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 March 31, 1999 [ ] 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 April 30, 1999 Common Stock, par value $1.00 per share 6,149,160 ARROW FINANCIAL CORPORATION FORM 10-Q MARCH 31, 1999 INDEX PART I FINANCIAL INFORMATION Item 1. Consolidated Balance Sheets as of March 31, 1999 and December 31, 1998 Consolidated Statements of Income for the Three Months Ended March 31, 1999 and 1998 Consolidated Statements of Changes in Shareholders' Equity for the Three Months Ended March 31, 1999 and 1998 Consolidated Statements of Cash Flows for the Three Months Ended March 31, 1999 and 1998 Notes to Consolidated Interim Financial Statements Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Cautionary Statement under Federal Securities Laws Year 2000 Readiness Disclosure Item 3. Quantitative and Qualitative Disclosures About Market Risk PART II OTHER INFORMATION SIGNATURES
<TABLE> <CAPTION> ARROW FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in Thousands)(Unaudited) 3/31/99 12/31/98 ASSETS <S> <C> <C> Cash and Due from Banks $ 18,968 $ 24,246 Federal Funds Sold 12,400 6,500 Cash and Cash Equivalents 31,368 30,746 Securities Available-for-Sale 252,108 267,731 Securities Held-to-Maturity (Approximate Fair Value of $53,290 in 1999 and $65,055 in 1998) 52,023 63,016 Loans and Leases 573,918 546,126 Less: Allowance for Loan Losses (6,957) (6,742) Net Loans and Leases 566,961 539,384 Premises and Equipment, Net 11,125 11,103 Other Real Estate and Repossessed Assets, Net 644 665 Other Assets 27,039 26,384 Total Assets $941,268 $939,029 LIABILITIES Deposits: Demand $ 94,620 $101,860 Regular Savings, N.O.W. & Money Market Deposit Accounts 343,929 355,002 Time Deposits of $100,000 or More 143,673 123,039 Other Time Deposits 196,055 195,696 Total Deposits 778,277 775,597 Short-Term Borrowings: Securities Sold Under Agreements to Repurchase 23,549 22,275 Other Short-Term Borrowings 3,772 1,757 Federal Home Loan Bank Advances 45,000 45,000 Other Liabilities 13,568 17,254 Total Liabilities 864,166 861,883 Commitments and Contingent Liabilities 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 1999 and 1998) 7,596 7,596 Surplus 87,333 87,262 Undivided Profits 8,444 6,721 Accumulated Other Comprehensive Income 23 579 Unallocated ESOP Shares (62,131 Shares in 1999 and 56,795 Shares in 1998) (1,700) (1,555) Treasury Stock, at Cost (1,345,929 Shares in 1999 and 1,311,518 Shares in 1998) (24,594) (23,457) Total Shareholders' Equity 77,102 77,146 Total Liabilities and Shareholders' Equity $941,268 $939,029 See Notes to Consolidated Interim Financial Statements. /TABLE
<TABLE> <CAPTION> ARROW FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (In Thousands, Except Per Share Amounts)(Unaudited) Three Months Ended March 31, 1999 1998 <S> <C> <C> INTEREST AND DIVIDEND INCOME Interest and Fees on Loans and Leases $11,307 $ 10,627 Interest on Federal Funds Sold 183 125 Interest and Dividends on Securities Available-for-Sale 3,829 3,686 Interest on Securities Held-to-Maturity 849 716 Total Interest and Dividend Income 16,168 15,154 INTEREST EXPENSE Interest on Deposits: Time Deposits of $100,000 or More 1,498 1,380 Other Deposits 4,630 4,995 Interest on Short-Term Borrowings: Federal Funds Purchased and Securities Sold Under Agreements to Repurchase 249 254 Other Short-Term Borrowings 30 28 Federal Home Loan Bank Advances 548 45 Total Interest Expense 6,955 6,702 NET INTEREST INCOME 9,213 8,452 Provision for Loan Losses 364 342 NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 8,849 8,110 OTHER INCOME Income from Fiduciary Activities 799 761 Fees for Other Services to Customers 1,019 957 Net Gains on Securities Transactions --- 157 Other Operating Income 226 232 Total Other Income 2,044 2,107 OTHER EXPENSE Salaries and Employee Benefits 3,688 3,259 Occupancy Expense of Premises, Net 469 419 Furniture and Equipment Expense 579 551 Other Operating Expense 1,729 1,560 Total Other Expense 6,465 5,789 INCOME BEFORE INCOME TAXES 4,428 4,428 Provision for Income Taxes 1,340 1,525 NET INCOME $ 3,088 $ 2,903 Average Basic Common Shares Outstanding 6,213 6,340 Average Diluted Common Shares Outstanding 6,298 6,443 Per Common Share: Basic Earnings $ .50 $ .46 Diluted Earnings .49 .45 Dividends Declared .22 .19 Book Value 12.46 11.90 Tangible Book Value 10.42 9.75 Share and per share amounts have been adjusted for the 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 Other Unallocated Compre- Shares Common Undivided ESOP hensive Treasury Issued Stock Surplus Profits Shares Income Stock Total <S> <C> <C> <C> <C> <C> <C> <C> <C> Balance at December 31, 1998 7,596,477 $7,596 $87,262 $6,721 $(1,555) $579 $(23,457) $77,146 Comprehensive Income, Net of Tax: Net Income --- --- --- 3,088 --- --- --- 3,088 Net Unrealized Gain on Securities Transfered from Held-to-Maturity to Available-for-Sale Upon the Adoption of SFAS No. 133 (Pre-tax $177) --- --- --- --- --- 105 --- 105 Net Unrealized Securities Holding Losses Arising During the Period, Net of Tax (Pre-tax $1,118) --- --- --- --- --- (661) --- (661) Other Comprehensive Income (556) Comprehensive Income 2,532 Cash Dividends Declared, $.22 per Share --- --- --- (1,365) --- --- --- (1,365) Stock Options Exercised (11,007 Shares) --- --- 7 --- --- --- 106 113 Tax Benefit for Disposition of Stock Options --- --- 64 --- --- --- --- 64 Purchase of Treasury Stock (45,418 Shares) --- --- --- --- --- --- (1,243) (1,243) Acquisition of Common Stock By ESOP (9,000 Shares) --- --- --- --- (255) --- --- (255) Allocation of ESOP Stock (3,664 Shares) --- --- --- --- 110 --- --- 110 Balance at March 31, 1999 7,596,477 $7,596 $87,333 $8,444 $(1,700) $23 $(24,594) $77,102 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 --- --- --- 2,903 --- --- --- 2,903 Net Unrealized Securities Holding Losses Arising During the Period, Net of Tax (Pre-tax $122) --- --- --- --- --- (72) --- (72) Reclassification Adjustment for Net Securities Gains Included in Net Income, Net of Tax (Pre-tax $157) --- --- --- --- --- (93) --- (93) Other Comprehensive Income (165) Comprehensive Income 2,738 Cash Dividends Declared, $.19 per Share --- --- --- (1,211) --- --- --- (1,211) Stock Options Exercised (4,400 Shares) --- --- 27 --- --- --- 33 60 Tax Benefit for Disposition of Stock Options --- --- 31 --- --- --- --- 31 Balance at March 31, 1998 6,905,888 $6,906 $65,335 $24,223 $--- $599 $(21,574) $75,489 Share and per share amounts have been adjusted for the 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) Three Months Ended March 31, 1999 1998 <S> <C> <C> Operating Activities: Net Income $ 3,088 $ 2,903 Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities: Provision for Loan Losses 364 342 Provision for Other Real Estate Owned Losses --- --- Depreciation and Amortization 466 611 Compensation Expense for Allocated ESOP Shares 110 --- Gains on the Sale of Securities Available-for-Sale --- (162) Losses on the Sale of Securities Available-for-Sale --- 5 Proceeds from the Sale of Loans 530 2,981 Net Gains on the Sale of Loans, Fixed Assets and Other Real Estate Owned (21) (24) Decrease (Increase) in Deferred Tax Assets (109) (151) Decrease (Increase) in Interest Receivable (107) 350 Increase (Decrease) in Interest Payable 60 (34) Decrease (Increase) in Other Assets (337) (199) Increase (Decrease) in Other Liabilities (3,746) 1,342 Net Cash Provided By Operating Activities 298 7,964 Investing Activities: Proceeds from the Sale of Securities Available-for-Sale --- 31,151 Proceeds from the Maturities and Calls of Securities Available-for-Sale 54,437 17,406 Purchases of Securities Available-for-Sale (20,733) (48,832) Proceeds from the Maturities and Calls of Securities Held-to-Maturity 1,724 1,111 Purchases of Securities Held-to-Maturity (9,666) (7,975) Net Increase in Loans and Leases (28,527) (13,346) Proceeds from the Sales of Fixed Assets and Other Real Estate Owned 103 8 Purchase of Fixed Assets (297) (200) Net Cash Used In Investing Activities (2,959) (20,677) Financing Activities: Net Increase (Decrease) in Deposits 2,680 (5,644) Net Increase in Short-Term Borrowings 3,289 3,195 Federal Loan Home Bank Advances --- 15,000 Purchase of Treasury Stock (1,169) --- Exercise of Stock Options 38 60 Disqualifying Disposition of Incentive Stock Options 65 31 Acquisition of Common Stock by ESOP (255) --- Cash Dividends Paid (1,365) (1,211) Net Cash Provided By Financing Activities 3,283 11,431 Net Increase (Decrease) in Cash and Cash Equivalents 622 (1,282) Cash and Cash Equivalents at Beginning of Period 30,746 46,909 Cash and Cash Equivalents at End of Period $31,368 $45,627 Supplemental Cash Flow Information: Interest Paid $ 6,895 $ 6,736 Income Taxes Paid 4,671 152 Transfer of Loans to Other Real Estate Owned and Repossessed Assets 60 71 Transfer of Securities from Held-to-Maturity to Available-for-Sale upon Adoption of SFAS No. 133 at Amortized Cost (Fair Value of $20,736) 20,559 --- See Notes to Consolidated Interim Financial Statements. </TABLE> ARROW FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS FORM 10-Q MARCH 31, 1999 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 March 31, 1999 and December 31, 1998; the results of operations for the three month periods ended March 31, 1999 and March 31, 1998; the statements of changes in shareholders' equity for the three month periods ended March 31, 1999 and 1998; and the statements of cash flows for the three month periods ended March 31, 1999 and March 31, 1998. All such adjustments are of a normal recurring nature. Certain items have been reclassified to conform to the 1999 presentation. Share and per share amounts have been restated to reflect the 1998 ten percent stock dividend. The consolidated interim financial statements should be read in conjunction with the annual consolidated financial statements of the Company on Form 10-K for the year ended December 31, 1998. 2. Accumulated Other Comprehensive Income (In Thousands) The following table presents the components, net of tax, of accumulated other comprehensive income as of March 31, 1999 and December 31, 1998: <TABLE> <CAPTION> 1999 1998 <S> <C> <C> Excess of Additional Pension Liability Over Unrecognized Prior Service Cost $(44) $(44) Net Unrealized Holding Gains on Securities Available-for-Sale 67 623 Total Accumulated Other Comprehensive Income $ 23 $579 </TABLE> 3. 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. The Company chose to adopt SFAS No. 133 in the first quarter of 1999. At the time of adoption, the Company elected to reclassify certain securities previously classified as held-to-maturity as available-for-sale, as allowed under SFAS No. 133. The net unrealized holding gains on the securities transferred of $177 thousand (pre-tax) was recorded as a transition adjustment in accumulated other comprehensive income. The Company has no derivative instruments or derivative instruments embedded in other contracts. 4. 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 month periods ended March 31, 1999 and 1998. Shares outstanding have been restated for the 1998 ten percent stock dividend. <TABLE> <CAPTION> Income Shares Per Share (Numerator) ( Denominator) Amount <S> <C> <C> <C> For the Three Months Ended March 31, 1999: Basic EPS: Income Available to Common Shareholders $3,088 $6,213 $.50 Dilutive Effect of Stock Options --- 85 Diluted EPS: Income Available to Common Shareholders and Assumed Conversions $3,088 6,298 $.49 For the Three Months Ended March 31, 1998: Basic EPS: Income Available to Common Shareholders $2,903 6,340 $.46 Dilutive Effect of Stock Options --- 103 Diluted EPS: Income Available to Common Shareholders and Assumed Conversions $2,903 6,443 $.45 /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 March 31, 1999, and the related consolidated statements of income, changes in shareholders' equity and cash flows for the three-month periods ended March 31, 1999 and 1998. 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, 1998, 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 22, 1999, 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, 1998, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived. /s/ KPMG LLP Albany, New York April 16, 1999
Item 2. ARROW FINANCIAL CORPORATION AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS MARCH 31, 1999 Cautionary Statement under Federal Securities Laws: The information contained in this Quarterly Report on Form 10-Q contains statements that are not historical in nature but rather are based on management's beliefs, assumptions, expectations, estimates and projections about the future. These statements are "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and involve a degree of uncertainty and attendant risk. 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, are merely presentations of what future performance may look like based on hypothetical assumptions and on simulation models. Other forward-looking statements, such as those 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, prevailing levels of competition, emerging technologies and the Company's ability to adapt thereto, 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. This quarterly report should be read in conjunction with the Company's Annual Report on Form 10-K for December 31, 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. Peer Group Comparisons: At certain points in the ensuing discussion and analysis, the Company's performance is compared with that of its peer group of financial institutions. Peer data has been obtained from the Federal Reserve Board's "Bank Holding Company Performance Reports." The Company's peer group is comprised of bank holding companies with $500 million to $1 billion in total consolidated assets. <TABLE> <CAPTION> OVERVIEW Selected Quarterly Information: (Dollars In Thousands, Except Per Share Amounts) Mar 1999 Dec 1998 Sep 1998 Jun 1998 Mar 1998 <S> <C> <C> <C> <C> <C> Net Income $3,088 $3,166 $2,906 $2,860 $2,903 Net Securities Gains, Net of Tax --- 143 --- 5 93 Diluted Earnings Per Share .49 .50 .45 .44 .45 Diluted Earnings Per Share, Based on Core Net Income 1 .49 .48 .45 .44 .44 Diluted Earnings Per Share, Cash Basis 2 .51 .52 .48 .47 .47 Return on Average Assets 1.34% 1.38% 1.31% 1.33% 1.42% Return on Average Equity 16.17 16.23 15.02 15.09 15.71 Net Interest Margin 3 4.40 4.31 4.28 4.48 4.56 Efficiency Ratio 4 53.90 54.66 56.62 55.15 54.31 Total Average Assets $933,158 $912,301 $882,312 $865,983 $831,495 Tier 1 Leverage Ratio 6.95% 7.10% 7.23% 7.32% 7.51% Book Value per Share $12.46 $12.39 $12.39 $12.09 $11.90 Tangible Book Value per Share 10.42 10.32 10.32 9.97 9.75 1 Core Net Income excludes one time material nonrecurring income, expenses and gains/losses on securities transactions. 2 Cash Earnings Per Share adds back to Core Net Income the amortization, net of tax, of goodwill associated with branch transactions. 3 Net Interest Margin is the ratio of tax-equivalent net interest income to average earning assets. 4 The Efficiency Ratio is the ratio of core noninterest expense to the sum of tax-equivalent core net interest income and core noninterest income. </TABLE> The Company reported earnings of $3.1 million for the first quarter of 1999, an $185 thousand increase, or 6.4%, over the first quarter of 1998. Diluted earnings per share were $.49 and $.45 for the two respective periods. The returns on average assets were 1.34% and 1.42% for the first quarter of 1999 and 1998, respectively. The returns on average equity were 16.17% and 15.71% for the first quarter of 1999 and 1998, respectively. Total assets were $941 million at March 31, 1999, which represented an increase of $2.2 million, or 0.2%, from December 31, 1998, and an increase of $94.2 million, or 11.1%, above the level at March 31, 1998. On the asset side of the balance sheet, the Company experienced strong internal growth in the loan portfolio from March 31, 1998 to March 31, 1999 as total loans increased 15.7%. The largest source of net new funds was internally generated deposits which increased by $60 million during the twelve month period. The Company also borrowed $30 million in long-term advances from the Federal Loan Home Bank ("FHLB") during the period. Shareholders' equity decreased $44 thousand during the first three months of 1999, as net income of $3.1 million was offset by cash dividends of $1.4 million, common stock repurchases of $1.2 million and net unrealized securities losses of $556 thousand. 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. <TABLE> <CAPTION> CHANGE IN FINANCIAL CONDITION Summary of Consolidated Balance Sheets (Dollars in Thousands) $ Change $ Change % Change % Change Mar 1999 Dec 1998 Mar 1998 From Dec From Mar From Dec From Mar <S> <C> <C> <C> <C> <C> <C> <C> Federal Funds Sold $ 12,400 $ 6,500 $ 18,700 $ 5,900 $(6,300) 47.6% (33.7)% Securities Available for Sale 252,108 267,731 221,959 (15,623) 30,149 (6.2) 13.6 Securities Held to Maturity 52,023 63,016 50,848 (10,993) 1,175 (21.1) 2.3 Loans, Net of Unearned Income1 573,918 546,126 495,962 27,792 77,956 4.8 15.7 Allowance for Loan Losses 6,957 6,742 6,375 215 582 3.1 9.1 Earning Assets1 890,449 883,373 787,469 7,076 102,980 0.8 13.1 Total Assets 941,268 939,029 847,075 2,239 94,193 0.2 11.1 Demand Deposits $ 94,620 $101,860 $ 90,202 $ (7,240) $ 4,418 (7.7) 4.9 Regular, N.O.W. & Money Market Savings Accounts 343,929 355,002 326,380 (11,073) 17,549 (3.2) 5.4 Time Deposits of $100,000 or More 143,673 123,039 105,425 20,634 38,248 14.4 36.3 Other Time Deposits 196,055 195,696 193,264 359 2,791 0.2 1.4 Total Deposits $778,277 $775,597 $715,271 $ 2,680 $ 63,006 0.3 8.8 Short-Term Borrowings $ 27,321 $ 24,032 $ 27,950 $3,289 $ (629) 12.0 2.3 Federal Home Loan Bank Advances 45,000 45,000 15,000 --- 30,000 --- --- Shareholders' Equity 77,102 77,146 75,489 (44) 1,613 (0.1) 2.1 1 Includes Nonaccrual Loans </TABLE> Total assets were $941 million at March 31, 1999, which represented an increase of $2.2 million, or 0.2%, from December 31, 1998, and an increase of $94.2 million, or 11.1%, above the level at March 31, 1998. Total loans at March 31, 1999 amounted to $574 million, an increase of $28 million, or 4.8%, from December 31, 1998, and an increase of $78 million, or 15.7%, from March 31, 1998. The increase from March 31, 1998 was primarily attributable to the growth within the indirect and residential real estate portfolios. Indirect consumer loans are principally auto loans financed through local dealerships where the Company acquires the dealer paper. Total deposits of $778 million at March 31, 1999 were virtually unchanged from the December 31, 1998 level. Total deposits at March 31, 1999 represented an increase of $63 million, or 8.8%, from March 31, 1998. While the Company experienced growth in all types of deposit accounts from March 31, 1998 to March 31, 1999, over half of the year-to-year increase was attributable to time deposits of $100,000 or more, primarily from municipalities in the Company's market area. Shareholders' equity decreased $44 thousand during the first three months of 1999, as net income of $3.1 million was offset by cash dividends of $1.4 million, common stock repurchases of $1.2 million and net unrealized securities losses of $556 thousand. Shareholders' equity was also influenced by the exercise of incentive stock options by employees and the loan amounts borrowed and/or repaid during the period by the Company's leveraged ESOP. Current period changes in shareholders' equity are presented in the Consolidated Statements of Changes in Shareholders' Equity. The Company paid a $.22 cash dividend per share for the past two quarters, which followed dividends of $.21 and $.19 for the prior two quarters. The Company recently announced a $.22 dividend for the second quarter of 1999. 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 balances by deposit type and the relative proportion of each deposit type for each of the last five quarters. <TABLE> <CAPTION> Quarterly Average Deposit Balances (Dollars in Thousands) Mar 1999 Dec 1998 Sep 1998 Jun 1998 Mar 1998 Amount % Amount % Amount % Amount % Amount % <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> Demand Deposits $ 97,809 13 $ 98,254 13 $101,053 14 $ 92,590 13 $ 92,584 13 Interest-Bearing Demand Deposits 187,791 24 182,290 24 165,547 22 170,394 23 166,494 23 Regular and Money Market Savings 162,029 21 160,347 21 167,066 22 161,009 22 158,997 22 Time Deposits of $100,000 or More 122,342 16 116,394 16 116,375 16 113,672 15 102,263 14 Other Time Deposits 196,656 26 196,642 26 195,567 26 193,865 27 195,039 28 Total Deposits $766,627 100 $753,927 100 $745,608 100 $731,530 100 $715,377 100 </TABLE> The Company typically experiences little net deposit growth in the first quarter of the year due to seasonality factors. Over the periods presented above, the Company experienced steady growth in virtually all categories of deposits, with proportionately slightly faster growth in time deposits of $100,000 or more, which was attributable to a significant increase in municipal deposits. Other time deposits remained virtually unchanged over the period, and in proportion to other categories of deposits declined somewhat. The deposit growth during the period was achieved through the Company's existing base of branches. The Company has announced plans to open two new branches later in the year, one each in the Glens Falls and Saratoga Springs market areas. <TABLE> <CAPTION> Quarterly Average Rate Paid on Deposits Mar 1999 Dec 1998 Sep 1998 Jun 1998 Mar 1998 <S> <C> <C> <C> <C> <C> Demand Deposits --- % --- % --- % --- % --- % Interest-Bearing Demand Deposits 2.62 2.79 2.83 2.92 2.99 Regular and Money Market Savings 2.23 2.35 2.68 2.71 2.75 Time Deposits of $100,000 or More 4.96 5.26 5.45 5.49 5.47 Other Time Deposits 5.21 5.36 5.40 5.52 5.57 Total Deposits 3.24 3.38 3.52 3.59 3.61 </TABLE> <TABLE> <CAPTION> Key Interest Rate Changes 1996 - 1999 Federal Discount Funds Prime Date Rate Rate Rate <S> <C> <C> <C> November 17, 1998 4.50% 4.75% 7.75% October 8, 1998 4.75 5.00 8.00 September 29, 1998 4.75 5.25 8.25 March 26, 1997 4.75 5.50 8.50 January 31, 1996 5.00 5.25 8.00 </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. In the last quarter of 1998, the Federal Reserve Board took actions resulting in three 25 basis point decreases in the federal funds and prime rates. Accordingly, the Company experienced a decrease in the cost of all deposit types during the past two quarters. In the recent past, other sources of short-term borrowings for the Company have included repurchase agreements (essentially a substitute deposit product) and tax deposit balances with the U.S. Treasury. Incrementally during 1998, the Company borrowed $45 million from the FHLB in the form of "convertible advances." These advances have a final maturity of 5 - 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. The following table presents the quarterly average balances by loan type and the relative proportion of each loan type for each of the last five quarters. <TABLE> <CAPTION> Quarterly Average Loan Balances (Dollars in Thousands) Mar 1999 Dec 1998 Sep 1998 Jun 1998 Mar 1998 Amount % Amount % Amount % Amount % Amount % <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> Commercial and Commercial Real Estate $105,353 19 $ 99,718 18 $ 98,177 19 103,805 21 $102,983 21 Residential Real Estate 189,293 34 181,211 34 173,598 33 162,071 32 151,417 31 Home Equity 31,787 5 32,782 6 33,474 7 35,331 7 36,593 7 Indirect Consumer Loans 183,792 33 172,921 32 161,508 31 151,603 30 143,495 29 Direct Consumer Loans 42,886 8 46,033 9 46,253 9 46,495 9 49,084 10 Credit Card Loans 6,691 1 6,841 1 6,855 1 7,138 1 7,413 2 Total Loans $559,802 100 $539,506 100 $519,865 100 $506,443 100 $490,985 100 </TABLE> Total average loans increased at a steady pace over the five most recent quarters. While all categories of loans, except for credit card loans, experienced absolute increases, indirect consumer loans demonstrated the most significant increase. 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 29% in the first quarter of 1998 to 32% in the first quarter of 1999. The Company also experienced strong demand for residential real estate loans, which grew both in the total dollar amount outstanding and as a percentage of the total loan portfolio. Commercial and commercial real estate loans decreased as a percentage of the total loan portfolio, from 21% in the first quarter of 1998 to 19% in the first quarter of 1999, and also decreased in absolute terms over the last three quarters of 1998 before rebounding in the first quarter of 1999 to a level slightly above the year-earlier level. The Company believes this trend, away from commercial and commercial real estate loans, is likely to continue in forthcoming periods, although pronounced fluctuations in portfolio emphasis are not anticipated. <TABLE> <CAPTION> Quarterly Taxable Equivalent Yield on Loans Mar 1999 Dec 1998 Sep 1998 Jun 1998 Mar 1998 <S> <C> <C> <C> <C> <C> Commercial and Commercial Real Estate 8.94% 9.22% 9.50% 10.24% 9.60% Residential Real Estate 7.70 7.77 7.86 8.13 8.34 Home Equity 8.45 8.78 9.00 9.10 9.07 Indirect Consumer Loans 7.88 8.11 8.13 8.16 8.17 Direct Consumer Loans 9.03 8.72 8.55 9.00 9.18 Credit Card Loans 15.70 15.02 15.51 16.34 16.41 Total Loans 8.23 8.38 8.51 8.83 8.82 </TABLE> As reflected in the arverage rate paid on deposits analysis earlier, the yield on the loan portfolio is affected by changes in market rates. Many of the loans in the commercial portfolio have variable rates tied to prime or U.S. treasury indices. Additionally, there is a significant amount of cash flow from normal amortization and prepayments in all loan categories, which reprices at current rates as new loans are generated. The yield on residential real estate loans is impacted by the high volume of new loans coming into the portfolio at lower rates than the existing loans. As a result of the Federal Reserve Board's actions in the fall of 1998, precipitating a 75 basis point decrease in the federal funds and prime rates, the Company experienced a general decrease in the yields on the loan portfolio, similar to the general decrease in rates in the deposit portfolio. The increased yield for commercial and commercial real estate loans for the second quarter of 1998 (10.24%) was the result of a full payoff on a large nonaccrual loan in that period, otherwise, the yield for that period would have been 9.46%.
The following table presents information related to the Company's allowance and provision for loan losses for the past five quarters. The provision for loan losses and net charge-offs are reported on a year-to-date basis, and are annualized for the purpose of calculating the ratio of each to average loans for each of the periods presented. <TABLE> <CAPTION> Summary of the Allowance and Provision for Loan Losses (Dollars in Thousands)(Loans Stated Net of Unearned Income) Mar 1999 Dec 1998 Sep 1998 Jun 1998 Mar 1998 <S> <C> <C> <C> <C> <C> Loan Balances: Period-End Loans $573,918 $546,126 $527,286 $512,984 $495,962 Average Loans, Year-to-Date 559,802 514,348 505,870 498,757 490,985 Allowance for Loan Losses: Allowance for Loan Losses, Beginning of Period $ 6,742 $ 6,191 $ 6,191 $ 6,191 $ 6,191 Provision for Loan Losses, Y-T-D 364 1,386 1,026 684 342 Net Charge-offs, Y-T-D (149) (835) (569) (407) (158) Allowance for Loan Losses, End of Period $ 6,957 $ 6,742 $ 6,648 $ 6,468 $ 6,375 Nonperforming Assets: Nonaccrual Loans $2,512 $2,270 $2,196 $ 2,367 $ 3,615 Loans Past due 90 Days or More and Still Accruing Interest 96 657 415 360 242 Loans Restructured and in Compliance with Modified Terms --- --- --- --- --- Total Nonperforming Loans 2,608 2,927 2,611 2,727 3,857 Repossessed Assets 38 38 12 31 64 Other Real Estate Owned 606 627 606 496 386 Total Nonperforming Assets $3,252 $3,592 $3,230 $ 3,254 $ 4,307 Performance Ratios: Allowance to Nonperforming Loans 266.76% 230.32% 254.62% 237.18% 165.28% Allowance to Period-End Loans 1.21 1.23 1.26 1.26 1.29 Provision to Average Loans (annualized) 0.26 0.27 0.27 0.28 0.28 Net Charge-offs to Average Loans (annualized) 0.11 0.16 0.15 0.16 0.13 Nonperforming Assets to Loans, OREO & Repossessed Assets 0.57 0.66 0.61 0.63 0.87 </TABLE> The Company's nonperforming assets at March 31, 1999 amounted to $3.3 million, a decrease of $340 thousand, or 9.5%, from December 31, 1998. At period-end, nonperforming assets represented .57% of loans, other real estate owned and repossessed assets, a decrease of 9 basis points from year-end 1998 and 30 basis points from the year-earlier level. At December 31, 1998, this ratio for the Company's peer group was .98%. On an annualized basis, the ratio of the 1998 first quarter net charge-offs to average loans was .11%, two basis points lower than the annualized ratio of net charge-offs to average loans in the comparable 1998 period of .13%. The provision for loan losses was $364 thousand for the first quarter of 1999, compared to a provision of $342 thousand for the first quarter of 1998. The provision as a percentage of average loans was .26% for the first quarter of 1999, or 15 basis points higher than net charge-offs for the period. The increase in the provision for loan losses from $342 thousand in first quarter of 1998 to $364 thousand for the first quarter of 1999 was consistent with the general increase in the loan portfolio. The allowance for loan losses at March 31, 1999 amounted to $7.0 million. The ratio of the allowance to outstanding loans at March 31, 1999, was 1.21%, slightly lower than the ratio at December 31, 1998.
CAPITAL RESOURCES Shareholders' equity decreased $44 thousand during the first three months of 1999, as net income of $3.1 million was offset by cash dividends of $1.4 million, common stock repurchases of $1.2 million and net unrealized securities losses of $556 thousand. Shareholders' equity was also influenced by the exercise of incentive stock options by employees and the loan amounts borrowed and/or repaid during the period by the Company's leveraged ESOP. Current period changes in shareholders' equity are presented in the Consolidated Statements of Changes in Shareholders' Equity. 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 loan losses. The leverage ratio test establishes minimum limits on the ratio of Tier 1 capital to total 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. 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 five levels of capitalization for financial institutions ranging from "critically undercapitalized" to "well-capitalized." As of March 31, 1999, 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 Risk-Based Risk-Based Leverage Capital Capital Ratio Ratio Ratio <S> <C> <C> <C> Arrow Financial Corporation 7.01% 11.40% 12.63% Glens Falls National Bank & Trust Co. 7.17 12.31 13.56 Saratoga National Bank & Trust Co. 7.33 8.59 13.25 Regulatory Minimum 3.00 4.00 8.00 FDICIA's "Well-Capitalized" Standard 5.00 6.00 10.00 </TABLE> All capital ratios for the Company and its subsidiary banks at March 31, 1999 were above minimum capital standards for financial institutions. Additionally, all Company and subsidiary banks' capital ratios at that date were above FDICIA's "well-capitalized" standard. The Company's common stock is traded on The Nasdaq Stock MarketSM under the symbol AROW. The high and low prices listed below represent actual sales transactions, as reported by Nasdaq, rounded to the nearest 1/8 point. Per share amounts and market prices have been adjusted for the 1998 ten percent stock dividend. On April 16, 1999, the Company announced the 1999 second quarter dividend of $.22 payable on June 15, 1999. <TABLE> <CAPTION> Quarterly Per Share Stock Prices and Dividends Cash (Restated for Stock Dividends) Sales Price Dividends High Low Declared <S> <C> <C> <C> 1998 1st Quarter $31.250 $26.875 $.19 2nd Quarter 32.750 27.755 .19 3rd Quarter 32.750 24.000 .21 4th Quarter 29.125 24.500 .22 1999 1st Quarter $29.000 $25.750 $.22 2nd Quarter n/a n/a .22 </TABLE> <TABLE> <CAPTION> 1999 1998 <S> <C> <C> First Quarter Earnings Per Share, Based on Core Net Income $.49 $.44 Dividend Payout Ratio: (Second quarter dividends as a percent of first quarter core diluted earnings per share) 44.90% 43.18% Book Value Per Share $12.46 $11.90 Tangible Book Value Per Share 10.42 9.75 </TABLE> 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. 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. 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. Other than the general concerns relating to the Year 2000 issue discussed later in this report in the section entitled "Year 2000 Readiness Disclosures," 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 March 31, 1999 Compared With Three Months Ended March 31, 1998 <TABLE> <CAPTION> Summary of Earnings Performance (Dollars in Thousands) Mar 1999 Mar 1998 Change % Change <S> <C> <C> <C> <C> Net Income $3,088 $2,903 $ 185 6.4 % Diluted Earnings Per Share .49 .45 0.04 8.9 Return on Assets 1.34% 1.42% (0.07)% (5.2) Return on Equity 16.17% 15.71% 0.46% 2.9 </TABLE> The Company reported earnings of $3.1 million for the first quarter of 1999, an increase of $185 thousand, or 6.4%, above the total for the 1998 quarter. Diluted earnings per share of $.49 for 1999 represented 8.9% increase of 10.0% over the $.45 per share ($.44 on a core earnings basis) for the 1998 quarter. Earnings in the 1998 period included, on an after tax basis, $93 of net securities gains. There were no securities sales in the 1999 period. On a core earnings basis, diluted earnings per share increased 11.4% from 1998 to 1999. Net Interest Income <TABLE> <CAPTION> Summary of Net Interest Income (Taxable Equivalent Basis) (Dollars in Thousands) Mar 1999 Mar 1998 Change % Change <S> <C> <C> <C> <C> Interest and Dividend Income $ 16,485 $ 15,411 $ 1,074 7.0% Interest Expense 6,955 6,702 253 3.8 Net Interest Income $ 9,530 $ 8,709 $ 821 8.4 Taxable Equivalent Adjustment 317 257 60 23.3 Average Earning Assets 1 $878,722 $775,282 $103,440 13.3 % Average Paying Liabilities 740,088 650,561 89,827 13.8 Yield on Earning Assets1 7.61% 8.06% (0.45)% (5.6)% Cost of Paying Liabilities 3.81 4.18 (0.37) (8.8) Net Interest Spread 3.80 3.88 (0.08) (2.2) Net Interest Margin 4.40 4.56 (0.16) (3.4) 1Includes Nonaccrual Loans </TABLE> The Company's net interest margin (net interest income on a tax-equivalent basis divided by average earning assets, annualized) decreased by 16 basis points from the first quarter of 1998 to the first quarter of 1999. With interest rates already at low levels in the beginning of 1998, the Company, along with other financial institutions, was not able to reduce its cost of funds during 1998 by the same absolute amount by which its yield on earning assets declined during the year, and this trend has continued in the first quarter of 1999. The provision for loan losses was $364 thousand and $342 thousand for the quarters ended March 31, 1999 and 1998, respectively. The provision for loan losses was discussed previously under the heading "Summary of the Allowance and Provision for Loan Losses." Other Income <TABLE> <CAPTION> Summary of Other Income (Dollars in Thousands) Mar 1999 Mar 1998 $ Change % Change <S> <C> <C> <C> <C> Income From Fiduciary Activities $ 799 $ 761 $ 38 5.0% Fees for Other Services to Customers 1,019 957 62 6.5 Net Gains on Securities Transactions --- 157 (157) --- Other Operating Income 226 232 (6) (2.6) Total Other Income $2,044 $2,107 $ (63) (3.0) Total Other Income, Without Securities Transactions $2,044 $1,950 $ 94 4.8 </TABLE> Other income for the first quarter of 1998 included $157 thousand of net securities gains. There were no securities sales in the 1999 period. Without regard to securities transactions, total other income for 1999 increased $94 thousand, or 4.8%, from 1998. Trust income totaled $799 thousand for the first quarter of 1999, an increase of $38 thousand, or 5.0%, from the first quarter of 1998. Trust assets under administration at March 31, 1999 amounted to $629 million, an increase of $39 million, or 6.6%, from March 31, 1998. Fees for other services to customers (primarily service charges on deposit accounts, credit card merchant fee income and servicing income on sold loans) was $1.0 million for the first quarter of 1999, an increase of $62 thousand, or 6.5%, from the 1998 first quarter. The increase was primarily attributable to growth in the number of transaction deposit accounts and the related service charges on those accounts. 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 $226 thousand, a decrease of $6 thousand, or 2.6%, from the first quarter of 1998. The period-to-period decrease was attributable to normal fluctuations in this type of income. During the first quarter of 1998, on the sale of $31.2 million of securities from the available-for-sale portfolio, the Company recognized $162 thousand in gains, offset in part by $5 thousand of securities losses. The securities were sold for the primary purpose of extending the average maturity on the portfolio. Other Expense <TABLE> <CAPTION> Summary of Other Expense (Dollars in Thousands) Mar 1999 Mar 1998 $ Change % Change <S> <C> <C> <C> <C> Salaries and Employee Benefits $3,688 $3,259 $ 429 13.2% Occupancy Expense of Premises, Net 469 419 50 11.9 Furniture and Equipment Expense 579 551 28 5.1 Other Operating Expense 1,729 1,560 169 10.8 Total Other Expense $6,465 $5,789 $ 676 11.7 Efficiency Ratio 53.90% 52.10% 1.80% 3.5% </TABLE> Other expense for the first quarter of 1999 was $6.5 million, an increase of $676 thousand, or 11.7%, over the expense for the first quarter of 1998. For the quarter ended March 31, 1999, the Company's efficiency ratio was 53.90%. The efficiency ratio is calculated as 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 comparative measure of a financial institution's operating efficiency. At December 31, 1998, the ratio for the Company's peer group was 61.17%. Salaries and employee benefits expense increased $429 thousand, or 13.2%, from the first quarter of 1998 to the first quarter of 1999. This increase was attributable to normal salary increases and the addition of staff, primarily in sales positions. On an annualized basis, total personnel expense to average assets was 1.60% for the first quarter of 1999. At December 31, 1998, the ratio for the Company's peer group was 1.70%. Occupancy expense was $469 thousand for the first quarter of 1999, a $50 thousand increase, or 11.9%, over the first quarter of 1998. The increase was primarily attributable to increased depreciation associated with branch renovations. Furniture and equipment expense was $579 thousand for the first quarter of 1999, a $28 thousand increase, or 5.1%, over the first quarter of 1998, attributable to the upgrading of computer equipment as part of the Year 2000 Readiness program. Other operating expense was $1.7 million for the first quarter of 1999, an increase of $169 thousand, or 10.8%, from the first quarter of 1998. The largest increase was attributable to marketing expenses, primarily in the areas served by the six branches acquired from Fleet Bank in June of 1997 in northeastern New York. Income Taxes <TABLE> <CAPTION> Summary of Income Taxes (Dollars in Thousands) Mar 1999 Mar 1998 Change <S> <C> <C> <C> Provision for Income Taxes $ 1,340 $1,525 $ (185) Effective Tax Rate 30.26% 34.44% 4.18 % </TABLE> The provision for federal and state income taxes amounted to $1.3 million and $1.5 million for the first quarter of 1999 and 1998, respectively. The Company experienced a decrease in the effective tax rate which was attributable to the effects of certain tax planning strategies implemented in prior years and the additional benefit from the increase in tax exempt securities from 1998 to 1999. YEAR 2000 READINESS DISCLOSURE 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., "99" for "1999"). 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, which includes members of senior management, 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 other senior officers 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 March 31, 1999, the Company had completed the Awareness, Assessment, Renovation and Validation phases. The first two of 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 consisted of replacing or updating certain mission critical systems or components thereof with a view to preventing or minimizing any Y2K related problems. The Renovation phase for all internal mission critical systems was completed prior to year-end 1998. As part of the Renovation phase, the Company accelerated, and had completed, the installation of a major upgrade to its central computer processing system, which had originally been scheduled for implementation in 1999. Acceleration of the upgrade 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 March 31, 1999, the Company had completed the Validation (testing) phase of the Plan with respect to those mission critical systems that are operated by the Company internally. Moreover, the Validation (testing) phase with respect to mission critical systems furnished to the Company by third party providers was also completed by 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 the remainder of 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 part of the Company's on-going review of major loan accounts. The Company also has contacted and reviewed the state of Y2K 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 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, such as the Companies that rely on them. The Company will also continue to monitor Y2K readiness 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 timetable 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 March 31, 1999 and target dates for completion of remaining phases. <TABLE> <CAPTION> Internal System External Systems Third Parties Not Not Percent Mission Critical Mission Critical Mission Critical Mission Critical Loan Funds Complete IT NonIT IT NonIT IT NonIT* IT NonIT* Customers Providers <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> Awareness 100% 9/30/98 9/30/98 9/30/98 9/30/98 9/30/98 9/30/98 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 9/30/98 9/30/98 9/30/98 9/30/98 9/30/98 9/30/98 Renovation 100% 12/31/98 9/30/98 12/31/98 9/30/98 12/31/98 12/31/98 12/31/98 12/31/98 N/A N/A Validation 100% 12/31/98 9/30/98 3/31/99 3/31/99 3/31/99 3/31/99 N/A N/A N/A N/A Implementation 80% 6/30/99 6/30/99 12/31/99 12/31/99 6/30/99 6/30/99 12/31/99 12/31/99 12/31/99 12/31/99 * External Non-IT systems are generally described as product vendors. </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 March 31, 1999, were approximately $348 thousand, 59% of which represented the expenditures related to upgrading the Company's central computer processing systems , a project that would have been required even without the Y2K problem, and that had already been budgeted albeit for a later time period (i.e. 1999). 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 89% for hardware and 11% 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 complete all material aspects of its Plan or to complete them on time 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 may 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. In summary, 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 time frame. The Company may 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 external 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 detailed information on their Y2K readiness and the inability of some vendors to verify with any high degree of reliability the Y2K preparedness of their own systems or their sub-providers. However, the Company participates in user groups that include some of its third party vendors, and receives assessments of Y2K preparedness of vendors periodically from federal banking agencies. The Company's Plan also includes protocols for interface testing with third party vendor systems. In summary, the Company does not currently anticipate that its significant third party vendors will experience material failures in their ability to provide continuing service to the Company due to the Year 2000 Problem, but is unable to warrant this. 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, although not a likely occurance, nevertheless 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 finalizing an overall contingency strategy with specific contingency plans for each core business process, assigning responsibilities and trigger dates for each contingency plan, and validating the plans. These activities were completed during the first quarter of 1999. Certain catastrophic events (such as the protracted loss of essential 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 other local providers of financial services, community leaders and service organizations. Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK In addition to the credit risk in the Company's loan portfolio and its 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 market 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. At March 31, 1999, the results of the sensitivity analyses were within the parameters established by the Company's ALCO Policy. 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 At the Company's Annual Meeting of Shareholders held April 14, 1999, shareholders elected the following directors to serve terms expiring in 2002. The voting results were as follows: <TABLE> <CAPTION> Withhold Broker Director For Authority Non-Votes <S> <C> <C> <C> Michael B. Clarke 4,773,612 17,913 --- Kenneth C. Hopper, M.D. 4,766,734 24,791 --- Michael F. Massiano 4,771,760 19,765 --- </TABLE> Item 5. Other Information - None Item 6. Exhibits and Reports on Form 8-K Exhibit 27 - Financial Data Schedule (Submitted with electronic filing only) No Current Reports were filed on Form 8-K during the quarter ended March 31, 1999. 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: May 13, 1999 s/Thomas L. Hoy Thomas L. Hoy, President and Chief Executive Officer Date: May 13, 1999 s/John J. Murphy John J. Murphy, Executive Vice President, Treasurer and CFO (Principal Financial Officer and Principal Accounting Officer)