federal Funds Sold 128 411 491 597 Interest and Dividends on Securities Available-for-Sale 3,702 3,267 11,152 8,748 Interest and Dividends on Securities Held-to-Maturity 854 680 2,336 1,983 Total Interest and Dividend Income 15,796 14,831 46,826 39,595 INTEREST EXPENSE Interest on Deposits: Time Deposits of $100,000 or More 1,596 1,084 4,532 3,402 Other Deposits 5,024 5,129 15,015 12,810 Interest on Short-Term Borrowings: Federal Funds Purchased and Securities Sold Under Agreements to Repurchase 308 210 868 582 Other Short-Term Borrowings 37 81 103 243 Federal Home Loan Bank Advances 199 --- 442 --- Total Interest Expense 7,164 6,504 20,958 17,037 NET INTEREST INCOME 8,632 8,327 25,868 22,558 Provision for Credit Losses 342 500 1,026 972
NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES 8,290 7,827 24,842 21,586 OTHER INCOME Income from Fiduciary Activities 748 686 2,305 2,007 Fees for Other Services to Customers 1,195 1,122 3,181 2,712 Net Gains on Securities Transactions --- --- 166 37 Other Operating Income 263 413 661 1,422 Total Other Income 2,206 2,221 6,313 6,178 OTHER EXPENSE Salaries and Employee Benefits 3,607 3,309 10,322 9,212 Occupancy Expense of Premises, Net 424 432 1,276 1,173 Furniture and Equipment Expense 542 461 1,636 1,414 Other Operating Expense 1,729 1,627 4,942 3,989 Total Other Expense 6,302 5,829 18,176 15,788 INCOME BEFORE PROVISION FOR INCOME TAXES 4,194 4,219 12,979 11,976 Provision for Income Taxes 1,288 1,451 4,310 3,789 NET INCOME $ 2,906 $ 2,768 $ 8,669 $ 8,187 Average Shares Outstanding Basic 6,295 6,346 6,323 6,463 Diluted 6,397 6,427 6,428 6,540 Per Common Share: Basic Earnings $ .46 $ .44 $ 1.37 $ 1.27 Diluted Earnings $ .45 $ .43 $ 1.35 $ 1.25 Dividends Declared .21 .17 .59 .52 Book Value 12.39 11.40 12.39 11.40 Tangible Book Value 10.28 9.21 10.28 9.21 Per share amounts have been restated for the August 1998 ten percent stock dividend. See notes to consolidated interim financial statements. </TABLE> <TABLE> <CAPTION> ARROW FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (In Thousands, Except Share and Per Share Amounts) (Unaudited) Accumulated Unallocated Other Employee Compre- Stock Shares Common Undivided hensive Ownership Treasury Issued Stock Surplus Profits Income Plan Stock Total <S> <C> <C> <C> <C> <C> <C> <C> <C> Balance at December 31, 1996 6,577,036 $6,577 $54,569 $26,992 $208 $--- $(14,050) $74,296 Comprehensive Income, Net of Tax: Net Income --- --- --- 8,187 --- --- --- 8,187 Net Unrealized Securities Holding Losses Arising During the Period, Net of Tax (Pre-tax $917) --- --- --- --- 550 --- --- 550 Reclassification Adjustment for Net Securities Gains Included in Net Income, Net of Tax (Pre-tax $37) --- --- --- --- (22) --- --- (22) Other Comprehensive Income (Loss) 528 Comprehensive Income 8,715 Cash Dividends Declared, $.52 per Share --- --- --- (3,356) --- --- --- (3,356) Stock Options Exercised (44,668 Shares) --- --- 89 --- --- --- 388 477 Purchase of Treasury Stock (367,218 Shares) --- --- --- --- --- --- (7,957) (7,957) Balance at September 30, 1997 6,577,036 $6,577 $54,658 $31,823 $736 $ --- $(21,619) $72,175 Balance at December 31, 1997 6,905,888 $6,906 $65,277 $22,531 $764 $--- $(21,607) $73,871 Comprehensive Income, Net of Tax: Net Income --- --- --- 8,669 --- --- --- 8,669 Net Unrealized Securities Holding Gains Arising During the Period, Net of Tax (Pre-tax $2,057) --- --- --- --- 1,234 --- --- 1,234 Reclassification Adjustment for Net Securities Gains Included in Net Income, Net of Tax (Pre-tax $166) --- --- --- --- (99) --- --- (99) Other Comprehensive Income (Loss) 1,135 Comprehensive Income 9,804 10% Stock Dividend 690,589 690 21,840 (22,530) --- --- --- --- Cash Dividends Declared, $.59 per Share --- --- --- (3,741) --- --- --- (3,741) Acquisition of Common Stock by ESOP, (52,100 Shares) --- --- --- --- --- (1,500) --- (1,500) Stock Options Exercised (8,865 Shares) --- --- 62 --- --- --- 58 120 Purchase of Treasury Stock (37,350 Shares) --- --- --- --- --- --- (1,039) (1,039) Tax Benefit for Disposition of Stock Options --- --- 42 --- --- --- --- 42 Balance at September 30, 1998 7,596,477 $7,596 $87,221 $4,929 $1,899 $(1,500) $(22,588) $77,557 Per share amounts have been adjusted for the August 1998 ten percent stock dividend. See notes to consolidated interim financial statements. </TABLE>
<TABLE> <CAPTION> ARROW FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in Thousands)(Unaudited) Nine Months Ended Sept 30, 1998 1997 Operating Activities: <S> <C> <C> Net Income $ 8,669 $ 8,187 Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities: Provision for Credit Losses 1,026 972 Depreciation and Amortization 1,068 958 Gains on the Sale of Securities Available-for-Sale (174) (101) Losses on the Sale of Securities Available-for-Sale 8 64 Proceeds from the Sale of Loans 3,489 1,897 Net Gains on the Sale of Loans, Fixed Assets and Other Real Estate Owned (52) (129) Decrease (Increase) in Deferred Tax Assets 1,460 797 Decrease (Increase) in Interest Receivable 126 (354) Increase (Decrease) in Interest Payable 262 353 Decrease (Increase) in Other Assets (1,530) (2,210) Increase (Decrease) in Other Liabilities 3,586 (2,153) Net Cash Provided By Operating Activities 17,938 8,281 Investing Activities: Proceeds from the Sale of Securities Available-for-Sale 23,121 23,996 Proceeds from the Maturities of Securities Available-for-Sale 124,603 22,180 Purchases of Securities Available-for-Sale (147,723) (75,661) Proceeds from the Maturities of Securities Held-to-Maturity 4,311 1,766 Purchases of Securities Held-to-Maturity (22,594) (14,801) Loans Purchased in Branch Transactions --- (44,190) Net Increase in Loans and Leases (47,500) (41,645) Fixed Assets Purchased in Branch Transactions --- (1,338) Proceeds from the Sales of Fixed Assets and Other Real Estate Owned 302 243 Purchase of Fixed Assets (1,023) (795) Net Cash Used In Investing Activities (66,503) (130,245) Financing Activities: Deposits Assumed in Branch Transactions, Net of Premium --- 127,708 Net Increase in Deposits, Excluding Branch Transactions 9,909 24,637 Net Increase in Short-Term Borrowings 4,957 6,874 Advances on FHLB Borrowings 15,000 --- Purchase of Treasury Stock (1,039) (7,479) Sale of Treasury Stock for Exercise of Stock Options 121 --- Disqualifying Disposition of ISO Shares 42 --- Cash Dividends Paid (3,741) (3,356) Net Cash Provided By Financing Activities 25,249 148,384 Net (Decrease) Increase in Cash and Cash Equivalents (23,316) 26,420 Cash and Cash Equivalents at Beginning of Period 46,909 37,497 Total Cash and Cash Equivalents $ 23,593 $ 63,917 Supplemental Cash Flow Information: Interest Paid $20,697 $16,684 Income Taxes Paid 152 5,146 Transfer of Loans to Other Real Estate Owned 484 283 Acquisition of Common Stock by ESOP 1,500 --- See notes to consolidated interim financial statements. </TABLE> ARROW FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS FORM 10-Q SEPTEMBER 30, 1998 1. Financial Statement Presentation In the opinion of the management of Arrow Financial Corporation (the "Company"), the accompanying consolidated interim financial statements contain all of the adjustments necessary to present fairly the financial position as of September 30, 1998 and December 31, 1997; the results of operations for the three and nine month periods ended September 30, 1998 and 1997; the statements of changes in shareholders' equity for the nine month periods ended September 30, 1998 and 1997; and the statements of cash flows for the nine month periods ended September 30, 1998 and 1997. All such adjustments are of a normal recurring nature. Certain items have been reclassified to conform to the 1998 presentation. Share and per share amounts have been restated to reflect the August 1998 ten percent stock dividend. The consolidated interim financial statements should be read in conjunction with the annual consolidated financial statements of the Company for the year ended December 31, 1997. 2. Reporting Comprehensive Income In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income." SFAS No. 130 establishes standards for reporting and displaying of comprehensive income and its components in a full set of general-purpose financial statements. Comprehensive income is defined as "the change in equity of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners." For the Company, the statement was effective for interim financial statements beginning with the first quarter of 1998. SFAS No. 130 accepts a variety of presentations of comprehensive income within the income statement or the statement of changes in shareholders' equity. The Company has elected to present the components of comprehensive income in the Consolidated Statements of Changes in Shareholders' Equity. 3. Disclosures about Operating Segments In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." SFAS No. 131 establishes standards for the way that public business enterprises report information about operating segments. For the Company, the statement will be effective for annual financial statements issued for the year ended December 31, 1998. However, the Company does not have operating segments within the meaning of SFAS No. 131. 4. Pensions and Other Postretirement Benefits In February 1998, the FASB issued SFAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits," which amends the disclosure requirements of SFAS No. 87, "Employers' Accounting for Pensions," SFAS No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits," and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." Statement No. 132 standardizes the disclosure requirements of Statements No. 87 and No. 106 to the extent practicable and recommends a parallel format for presenting information about pensions and other postretirement benefits. This Statement is applicable to all entities and addresses disclosure only. The Statement does not change any of the measurement or recognition provisions provided for in Statements No. 87, No. 88, or No. 106. The Statement is effective for fiscal years beginning after December 15, 1997. Management anticipates providing the required disclosures in the December 31, 1998 consolidated financial statements. 5. Derivative Instruments and Hedging Activities In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. This Statement is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. Management is currently evaluating the impact of this Statement on the Company's consolidated financial statements.
6. Earnings Per Common Share (In Thousands, Except Per Share Amounts) The following table presents a reconciliation of the numerator and denominator used in the calculation of basic and diluted earnings per common share (EPS) for the three and nine month periods ended September 30, 1998 and 1997. Average shares outstanding have been restated for the August 1998 ten percent stock dividend. <TABLE> <CAPTION> Income Shares Per Share (Numerator) (Denominator) Amount <S> <C> <C> <C> For the Three Months Ended September 30, 1998: Basic EPS: Income Available to Common Shareholders $2,906 6,295 $ .46 Dilutive Effect of Stock Options --- 102 Diluted EPS: Income Available to Common Shareholders and Assumed Conversions $2,906 6,397 $ .45 For the Three Months Ended September 30, 1997: Basic EPS: Income Available to Common Shareholders $2,768 6,346 $ .44 Dilutive Effect of Stock Options --- 81 Diluted EPS: Income Available to Common Shareholders and Assumed Conversions $2,768 6,427 $ .43 For the Nine Months Ended September 30, 1998: Basic EPS: Income Available to Common Shareholders $8,669 6,323 $1.37 Dilutive Effect of Stock Options --- 105 Diluted EPS: Income Available to Common Shareholders and Assumed Conversions $8,669 6,428 $1.35 For the Nine Months Ended September 30, 1997: Basic EPS: Income Available to Common Shareholders $8,187 6,463 $1.27 Dilutive Effect of Stock Options --- 77 Diluted EPS: Income Available to Common Shareholders and Assumed Conversions $8,187 6,540 $1.25 </TABLE> Independent Auditors' Review Report The Board of Directors and Shareholders Arrow Financial Corporation: We have reviewed the consolidated balance sheet of Arrow Financial Corporation and subsidiaries (the "Company") as of September 30, 1998, the related consolidated statements of income for the three-month and nine-month periods ended September 30, 1998 and 1997, and the consolidated statements of changes in shareholders' equity and cash flows for the nine-month periods ended September 30, 1998 and 1997. These consolidated financial statements are the responsibility of the Company's management. We conducted our review in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our review, we are not aware of any material modifications that should be made to the consolidated financial statements referred to above for them to be in conformity with generally accepted accounting principles. We have previously audited, in accordance with generally accepted auditing standards, the consolidated balance sheet of Arrow Financial Corporation and subsidiaries as of December 31, 1997, and the related consolidated statements of income, changes in shareholders' equity and cash flows for the year then ended (not presented herein); and in our report dated January 23, 1998, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 1997, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived. /s/ KPMG Peat Marwick LLP Albany, New York October 21, 1998 ARROW FINANCIAL CORPORATION AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS SEPTEMBER 30, 1998 Arrow Financial Corporation (the "Company") is a two bank holding company headquartered in Glens Falls, New York. The banking subsidiaries are Glens Falls National Bank and Trust Company ("GFNB") whose main office is located in Glens Falls, New York and Saratoga National Bank and Trust Company whose main office is located in Saratoga Springs, New York. Cautionary Statement under Federal Securities Laws: The information contained in this Quarterly Report on Form 10-Q 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 future 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. Some of these statements, such as those included in the interest rate sensitivity analysis in the section entitled "Quantitative and Qualitative Disclosures About Market Risk" are merely hypothetical estimates of future performance or changes in future performance based on simulation models. Other forward-looking statements, such as those in the section below dealing with the Company's program to deal with the so-called "Year 2000" problem, involve speculation about a broad range of factors many of which are beyond the Company's control or its ability to evaluate with any degree of precision. 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. In the case of all forward-looking statements, actual outcomes and results may differ materially from what the statements predict or forecast. 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. Peer Ratios: Certain ratios are compared with the Company's peer group. Peer data was taken from the Federal Reserve Board's "December 1997 Bank Holding Company Performance Report." The Company's peer group is comprised of bank holding companies with $500 million to $1 billion in total consolidated assets. This Quarterly Report should be read in conjunction with the Company's Annual Report filed on Form 10-K for December 31, 1997. Per share amounts have been restated for the August 24, 1998 ten percent stock dividend declared July 23, 1998. Acquisition of Six Fleet Branches On June 27, 1997, the Company completed the acquisition of six branches in upstate New York from Fleet Bank of New York ("Branch Acquisition"). The branches are located in the towns of Plattsburgh (2), Lake Luzerne, Port Henry, Ticonderoga and Warrensburg and became branches of GFNB. GFNB acquired substantially all deposits at the branches and most of the loans held by Fleet Bank related to the branches. Total deposit liabilities at the branches assumed by GFNB were approximately $140 million and the total amount of the branch-related loans acquired was approximately $34 million. Under the acquisition agreement, GFNB also acquired from Fleet an additional $10 million of residential real estate loans not related to the branches. The Company has experienced several benefits from the Branch Acquisition in the past fifteen month period. Most significant was the positive impact on earnings per share, because the acquisition was completed without external borrowing or raising additional capital. The Company further improved its earnings per share record in 1997 and 1998 through a stock repurchase program. Other positive results of the Branch Acquisition include an improvement in the Company's efficiency ratio (noninterest expense to net interest income and noninterest income), and an increase in the ratio of net income per full time-equivalent employee. The Branch Acquisition was the principal cause of the differences between the consolidated statements of income for the 1997 and 1998 none-month periods, as noted in the following discussion. Stock Repurchase Program During 1998, the Company continued to repurchase shares of the Company's common stock under a $20 million repurchase program authorized by the board of directors in 1996. As of September 30, 1998, approximately $2.2 million was available for future repurchases.
OVERVIEW The Company reported earnings of $2.9 million for the third quarter of 1998 as compared to $2.8 million for the third quarter of 1997. Diluted earnings per share were $.45 and $.43 for the two respective periods. On a year-to-date basis, net income was $8.7 million for the first nine months of 1998, as compared to earnings of $8.2 million for the 1997 period. Diluted earnings per share for the nine month periods were $1.35 and $1.25, respectively. Earnings in the 1997 period, however, reflected the favorable settlement of a combined reporting issue with the New York State Department of Taxation and Finance, resulting in a significant reduction in the provision for income taxes for that period, as well as the receipt of an insurance settlement. On a comparable basis, excluding nonrecurring items and securities transactions for both periods, diluted earnings per share for the first nine months of 1998 and 1997 were $1.33 and $1.12, respectively, representing a 18.8% improvement between the respective periods. The following table presents the adjustments necessary to arrive at the recurring net income of the Company. <TABLE> <CAPTION> Analysis of Recurring Net Income (In Thousands, Except Per Share Amounts) Three Months Ended Nine Months Ended Sep 1998 Sep 1997 Sep 1998 Sep 1997 <S> <C> <C> <C> <C> Net Income, as Reported $2,906 $2,768 $8,669 $ 8,187 Adjustments, net of Tax: OREO Transactions --- (67) --- (70) Net Securities Transactions --- --- (98) (22) Restructured Loan Transactions --- --- --- (166) Insurance Settlement --- --- --- (163) State Income Tax Benefit --- --- --- (464) Recurring Income $2,906 $2,701 $ 8,571 $7,302 Diluted Earnings Per Share, as Reported $ .45 $ .43 $ 1.35 $ 1.25 Diluted Earnings Per Share, Recurring .45 .42 1.33 1.12 "Cash" earnings per share excludes from net income the amortization, net of tax, of goodwill associated with branch acquisitions: Diluted Earnings Per Share, as Reported $ .45 $ .43 $ 1.35 $ 1.25 Cash Diluted Earnings Per Share $ .48 $ .45 $ 1.41 $ 1.27 </TABLE> The returns on average assets were 1.31% and 1.36% for the third quarter of 1998 and 1997, respectively. The returns on average equity were 15.02% and 15.38% for the third quarter of 1998 and 1997, respectively. Excluding the nonrecurring items, the returns on average assets were 1.31% and 1.36%, and the returns on average equity were 15.02% and 15.20%, for the respective quarters. On a year-to-date basis, the returns on average assets were 1.35% and 1.54% for the first nine months of 1998 and 1997, respectively. The returns on average equity were 15.30% and 15.15% for the first nine months of 1998 and 1997, respectively. Excluding the nonrecurring items, the returns on average assets were 1.33% and 1.22%, and the returns on average equity were 15.10% and 13.63%, for the respective periods. Total assets were $869.0 million at September 30, 1998, which represented an increase of $37.4 million, or 4.5%, from December 31, 1997, and an increase of $49.0 million, or 6.0%, above the level at September 30, 1997. In the fifteen month period following the Branch Acquisition, the Company experienced deposit growth of approximately $6.3 million, or 4.5%, at the acquired branches. Although the Company experienced even greater growth over the period, in both loans and deposits, at pre-existing branches. Shareholders' equity increased $3.7 million to $77.6 million during the first nine months of 1998, as net income of $8.7 million and unrealized net securities gains were partially offset by cash dividends of $3.7 million, $1.0 million used to reacquire the Company's common stock and a $1.5 million loan to the Company's ESOP for purchase of the Company's stock. Shares purchased by the ESOP are treated as treasury stock until allocated to individual participants in the plan. The Company's risk-based capital ratios and Tier 1 leverage ratio continued to exceed regulatory minimum requirements at period-end and both Company banks qualified as "well-capitalized" under federal bank guidelines.
CHANGE IN FINANCIAL CONDITION <TABLE> <CAPTION> Summary of Consolidated Balance Sheets (Dollars in Thousands) $ Change $ Change % Change % Change Selected Period-End Balances: Sep 1998 Dec 1997 Sep 1997 From Dec From Sep From Dec From Sep <S> <C> <C> <C> <C> <C> <C> <C> Federal Funds Sold $ --- $ 23,000 $ 34,000 $ (23,000) $(34,000) (100.0)% (100.0)% Securities Available for Sale 224,331 221,837 202,089 2,494 22,242 1.1 11.0 Securities Held to Maturity 62,338 44,082 43,990 18,256 18,348 41.4 41.7 Loans, Net of Unearned Income (1) 527,286 485,810 476,863 41,476 50,422 8.5 10.6 Allowance for Loan Losses 6,648 6,191 6,299 457 419 7.4 6.7 Earning Assets (1) 812,955 774,729 756,943 38,226 57,012 5.1 7.5 Total Assets 868,999 831,599 819,988 37,400 49,011 4.5 6.0 Demand Deposits $ 95,599 $ 96,482 $ 90,103 $ (883) $ 5,496 (0.9) 6.1 Interest-Bearing Demand Deposits 178,043 162,016 172,958 16,027 5,085 9.9 2.9 Regular and Money Market Savings 163,749 158,690 166,519 5,059 (2,770) 3.2 (1.7) Time Deposits of $100,000 or More 96,193 106,620 78,945 (10,427) 17,248 (9.8) 21.8 Other Time Deposits 197,240 197,107 197,653 133 (413) 0.1 (0.2) Total Deposits $730,824 $720,915 $706,178 $ 9,909 $ 24,646 1.4 3.5 Short-Term Borrowings $ 29,712 $ 24,755 $ 29,580 $ 4,957 $ 3,132 20.0 11.8 Federal Home Loan Bank Advances 15,000 --- --- 15,000 15,000 --- --- Shareholders' Equity 77,557 73,871 72,175 3,686 5,382 5.0 7.5 (1) Includes Nonaccrual Loans </TABLE> Total resources at September 30, 1998 amounted to $869.0 million, an increase of $37.4 million, or 4.5%, from year-end 1997 and an increase of $49.0 million, or 6.0%, from September 30, 1997. Total loans at September 30, 1998 amounted to $527.3 million, an increase of $41.5 million, or 8.5%, from December 31, 1997, and an increase of $50.4 million, or 10.6%, from September 30, 1997. The increase from September 30, 1997 was primarily attributable to growth within the indirect consumer and residential real estate loan portfolios. Indirect consumer loans are principally auto loans financed through local dealerships where the Company acquires the dealer paper. Total deposits of $730.8 million at September 30, 1998 increased $9.9 million, or 1.4%, from the December 31, 1997 level. The amount of deposits at September 30, 1998, represented an increase of $24.6 million, or 3.5%, from September 30, 1997. The primary area of deposit growth, in the year-to-year comparison, was municipal time deposits of $100,000 or more, with additional significant growth in demand deposits and interest-bearing demand deposits. Shareholders' equity increased $3.7 million to $77.6 million during the first nine months of 1998, as net income of $8.7 million and unrealized net securities gains were partially offset by cash dividends of $3.7 million, $1.0 million used to reacquire the Company's common stock and a $1.5 million loan to the Company's ESOP for purchase of the Company's stock. Shares purchased by the ESOP are treated as treasury stock until allocated to individual participants in the plan. The Company paid a $.191 cash dividend (as restated) for each of the first two quarters of 1998, and $.21 for the third quarter of 1998. The Company recently announced a $.22 cash dividend for the fourth quarter of 1998, payable on December 15, 1998. The following discussion focuses more closely on the trend of balances and yields of the Company's deposit and loan portfolios. Deposit and Loan Trends The following table provides information on trends in the balance and mix of the Company's deposit portfolio by presenting the quarterly average balance by deposit type and the relative proportion of each deposit type for each of the last five quarters. The Branch Acquisition, completed on June 27, 1997, is fully reflected in each of the five periods presented.
<TABLE> <CAPTION> Quarterly Average Deposit Balances (Dollars in Thousands) Sep 1998 Jun 1998 Mar 1998 Dec 1997 Sep 1997 Amount % Amount % Amount % Amount % Amount % <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> Demand Deposits $101,053 14 $ 92,590 13 $ 92,584 13 $ 91,309 13 $ 93,907 14 Interest-Bearing Demand Deposits 165,547 22 170,394 23 166,494 23 170,321 24 155,461 22 Regular and Money Market Savings 167,066 22 161,009 22 158,997 22 159,591 22 167,821 24 Time Deposits of $100,000 or More 116,375 16 113,672 15 102,263 14 96,851 13 78,927 11 Other Time Deposits 195,567 26 193,866 27 195,039 28 191,018 28 201,125 29 Total Deposits $745,608 100 $731,530 100 $715,377 100 $716,090 100 $697,241 100 </TABLE> Deposit growth over the five periods presented, occurred primarily in the area of demand deposits, interest-bearing demand deposits and time deposits of $100,000 or more. <TABLE> <CAPTION> Quarterly Cost of Deposits Sep 1998 Jun 1998 Mar 1998 Dec 1997 Sep 1997 <S> <C> <C> <C> <C> <C> Demand Deposits ---% ---% --- % --- % --- % Interest-Bearing Demand Deposits 2.83 2.92 2.99 3.16 2.98 Regular and Money Market Savings 2.68 2.71 2.78 2.79 2.87 Time Deposits of $100,000 or More 5.45 5.49 5.47 5.45 5.45 Other Time Deposits 5.40 5.52 5.57 5.50 5.45 Total Deposits 3.52 3.59 3.61 3.63 3.54 </TABLE> The Federal Reserve Board attempts to influence the prevailing federal funds rate and prime interest rates by changing the Federal Reserve Bank discount rate and/or through open market operations. Until mid-October 1998, the Fed had not changed its discount rate since January 1996. Partly as a result of the Fed's open market operations, however, the prevailing federal funds rate increased in the first quarter of 1997 by 25 basis points and decreased in late September 1998 by 25 basis points. Like the federal funds rate, the Company's cost of deposits has been fairly stable over the past five quarters. Following the September 29, 1998 decrease in the prevailing federal funds rate, commercial banks reduced their prime lending rate by 25 basis points. In mid-October 1998, the federal reserve discount rate, the prevailing federal funds rate and the prime rate all decreased 25 basis points. The Company expects that the twelve month impact of these recent trends will have a slightly positive impact on net interest margin, since a greater portion of its interest-bearing liabilities will reprice more quickly than interest- earning assets. In the recent past, other sources of short-term borrowings for the Company included repurchase agreements (essentially a substitute deposit product) and tax deposit balances with the U.S. Treasury. During the first quarter of 1998, the Company borrowed $15 million from the Federal Home Loan Bank of New York ("FHLB") in the form of a "convertible advance." These advances (extended in three $5 million increments) have a final maturity of 10 years and are callable by the FHLB at certain dates beginning no earlier than one year from the issuance date. If the advances are called, the Company may elect to have the funds replaced by the FHLB at the then prevailing market rate of interest. <TABLE> <CAPTION> Quarterly Average Loan Balances (Dollars in Thousands) Sep 1998 Jun 1998 Mar 1998 Dec 1997 Sep 1997 Amount % Amount % Amount % Amount % Amount % <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> Commercial and Commercial Real Estate $ 98,177 19 $ 103,805 21 $ 102,983 21 $ 100,604 21 $102,211 22 Residential Real Estate 173,598 33 162,071 32 151,417 31 147,928 31 142,863 31 Home Equity 33,474 7 35,331 7 36,593 7 36,601 7 37,100 7 Indirect Consumer Loans 161,508 31 151,603 30 143,495 29 139,401 29 128,086 27 Direct Consumer Loans 46,253 9 46,495 9 49,047 10 49,747 10 51,185 11 Credit Card Loans 6,855 1 7,138 1 7,413 2 7,602 2 7,582 2 Total Loans $519,865 100 $506,444 100 $490,985 100 $481,883 100 $469,027 100 </TABLE> Average total loans have increased at a steady pace over the past five quarters. Indirect consumer loans and residential real estate loans demonstrated the most significant growth. Indirect consumer loans are primarily auto loans financed through local dealerships where the Company acquires the dealer paper. As a percentage of the overall loan portfolio, these loans increased from 27% in the third quarter of 1997 to 31% in the third quarter of 1998. The Company also experienced significant activity in residential real estate lending, which is expected to continue into the fourth quarter of 1998. <TABLE> <CAPTION> Quarterly Taxable Equivalent Yield on Loans Sep 1998 Jun 1998 Mar 1998 Dec 1997 Sep 1997 <S> <C> <C> <C> <C> <C> Commercial and Commercial Real Estate 9.50% 10.24% 9.60% 9.62% 9.56% Residential Real Estate 7.86 8.13 8.34 8.23 8.33 Home Equity 9.00 9.10 9.07 9.10 9.20 Indirect Consumer Loans 8.13 8.16 8.17 8.24 8.39 Direct Consumer Loans 8.85 9.00 9.18 9.18 9.00 Credit Card Loans 15.51 16.34 16.41 16.07 16.46 Total Loans 8.51 8.83 8.82 8.81 8.86 </TABLE> Yields on the Company's loan portfolio segments were quite constant over the four quarters ending June 30, 1998, reflecting a period of general interest rate stability. In the third quarter of 1998, however, yields decreased generally and in certain sectors, particularly residential real estate loans, the drop-off was noteworthy. The declining yields reflected increasingly competitive pricing on loans in the Company's market area, which as been underway for some time, as well as widespread consumer expectation of a softening interest rate economy. During the second quarter of 1998 the Company received full payment on a large commercial loan on nonaccrual status. Without that payment, the yield on the commercial portfolio for the second quarter would have been 9.52% instead of 10.24%, and the yield on the entire loan portfolio would have been 8.68%, as opposed to 8.83%. The following table presents information related to the Company's allowance and provision for credit losses for each of the past five quarters. The provision for credit losses and net charge-offs are reported on a year-to-date basis, and are annualized when expressed as a percentage of average loans.
<TABLE> <CAPTION> Summary of the Allowance and Provision for Credit Losses (Dollars in Thousands)(Loans Stated Net of Unearned Income) Sep 1998 Jun 1998 Mar 1998 Dec 1997 Sep 1997 Loan Balances: <S> <C> <C> <C> <C> <C> Period-End Loans $527,286 $512,984 $495,962 $485,810 $476,863 Average Loans, Year-to-Date 505,870 498,757 490,985 439,103 424,686 Allowance for Credit Losses: Allowance for Credit Losses, Beginning of Period $6,191 $6,191 $ 6,191 $ 5,581 $ 5,581 Allowance Acquired, YTD --- --- --- 700 700 Provision for Credit Losses, Y-T-D 1,026 684 342 1,303 972 Net Charge-offs, Y-T-D (569) (407) (158) (1,393) (1,024) Allowance for Credit Losses, End of Period $6,648 $6,468 $ 6,375 $ 6,191 $ 6,229 Nonperforming Assets (Period-end): Nonaccrual Loans $2,196 $2,367 $3,615 $3,321 $3,034 Loans Past due 90 or More Days and Still Accruing Interest 415 360 242 363 296 Loans Restructured and in Compliance with Modified Terms --- --- --- --- --- Total Nonperforming Loans 2,611 2,727 3,857 3,684 3,330 Repossessed Assets 12 31 64 --- --- Other Real Estate Owned 606 496 386 315 322 Total Nonperforming Assets $3,230 3,254 $4,307 $3,999 $3,652 Performance Ratios: Allowance to Nonperforming Loans 254.62% 237.18% 165.28% 168.05% 187.06% Allowance to Period-End Loans 1.26 1.26 1.29 1.27 1.31 Provision to Average Loans (annualized) 0.27 0.28 0.28 0.30 0.31 Net Charge-offs to Average Loans (annualized) 0.15 0.16 0.13 0.32 0.32 Nonperforming Assets to Loans, OREO & Repossessed Assets 0.61 0.63 0.87 0.82 0.77 </TABLE> The Company's nonperforming assets at September 30, 1998 amounted to $3.2 million, a decrease of $769 thousand, or 19.2%, from December 31, 1997. The decrease was primarily attributable to a cash pay-off by one commercial borrower of a loan that had been on nonaccrual status. At period-end, nonperforming assets represented .61% of loans, other real estate and repossessed assets, a decrease of 21 basis points from year-end 1997. At December 31, 1997, this ratio for the Company's peer group was 1.04%. On an annualized basis, the ratio of net charge-offs to average loans was .15% for the 1998 nine month period. This compares favorably to the .32% ratio for the 1997 year. The provision for credit losses was $342 thousand and $500 thousand for the third quarter of 1998 and 1997, respectively. The year-to-date provisions were $1.0 million for 1998 and $972 thousand for 1997, such increase being attributable to the higher level of average loans in the 1998 period and a change in the mix of loans favoring automotive installment loans. The provision as a percentage of average loans was .27% for the first nine months of 1998, over twice the ratio of net charge-offs to average loans. The allowance for credit losses at September 30, 1998 amounted to $6.6 million. The ratio of the allowance to outstanding loans at September 30, 1998, was 1.26%, essentially unchanged from the ratio at December 31, 1997. CAPITAL RESOURCES Shareholders' equity increased $3.7 million to $77.6 million during the first nine months of 1998, as net income of $8.7 million and unrealized net securities gains were partially offset by cash dividends of $3.7 million, $1.0 million used to reacquire the Company's common stock and a $1.5 million loan to the Company's ESOP for purchase of the Company's stock. Shares purchased by the ESOP are treated as treasury stock until allocated to individual participants in the plan.
The Company and its subsidiaries are currently subject to two sets of regulatory capital measures, a leverage ratio test and risk-based capital guidelines. The risk-based guidelines assign weightings to all assets and certain off-balance sheet items and establish an 8% minimum ratio of qualified total capital to risk-weighted assets. 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 credit losses. The leverage ratio test establishes minimum limits on the ratio of Tier 1 capital to total quarterly average tangible assets without risk weighting. For top-rated companies, the minimum leverage ratio is 3%, but lower-rated or rapidly expanding companies may be required to meet substantially higher minimum leverage ratios. As of September 30, 1998, the Tier 1 leverage and risk-based capital ratios for the Company and its subsidiaries were as follows: <TABLE> <CAPTION> Summary of Capital Ratios Tier 1 Total Tier 1 Risk-Based Risk-Based Leverage Capital Capital Ratio Ratio Ratio <S> <C> <C> <C> Arrow Financial Corporation 7.23% 11.67% 12.92% Glens Falls National Bank & Trust Company 7.28 12.22 13.48 Saratoga National Bank & Trust Company 7.55 9.65 10.76 Regulatory Minimum 3.00 4.00 8.00 FDICIA's "Well-Capitalized" Standard 5.00 6.00 10.00 </TABLE> The FDIC Improvement Act of 1991 ("FDICIA") mandated actions to be taken by banking regulators for financial institutions that are undercapitalized as measured by these ratios. FDICIA established a capital-grading system for financial institutions resulting in five levels of capitalization ranging from "critically undercapitalized" to "well-capitalized." At September 30, 1998 all Company and subsidiary banks' capital ratios were above FDICIA's "well- capitalized" standard. The common stock of Arrow Financial Corporation is traded on The Nasdaq Stock MarketSM under the symbol AROW. The price ranges below represent actual transactions rounded to the nearest 1/8 point. (There may have been unreported sales outside the parameters shown, but management believes that the price ranges fairly represent the trends.) Per share amounts and market prices have been adjusted for the August 1998 ten percent. On October 29, 1998 the Company's board of directors declared a cash dividend of $.22 payable December 15, 1998 to shareholders of record on December 1, 1998. The dividend represents an increase of 4.8% from the third quarter cash dividend. <TABLE> <CAPTION> Quarterly Stock Prices and Dividends Market Price Cash (Restated for Stock Dividends) (Bid) Dividends High Low Declared <S> <C> <C> <C> 1997 1st Quarter $21.250 $20.125 $.173 2nd Quarter 24.000 21.250 .173 3rd Quarter 26.000 22.250 .173 4th Quarter 30.625 26.875 .191 1998 1st Quarter $30.250 $27.000 $.191 2nd Quarter 31.250 27.625 .191 3rd Quarter 31.250 24.000 .210 4th Quarter (payable December 15, 1998) .220 </TABLE> <TABLE> <CAPTION> 1998 1997 <S> <C> <C> Third Quarter Diluted Earnings Per Share, as Reported $.45 $.43 Third Quarter Core Diluted Earnings Per Share $.45 $.42 Dividend Payout Ratio: (Fourth quarter dividends as a percent of third quarter core diluted earnings per share) 48.89% 45.48% Book Value Per Share $12.39 $11.40 Tangible Book Value Per Share 10.28 9.21 </TABLE> One of the principal uncertainties affecting future capital levels of the Company, as well as future earnings and liquidity concerns , is the so-called "Year 2000"problem. Banking regulators have required all financial institutions to prepare and implement detailed plans to prepare for and address this issue. See the following section for a full discussion of this issue. Otherwise, the Company is not aware of any known trends, events or uncertainties that will have or that are reasonably likely to have a materially adverse effect on the Company's capital resources in forthcoming periods. Year 2000 Preparedness General The advent of the year 2000 poses certain technological challenges resulting from a reliance in computer technologies on two digits rather than four digits to represent the calendar year (e.g., "98" for "1998"). Computer technologies programmed in this manner, if not corrected, could produce inaccurate or unpredictable results or system failures in connection with the transition from 1999 to 2000, when dates will begin to have a lower two-digit number than dates in the prior century. This problem, the so-called "Year 2000 Problem" or "Y2K Problem," may have a material adverse effect on the Company's financial condition, results of operations, business or business prospects because the Company, like most financial institutions, relies extensively on computer technology to manage its financial information and serve its customers. The Company and its banking subsidiaries are regulated by federal banking agencies, which are requiring substantial efforts by banks and their affiliated companies to prevent or mitigate disruptions relating to the year 2000. The Company's State of Readiness To deal with the Year 2000 Problem, the Company, beginning in 1997, formed a Year 2000 Project Team (the "Team"). The Team has developed a Year 2000 Action Plan (the "Plan"), specifying a range of tasks and goals to be achieved at various dates before the year 2000. To date, the Plan is on target and major deadlines have been met. The Team has kept senior management and the board of directors of the Company apprised of its progress, and has received input and guidance from both. The Company's Year 2000 Action Plan is divided into five phases consistent with guidance issued by the federal bank regulators: 1) Awareness; (2) Assessment; (3) Renovation; (4) Validation (testing); and (5) Implementation. As of September 30, 1998, the Company had completed the Awareness and Assessment phases of the Plan. These phases involved, among other things, identification of those data systems, including information technology ("IT") and non- information technology ("Non-IT") systems, that are deemed critical to the continuing functioning of the Company's principal business operations (so-called "mission critical systems"). The Renovation phase of the Plan consists of replacing or updating certain mission critical systems or components thereof with a view to preventing or minimizing any Y2K related problems. This phase for mission critical systems was substantially completed as of September 30, 1998. The Renovation phase for all systems is scheduled to be completed prior to year-end 1998. As part of the Renovation phase, the Company accelerated, and has now completed, the installation of a major upgrade to its central computer processing systems, which had originally been scheduled for implementation in 1999. Acceleration of the upgrade has enabled the Company to conduct certain Year 2000 testing in-house, which otherwise would have to have been conducted by a third party provider at additional expense to the Company. As of September 30, 1998, the Company had begun the Validation (testing) phase of the Plan with respect to those mission critical systems that are operated by the Company internally. Testing of internal mission critical systems is scheduled to be substantially completed prior to year-end 1998. The Validation (testing) phase with respect to mission critical systems furnished to the Company by third party providers also had begun as of September 30, 1998, and is scheduled to be completed prior to March 31, 1999. The Implementation phase, involving all modifications to systems indicated by the testing phase as well as on-going monitoring of Y2K concerns generally, is on-going and the Company anticipates it will continue throughout 1999. During all phases of the Plan, the Year 2000 Project Team has actively monitored the Y2K preparedness of its third party providers and servicers, utilizing various methods for testing and verification. The Company has requested certifications of Year 2000 preparedness from principal providers and has participated in user groups. The Company also has completed an assessment of major borrowing accounts and has assigned a risk rating to each based on information obtained from the borrower. Year 2000 preparedness assessment is now a part of on-going loan account review. The Company also has contacted and reviewed the state of preparedness of the Company's principal sources of liquidity. The Company believes that there is no single credit account or source of funding that is sufficiently critical to the Company's profitability or operations such that that Y2K preparedness or lack thereof represents a material exposure to the Company (see "Year 2000 Risks Facing the Company and the Company's Contingency Plans," below). The Company has not yet engaged in discussions with its utility providers (e.g., electricity, gas, telecommunications) regarding Y2K concerns. As part of the Plan, however, the Company will continue to monitor Y2K disclosures by all such providers to the businesses and financial organizations that rely on them. The Company will also continue to monitor such disclosures by the governmental agencies upon which the Company relies for certain services (e.g., the Federal Reserve System, the Federal Home Loan Bank of New York). In accordance with its Plan, the Company will make particular inquiries of such providers and agencies when circumstances warrant, and will generally strive for a Y2K preparedness against industry-wide and geographic Y2K systemic risks comparable to that maintained by similarly situated organizations exercising appropriate due care. Of course, any industry-wide or regional disruptions arising out of the Y2K Problem may be expected to affect the Company and its customers. The significance of any such disruption will depend on its duration and its systemic and geographic magnitude (see "Year 2000 Risks Facing the Company and the Company's Contingency Plans"). The following table sets forth the Company's time-table for completion of the various phases of its Year 2000 Action Plan, showing the Company's estimate of percentages of each phase completed as of September 30, 1998.
<TABLE> <CAPTION> Internal Systems Percent Mission Critical Not Mission Critical Complete IT Non IT IT Non IT <S> <C> <C> <C> <C> <C> Awareness 100% 9/30/98 9/30/98 9/30/98 9/30/98 Assessment 100% 9/30/98 9/30/98 9/30/98 9/30/98 Renovation 90% 12/31/98 9/30/98 12/31/98 9/30/98 Validation 65% 12/31/98 9/30/98 3/31/99 3/31/99 Implementation 65% 6/30/98 6/30/99 12/31/99 12/31/99 </TABLE> <TABLE> <CAPTION> External Systems Percent Mission Critical Not Mission Critical Complete IT Non IT* IT Non IT* <S> <C> <C> <C> <C> <C> Awareness 100% 9/30/98 9/30/98 9/30/98 9/30/98 Assessment 100% 9/30/98 9/30/98 9/30/98 9/30/98 Renovation 90% 12/31/98 12/31/98 12/31/98 12/31/98 Validation 65% 3/31/99 3/31/99 N/A N/A Implementation 65% 6/30/99 6/30/99 12/31/99 12/31/99 *External Non-IT systems are generally described as product vendors. </TABLE> <TABLE> <CAPTION> Third Parties Percent Loan Funds Complete Customers Providers <S> <C> <C> <C> Awareness 100% 9/30/98 9/30/98 Assessment 100% 9/30/98 9/30/98 Renovation 90% N/A N/A Validation 65% N/A N/A Implementation 65% 12/31/99 12/31/99 </TABLE> The Costs to Address the Company's Year 2000 Issues The Company originally projected Y2K expenditures of between $250 thousand and $500 thousand. Y2K expenditures through September 30, 1998, were approximately $282 thousand, 67% of which represented the cost of the accelerated upgrading of the Company's central computer processing systems which was substantially complete as of that date. The projection of the Company's Y2K costs does not include internal personnel costs, which are not expected to be significantly greater as a result of the Year 2000 Problem, or external consulting or advisory fees, which have been and are expected to be minimal. The Company's budget for Y2K expenditures consists predominantly of expenditures for the upgrading or replacement of hardware and software systems, divided approximately 83% for hardware and 17% for software. The Company has funded, and plans to fund, its Year 2000 related expenditures out of general operating resources. The Company has postponed certain minor computer-related projects that otherwise might have been completed during 1998 and 1999, due to the resources directed to the accelerated upgrading of the central computer processing systems and other Y2K related projects. The Company does not believe this postponement will have any significant effect on its operations or customer service. Year 2000 Risks Facing the Company and the Company's Contingency Plans The failure of the Company to substantially complete its Plan could result in an interruption in or failure of certain normal business activities or operations. Such failures could materially adversely affect the Company's results of operations, liquidity and financial condition. Currently, the Plan is on schedule and management believes that successful completion of the Plan should significantly reduce the risks faced by the Company with respect to the Year 2000 Problem. There is no single credit account or group of related credits which, in the Company's assessment, is or may be likely to present any significant exposure due to the Year 2000 Problem. The Company does not have any significant concentration of borrowers from any particular industry (to the extent some industries might be particularly susceptible to Y2K concerns), and no individual borrower accounts for a significant portion of the Company's assets. However, management anticipates some negative impact on the performance of various loan accounts due to failure of the borrowers to prepare adequately for the Year 2000 Problem. In a worst-case scenario, these borrower-related difficulties might require the Company to downgrade the affected credits in its internal loan classification system or to make one or more special provisions to its loan loss allowance for resulting anticipated losses in ensuing periods. In addition, although the Company is adopting special measures to maintain necessary liquidity to meet funding demands in the periods surrounding the transition from 1999 to 2000, the Company also could face increased funding costs or liquidity pressures if depositors are motivated out of Y2K concerns to withdraw substantial amounts of deposits or to shift their deposits from short-term to long-term accounts. A significant portion of the Company's deposits are so- called municipal deposits (i.e., provided by local municipalities, school districts and other governmental bodies), but the Company does not anticipate any increased Year 2000 related risk due to this concentration of deposits. The Company does not currently expect any material impact from Y2K related issues on its costs of funds or liquidity, but in a worst-case scenario, if funding costs do rise, net interest margins may be negatively impacted over the relevant timeframe. The Company could face some risk from the possible failure of one or more of its third party vendors to continue to provide uninterrupted service through the changeover to the year 2000. Critical providers include the Company's automated teller machine switching networks, the Company's credit card vendors (Visa and Mastercard), the Company's provider of trust department data processing, and the various credit bureaus upon which the Company relies for information necessary to evaluate credit risk. While an evaluation of the Year 2000 preparedness of its third party vendors has been part of the Company's Plan, the Company's ability to evaluate is limited to some extent by the willingness of vendors to supply information and the ability of vendors to verify the Y2K preparedness of their own systems or their sub-providers. However, the Company participates in user groups, receives assessments of Y2K preparedness of vendors periodically from federal banking agencies, and the Company's Plan includes third-party vendor system interface testing; accordingly the Company does not currently anticipate that any of its significant third party vendors will fail to provide continuing service due to the Year 2000 Problem. The Company, like similarly-situated enterprises, is subject to certain risks as a result of possible industry-wide or area-wide failures triggered by the Year 2000 Problem. For example, the failure of certain utility providers (e.g., electricity, gas, telecommunications) or governmental agencies (e.g., the Federal Reserve System, the Federal Home Loan Bank of New York) to avoid disruption of service in connection with the transition from 1999 to 2000 could materially adversely affect the Company's results of operations, liquidity and financial condition. In management's estimate, such a system-wide or area-wide failure presents a significant risk to the Company in connection with the Year 2000 Problem because the resulting disruption may be entirely beyond the ability of the Company to cure. The significance of any such disruption would depend on its duration and systemic and geographic magnitude. Of course, any such disruption would likely impact businesses other than the Company. In order to reduce the risks enumerated above, the Company's Year 2000 Project Team has begun to develop contingency plans in accordance with guidance issued by the federal bank regulators. The Team has identified the Company's core business processes (e.g., providing customers with access to funds and information) and has reviewed the Company's existing business continuity and contingency plans. The Team also has performed a risk analysis of each core business process, defined and documented Year 2000 failure scenarios, and determined the minimum acceptable level of outputs and services. The Team is in the process of evaluating options, selecting a contingency strategy, assigning responsibilities and trigger dates for such contingency plans, and validating such contingency plans. These activities are anticipated to be completed during the first quarter of 1999. Certain catastrophic events (such as the loss of utilities or the failure of certain governmental bodies to function) are outside the scope of the Company's contingency plans, although the Company anticipates that it would respond to any such catastrophe in a manner designed to minimize disruptions in customer service, and in full cooperation with its peer providers, community leaders and service organizations. Forward-Looking Statement Warnings The foregoing discussion of the Company's Year 2000 Preparedness contains a substantial number of forward-looking statements, indicated by such words as "expects," "believes," "estimates," "anticipates," "plans," "assessment," "should," "will," and similar words. These forward-looking statements are based on the Company's and management's beliefs, assumptions, expectations, estimates and projections any or all of which are subject to future change, depending on unknown developments and facts. These forward-looking statements should be read in conjunction with the Company's disclosures under the heading: "Cautionary Statement under Federal Securities Laws," located at the beginning of Management's Discussion and Analysis. LIQUIDITY Liquidity is measured by the ability of the Company to raise cash when it needs it at a reasonable cost. The Company must be capable of meeting expected and unexpected obligations to its customers at any time. Given the uncertain nature of customer demands as well as the desire to maximize earnings, the Company must have available sources of funds, on- and off- balance sheet, that can be acquired in time of need. Securities available-for-sale represent a primary source of on- balance sheet cash flow. Certain securities are designated by the Company at purchase as available-for-sale. Selection of such securities is based on their ready marketability, ability to collateralize borrowed funds, as well as their yield and maturity. In addition to liquidity arising from on-balance sheet cash flows, the Company has supplemented liquidity with additional off- balance sheet sources, such as credit lines with the Federal Home Loan Bank, and also has identified wholesale and retail repurchase agreements and brokered certificates of deposit as appropriate funding alternatives. The Company measures its basic liquidity as a ratio of liquid assets to short-term liabilities, both with and without the availability of borrowing arrangements. Because excess liquidity has a negative impact on earnings, the Company establishes both a high end and a low end on its target range for liquidity ratios. Other than the general concerns relating to the Year 2000 issue discussed above, the Company is not aware of any known trends, events or uncertainties that will have or are reasonably likely to have a material effect or make material demands on the Company's liquidity in upcoming periods. RESULTS OF OPERATIONS: Three Months Ended September 30, 1998 Compared With Three Months Ended September 30, 1997 Summary of Earnings Performance (Dollars in Thousands, Except Per Share Amounts) <TABLE> <CAPTION> As Reported: Sep 1998 Sep 1997 Change % Change <S> <C> <C> <C> <C> Net Income $2,906 $2,768 $138 5.0% Diluted Earnings Per Share .45 .43 .02 4.7 Return on Assets 1.31% 1.36% (.05)% (3.7) Return on Equity 15.02% 15.38% (.36)% (2.3) Recurring Earnings: Net Income $2,906 $2,701 $205 7.6% Diluted Earnings Per Share .45 .42 .03 7.1 Return on Assets 1.31% 1.33% (.02)% (1.5) Return on Equity 15.02% 15.20% (.18)% (1.2) </TABLE> The Company reported earnings of $2.9 million for the third quarter of 1998, an increase of $138 thousand, or 5.0%, over the third quarter of 1997. Adjusted to eliminate nonrecurring items and securities transactions, as reviewed above in the "Overview" section of this discussion, net income was $2.9 million and $2.7 million for the third quarters of 1998 and 1997, respectively. As thus adjusted, diluted earnings per share were $.45 and $.42 for each respective period. Net Interest Income <TABLE> <CAPTION> Summary of Net Interest Income (Taxable Equivalent Basis) (Dollars in Thousands) Sep 1998 Sep 1997 Change % Change <S> <C> <C> <C> <C> Interest Income $16,088 $15,047 $1,041 6.9% Interest Expense 7,164 6,504 660 10.1 Net Interest Income $ 8,924 $ 8,543 $ 381 4.5 Average Earning Assets (1) $826,772 738,713 $88,059 11.9% Average Paying Liabilities 688,009 626,336 61,674 9.8 Taxable Equivalent Adjustment 292 216 76 35.3 Yield on Earning Assets (1) 7.72% 8.08% (0.36)% (4.5)% Cost of Paying Liabilities 4.13 4.12 0.01 0.3 Net Interest Spread 3.59 3.96 (0.37) (9.4) Net Interest Margin 4.28 4.59 (0.31) (6.7) (1) Includes Nonaccrual Loans </TABLE> Net interest income increased $381 thousand from the third quarter of 1997 to the third quarter of 1998. This increase was principally the result of the increased size of the Company between the two periods, i.e., an 11.9% increase in average earning assets and a 9.8% increase in average paying liabilities. The increase in net interest income between the two periods (4.5%) was less than the percentage increase in assets and liabilities, reflecting the pressure in recent quarters on net interest margin. Net interest margin (net interest income on a tax- equivalent basis divided by average earning assets, annualized) decreased by 31 basis points from the third quarter of 1997 to the third quarter of 1998. The decrease in net interest margin between the comparative periods was, for the most part, attributable to competitive pricing for loans in the Company's marketplace, a flattening of the yield curve, and an average cost of deposits that at least through the third quarter, was resistant to downward pressure. There was virtually no change in the cost of paying liabilities for the Company from the third quarter of 1997 to the third quarter of 1998. This reflects the fact that there were no changes among the federal reserve discount rate, the federal funds rate or the prime rate during the fifteen month period beginning July 1, 1997. However, the flattening of the yield curve (while short-term rates remained virtually unchanged, long-term rates decreased) had a significant negative impact on the Company's loan portfolio. Most of the period-to-period loan growth occurred within the residential real estate and automobile installment loan portfolios, and it was in these two areas that the Company experience the most significant yield erosion. While the Company experienced some real estate loan refinancing from its own customer base, most of the activity in this segment of the portfolio came from refinancings of mortgages previously held by other financial institutions. Nearly all refinance customers in recent periods have selected fixed rate mortgages, since the flat yield curve has made that product more attractive. While the commercial and commercial real estate loan portfolio experienced no period-to-period growth, many of the Company's commercial customers took advantage of the interest rate environment to refinance existing loans. The provision for credit losses was $342 thousand and $500 thousand for the quarters ended September 30, 1998 and 1997, respectively. The provision for credit losses was discussed previously under the heading "Summary of the Allowance and Provision for Credit Losses." Other Income <TABLE> <CAPTION> Summary of Other Income (Dollars in Thousands) Sep 1998 Sep 1997 $ Change % Change <S> <C> <C> <C> <C> Income From Fiduciary Activities $ 748 $ 686 $ 62 9.0% Fees for Other Services to Customers 1,195 1,122 73 6.5 Other Operating Income 263 413 (150) (36.3) Total Other Income $2,206 $2,221 $ (15) (0.7) </TABLE> Other (i.e. noninterest) income for the third quarter of 1998 decreased $15 thousand, or 0.7%, from the third quarter of 1997, with all of the decrease being attributable to other operating income. Trust income increased $62 thousand, or 9.0%, between the two comparative quarters. The Company did not acquire any trust business in the Branch Acquisition, but the newly-acquired branches did expand the market area for the Company's trust and investment division. Fees for other services to customers (primarily service charges on deposit accounts, credit card merchant fee income and servicing income on sold loans) was $1.2 million for the third quarter of 1998, an increase of $73 thousand, or 6.5%, from the 1997 quarter. The increase was primarily attributable an increase in the level of demand deposits, the primary source of service charge income. Other operating income, (primarily third party credit card servicing income and gains on the sale of loans and other assets) amounted to $263 thousand, a decrease of $150 thousand, or 36.3%, from the third quarter of 1997. The decrease was primarily attributable to gains on the sale of other real estate owned in the 1997 period. Other Expense <TABLE> <CAPTION> Summary of Other Expense (Dollars in Thousands) Sep 1998 Sep 1997 $ Change % Change <S> <C> <C> <C> <C> Salaries and Employee Benefits $3,607 $3,309 $ 298 9.0% Occupancy Expense of Premises, Net 424 432 (8) (1.9) Furniture and Equipment Expense 542 461 81 17.6 Other Operating Expense 1,729 1,627 102 6.3 Total Other Expense $6,302 $5,829 $ 473 8.1 Efficiency Ratio 56.62% 54.55% 2.07% 3.8% </TABLE> The efficiency ratio, which is the ratio of other expense to tax- equivalent net interest income and other income (excluding nonrecurring items and securities gains and losses), is a standard measure of a financial institution's operating efficiency. For the year ended December 31, 1997, the ratio for the Company's peer group was 61.63%, approximately 6.4% higher than the Company's ratio for the year. Other (i.e. noninterest) expense increased $473 thousand, or 8.1% from the third quarter of 1997 to the third quarter of 1998. Salaries and employee benefits expense increased $298 thousand, or 9.0%, from the third quarter of 1997 to the third quarter of 1998. The increase reflects a 7.7% increase in salaries in the comparative period, and a related 12.4% increase in benefits. Full-time equivalent employees at the end of September 30, 1998 and 1997 were 367.3 and 351.8, respectively, representing a period-to-period increase of 4.4%. Occupancy expense of premises, net of rental income, remain virtually unchanged in the quarter-to-quarter comparison. However, furniture and equipment expense increased $81 thousand, or 17.6%, from the third quarter of 1997 to the third quarter of 1998. The increase was primarily attributable to increased costs to service and maintain the Company's main computer applications including costs to and test and upgrade computer applications in preparation for the so-called Year 2000 problem. See the preceding discussion on "Year 2000 Preparedness." Other operating expense increased $102 thousand, or 6.3%, from the third quarter of 1997 to the third quarter of 1998. The increase is primarily attributable to one large charitable contribution during the third quarter of 1998. The Company donated land, adjacent to one of its branches, to the Glens Falls Youth Center. Income Taxes <TABLE> <CAPTION> Summary of Income Taxes (Dollars in Thousands) Sep 1998 Sep 1997 Change % Change <S> <C> <C> <C> <C> Provision for Income Taxes $1,288 $1,451 $(163) (11.2)% Effective Tax Rate 30.71% 34.39% (3.68)% (10.7) </TABLE> The provision for federal and state income taxes amounted to $1.3 million and $1.5 million for the third quarter of 1998 and 1997, respectively. The decrease in the effective tax rate from the 1997 period to the 1998 period is primarily attributable to a reduction in state income taxes and an increase in tax exempt income. RESULTS OF OPERATIONS: Nine Months Ended September 30, 1998 Compared With Nine Months Ended September 30, 1997 <TABLE> <CAPTION> Summary of Earnings Performance (Dollars in Thousands) As Reported: Sep 1998 Sep 1997 Change % Change <S> <C> <C> <C> <C> Net Income $8,669 $ 8,187 $482 5.9% Diluted Earnings Per Share 1.35 1.25 --- --- Return on Assets 1.35% 1.54% (.19)% (12.3) Return on Equity 15.30% 15.15% .15 % (1.0) Recurring Earnings: Net Income $8,571 $7,302 $1,269 17.4% Diluted Earnings Per Share 1.33 1.12 .21 18.8 Return on Assets 1.33% 1.38% (.05)% (3.3) Return on Equity 15.10% 13.63% 1.47% 10.8 </TABLE> The Company's net income was $8.7 million for the first nine months of 1998, compared to earnings of $8.2 million for the first nine months of 1997. Diluted earnings per share were $1.35 and $1.25 for the respective periods. However, adjusting for the nonrecurring events in both periods, as discussed above in the "Overview" section, net income for the first nine months of 1998 increased $1.3 million, or 17.4%, from the first nine months of 1997. As adjusted, diluted earnings per share were $1.33 and $1.12 for the respective 1998 and 1997 nine month periods. The increase in average earning assets and paying liabilities resulting from the Branch Acquisition was the most significant factor in the period-to-period increase in recurring net income. The period-to-period change for the first nine months of 1998 as compared to the first nine months of 1997 is reviewed in the following sections on net interest income, other income, other expense and income taxes. Net Interest Income <TABLE> <CAPTION> Summary of Net Interest Income (Taxable Equivalent Basis) (Dollars in Thousands) Sep 1998 Sep 1997 Change % Change <S> <C> <C> <C> <C> Interest Income $47,635 $40,193 $ 7,442 18.5 % Interest Expense 20,958 17,037 3,921 23.0 Net Interest Income $26,677 $23,156 $ 3,521 15.2 Average Earning Assets (1) $804,312 $657,585 $146,726 22.3 % Average Paying Liabilities 673,827 547,394 126,433 23.1 Taxable Equivalent Adjustment 809 598 211 35.2 Yield on Earning Assets (1) 7.92% 8.17% (0.25)% (3.1)% Cost of Paying Liabilities 4.16 4.16 --- --- Net Interest Spread 3.76 4.01 (0.25) (6.3) Net Interest Margin 4.43 4.71 (0.27) (5.8) (1) Includes Nonaccrual Loans </TABLE> Net interest income increased $3.5 million from the first nine months of 1997 to the first nine months of 1998. While the increase in net interest income reflected a 22.3% increase in average earning assets and a 23.1% increase in average paying liabilities, the increase in net interest income was limited to 15.2%, reflecting the pressure in recent quarters on net interest margin. Net interest margin (net interest income on a tax- equivalent basis divided by average earning assets, annualized) decreased by 27 basis points from the first nine months of 1997 to the first nine months of 1998. The increase in average earning assets and paying liabilities was primarily attributable to the Branch Acquisition. The decrease in net interest margin between the comparative periods was attributable to a variety of factors, including the inability of the Company to immediately place liquid funds received from the June 1997 Branch Acquisition in higher yielding assets, competitive pricing for loans in the Company's marketplace, a flattening of the yield curve and downward inelasticity in the Company's cost of funds. Unlike the 1998 period results, net income from the 1997 nine- month period only partially reflects the effect of the Company's expansion from the Branch Acquisition which was completed at the end of the second quarter of 1997. In that transaction the Company acquired approximately $140 million in deposits, but only $44 million in loans. The Company received cash from the seller, Fleet Bank, equal to the difference, less an agreed-upon premium on the deposits and the value of other assets acquired (e.g., real and personal property at the branches). Initially, the Company invested the surplus cash received in securities and federal funds, with a view to reinvesting these amounts in higher-yielding market area loans as opportunities allowed. At March 31, 1997, prior to the Branch Acquisition, the Company's loan to deposit ratio was approximately 73%. At June 30, 1997, shortly after the acquisition, the loan to deposit ratio was 67%. By September 30, 1998, the loan to deposit ratio had risen to 72%. The return of the loan to deposit ratio to pre-Branch Acquisition levels was not enough to offset the impact of competitive loan pricing and the flattening of the yield curve. The flattening of the yield curve (while short-term rates remained virtually unchanged, long-term rates decreased) had a significant negative impact on the Company's loan portfolio. Most of the period-to-period loan growth occurred within the residential real estate and automobile installment loan portfolios, and it was in these two areas that the Company experience the most significant yield erosion. Moreover, there was no change in the cost of paying liabilities for the Company from the first nine months of 1997 to the first nine months of 1998. The provision for credit losses was $1.0 million and $972 thousand for the respective 1998 and 1997 nine month periods. The provision for credit losses was discussed previously under the heading "Summary of the Allowance and Provision for Credit Losses."
Other Income <TABLE> <CAPTION> Summary of Other Income (Dollars in Thousands) Sep 1998 Sep 1997 $ Change % Change <S> <C> <C> <C> <C> Income From Fiduciary Activities $2,305 $ 2,007 $ 289 14.8 % Fees for Other Services to Customers 3,181 2,712 469 17.3 Net Gains on Securities Transactions 166 37 129 348.6) Other Operating Income 661 1,422 (761) (53.5) Total Other Income $6,313 $ 6,178 $ 135 2.2 </TABLE> Other (i.e. noninterest) income for the first nine months of 1997 included $531 thousand of nonrecurring other operating income relating to the former Vermont operations. Adjusting to eliminate nonrecurring items and securities transactions, other income increased $645 thousand, or 11.7%, from the first nine months of 1997 to the first nine months of 1998. Trust income increased $289 thousand, or 14.8%, between the two comparative periods. The Company did not acquire any trust business in the Branch Acquisition, but the newly-acquired branches did provide the Company with an expanded customer base for its offerings of trust and investment services. Fees for other services to customers (primarily service charges on deposit accounts, credit card merchant fee income and servicing income on sold loans) was $3.2 million for the first nine months of 1998, an increase of $469 thousand, or 17.3%, from the 1997 period. The increase was primarily attributable to service charges on the deposits assumed in the Branch Acquisition. Other operating income, on a recurring basis (primarily third party credit card servicing income and gains on the sale of loans and other assets), amounted to $661 thousand for the first nine months of 1998, a decrease of $122 thousand, or 15.6%, from the first nine months of 1997. This area of other income was not significantly impacted by the Branch Acquisition, and the period- to-period decrease was attributable to the fluctuating nature of this type of income. During the first nine months 1998, the Company recognized $166 thousand in net gains on the sale of $23.1 million of securities from the available-for-sale portfolio. The securities were sold for the main purpose of extending the average maturity on the portfolio. During the 1997 period, the Company recognized a net gain of $37 thousand on the sale of $24.0 million of securities from the portfolio of securities classified as available-for-sale.
Other Expense <TABLE> <CAPTION> Summary of Other Expense (Dollars in Thousands) Sep 1998 Sep 1997 $ Change % Change <S> <C> <C> <C> <C> Salaries and Employee Benefits $10,322 $ 9,212 $ 1,110 12.0 % Occupancy Expense of Premises, Net 1,276 1,173 103 8.8 Furniture and Equipment Expense 1,636 1,414 222 15.7 Other Operating Expense 4,942 3,989 953 23.9 Total Other Expense $18,176 $15,788 $ 2,388 15.1 Efficiency Ratio 55.37% 55.10% (.27)% (0.5)% </TABLE> Other (i.e. noninterest) expense increased $2.4 million, or 15.1%, for the first nine months of 1998 compared with the first nine months of 1997. The increase was almost entirely attributable to the Branch Acquisition, which, measured by total assets, increased the size of the Company by 21.4% at the closing of the transaction, June 27, 1997. In spite of the increased operating expenses, including amortization of goodwill associated with the Branch Acquisition, the Company's efficiency ratio (a ratio where smaller is better) remained virtually unchanged between the two periods, at approximately 55%. The efficiency ratio, which is the ratio of other expense to tax-equivalent net interest income and other income (excluding nonrecurring items and securities gains and losses), and is a standard measure of a financial institution's operating efficiency. For the year ended December 31, 1997, the ratio for the Company's peer group was 61.63%, approximately 6.4% higher than the Company's ratio for that year. Salaries and employee benefits expense increased $1.1 million, or 12.0%, from the 1997 nine month period to the 1998 period primarily because of the increase salary expense associated with the Branch Acquisition. The Company retained all 34 former Fleet Bank employees working at the acquired branches. The increase also reflects normal salary increases and an increase of 15.5 full-time equivalent employees since the Branch Acquisition. Increases in occupancy expense of premises and furniture and equipment expense (8.8% and 15.7%, respectively) were primarily attributable to the Branch Acquisition. The increase in furniture and fixtures is also attributable to increased cost to service and maintain the Company's main computer applications, including costs related to Year 2000 resting and upgrading. Other operating expense increased $953 thousand, or 23.9%, from the first nine months of 1997 to the first nine months of 1998. An increase in the amortization of goodwill of $452 thousand represented 47.4% of the total increase. Other increases were also attributable to the Branch Acquisition. Income Taxes <TABLE> <CAPTION> Summary of Income Taxes (Dollars in Thousands) Sep 1998 Sep 1997 $ Change % Change <S> <C> <C> <C> <C> Provision for Income Taxes $4,310 $3,789 $ 521 13.8 % Effective Tax Rate 33.21% 31.64% 1.57 % 5.0 </TABLE> The provisions for federal and state income taxes amounted to $4.3 million and $3.8 million for the first nine months of 1998 and 1997, respectively. During the first quarter of 1997, the Company reached a favorable settlement with the New York Department of Taxation and Finance over a combined reporting issue. The effects of the settlement resulted in a $464 thousand decrease in the Company's provision for income taxes for the first nine months of 1997. As adjusted for this settlement, the effective tax rates for the first half of 1998 and 1997 were 33.21% and 35.51%, respectively. The decrease in the effective tax rate from the 1997 period to the 1998 period is primarily attributable to a reduction in state income taxes and an increase in tax exempt income. Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK In addition to credit risk in the Company's loan portfolio and liquidity risk, discussed earlier, the Company's business activities also generate market risk. Market risk is the possibility that changes in future market rates or prices will make the Company's position less valuable. The ongoing monitoring and management of risk is an important component of the Company's asset/liability management process which is governed by policies established and reviewed annually by the Board of Directors. The Board of Directors delegates responsibility for managing the asset/liability profile on an ongoing basis to management's Asset/Liability Committee ("ALCO"). In this capacity ALCO develops guidelines and strategies impacting the Company's asset/liability management related activities based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends. Interest rate risk is the most significant market risk affecting the Company. 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-related assets, early withdrawal of time deposits, and the fact that the speed and magnitude of responses to interest rate changes varies by product. The ALCO utilizes the results of a detailed and dynamic simulation model to quantify the estimated exposure of net interest income to sustained interest rate changes. While ALCO routinely monitors simulated net interest income sensitivity over a rolling two-year horizon, it also utilizes additional tools to monitor potential longer-term interest rate risk. The simulation model attempts to capture the impact of changing interest rates on the interest income received and interest expense paid with respect to all interest-bearing assets and liabilities on the Company's consolidated balance sheet. This sensitivity analysis is compared to ALCO policy limits which specify a maximum tolerance level for net interest income exposure over a one year horizon, assuming no balance sheet growth and a 200 basis point upward and downward shift in interest rates. A parallel and pro rata shift in rates over a 12 month period is assumed.
The hypothetical estimates generated by the analysis are based upon numerous assumptions including: the nature and timing of interest rate levels including yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment/replacement of asset and liability cashflows, and other speculative assumptions. While the assumptions are developed based upon current economic and local market conditions, the Company cannot make any assurance as to the predictive nature of these assumptions including how customer preferences or competitive influences might change. Also, as market conditions vary from those assumed in the sensitivity analysis, actual results will differ due to: prepayment/refinancing levels likely deviating from those assumed, the varying impact of interest rate changes on caps or floors on adjustable rate assets, the potential effect of changing debt service levels on customers with adjustable rate loans, depositor early withdrawals and product preference changes, and other internal/external variables. Furthermore, the sensitivity analysis does not reflect actions that the Company might take in responding to or anticipating changes in interest rates. PART II - OTHER INFORMATION Item 1. Legal Proceedings The Company is not involved in any material pending legal proceedings, other than ordinary routine litigation occurring in the normal course of its business. The Company's subsidiary banks are parties to various legal claims which arise in the normal course of their business, for example, lender liability claims that 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 will not, in the current opinion of management, likely result in any material liability to the subsidiary banks or the Company. Item 2. Changes in Securities - None Item 3. Defaults Upon Senior Securities - None Item 4. Submission of Matters to a Vote of Security Holders - None Item 5. Other Information Subsequent to the end of the quarter, at its regular meeting on October 28, 1998, the Board of Directors of the Registrant amended the By-laws to adopt a provision requiring advance notice by shareholders of any matters intended to be submitted by them for consideration at an annual meeting of shareholders. Under the new provision, added to Section 2.2 of the By-laws, any shareholder who wishes to bring a matter before an upcoming annual meeting of shareholders must deliver a written notice to the Secretary of the Company not less than 120 days prior to the anniversary date of the annual meeting of shareholders in the immediately preceding year, provided the actual date of the upcoming annual meeting is within 30 days of such anniversary date. The written notice must contain the name and record address of the shareholder submitting the proposal, a brief description of the proposal sought to be raised at the meeting, the number of shares of common stock of the Registrant beneficially owned by the proposing shareholder (who must be a record holder both on the day the notice is given and on the record date for the meeting) and certain other information specified in the new By-law provision. Failure to comply with this advance notice requirement will preclude the shareholder from submitting the proposal at the meeting. For the 1999 annual meeting of shareholders, the advance notice deadline for any matter sought to be raised by any shareholder at the meeting would be December 30, 1998, assuming the annual meeting is held within 30 days before or after April 28, 1999 (as is anticipated). Item 6. Exhibits and Reports Filed on Form 8-K (a) Exhibits Exhibit 3 Amended By-law Section 2.2 Exhibit 27 Financial Data Schedule (with electronic filing only) (b) Current Reports Filed on Form 8-K - None SIGNATURES Pursuant to the requirements 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 Registrant Date: November 12, 1998 s/Thomas L. Hoy Thomas L. Hoy, President and Chief Executive Officer Date: November 12, 1998 s/John J. Murphy John J. Murphy, Executive Vice President and Treasurer/CFO (Principal Financial Officer and Principal Accounting Officer)