UNITED STATES
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
COMMERCE BANCSHARES, INC.
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:
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 such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes X No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.o
Indicate by checkmark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act.)þ
As of February 7, 2003, the aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $2,073,000,000.
As of February 7, 2003, there were 66,855,683 shares of Registrant’s $5 Par Value Common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the definitive proxy statement with respect to the annual meeting of shareholders to be held on April 16, 2003, are incorporated in Part III.
TABLE OF CONTENTS
Commerce Bancshares, Inc.
Form 10-K
General
Commerce Bancshares, Inc. (the “Company”), a bank holding company as defined in the Bank Holding Company Act of 1956, as amended, was incorporated under the laws of Missouri on August 4, 1966. The Company presently owns all of the outstanding capital stock of four national banking associations, which are headquartered in Missouri, Illinois, Kansas, and Nebraska. The Nebraska bank is limited in its activities to the issuance of credit cards. The remaining three banking subsidiaries engage in general banking business, providing a broad range of retail, corporate, investment and private banking products and services to individuals and businesses. The Company also owns, directly or through its banking subsidiaries, various non-banking subsidiaries. Their activities include owning real estate leased to the Company’s banking subsidiaries, underwriting credit life and credit accident and health insurance, selling property and casualty insurance (relating to consumer loans made by the banking subsidiaries), venture capital investment, securities brokerage, mortgage banking, and leasing activities. The Company owns two second tier holding companies that are the direct owners of several of the above mentioned banks. The table setting forth the names and locations of the Company’s subsidiaries is included as Exhibit 21 hereto.
The Company is the largest bank holding company headquartered in Missouri. At December 31, 2002, the Company had consolidated assets of $13.3 billion, loans of $7.9 billion, deposits of $9.9 billion, and equity of $1.4 billion. Its principal offices are located at 1000 Walnut, Kansas City, Missouri (telephone number 816-234-2000). The Company makes available free of charge, through its web site at www.commercebank.com, reports filed with the Securities and Exchange Commission as soon as reasonably practicable after the electronic filing. These filings include the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports.
The Company’s Missouri bank charter is its largest, with total assets of $11.2 billion and offices in both Missouri and Kansas. The Missouri bank charter comprises approximately 84% of the banking assets of the Company. The Company’s bank charters in Kansas and Illinois operate within each of the states and have total assets of $1.2 billion and $914 million, respectively. The Kansas banking charter has significant operations and banking facilities mainly in the areas of Wichita, Hays, and Garden City, Kansas, along with facilities in the southeast Kansas area. The Illinois banking charter operates mainly in the Peoria and Bloomington, Illinois, areas.
The markets these three banking charters serve, being centrally located in the Midwest, provide natural sites for production and distribution facilities and also serve as transportation hubs. The economy has been well-diversified with many major industries represented, including telecommunications, automobile manufacturing, aircraft manufacturing, numerous service industries, food production and agricultural production and related industries. The markets served by the Illinois bank are located in an area with some of the best land in the world for crop production. The three banking charters operate in areas with stable real estate markets, which in the past have avoided the volatile prices that other parts of the country have experienced.
The Company regularly evaluates the potential acquisition of, and holds discussions with, various financial institutions eligible for bank holding company ownership or control. In addition, the Company regularly considers the potential disposition of certain of its assets and branches. The Company acquired The Vaughn Group, Inc. (Vaughn), a Cincinnati-based leasing company, on January 2, 2003. Vaughn has a lease portfolio of approximately $39 million, consisting mainly of data processing hardware. In addition, Vaughn services approximately $425 million of lease agreements for other institutions involving capital equipment ranging from production machinery to transportation equipment. The Company’s most recent bank acquisition was in March 2001, when Breckenridge Bancshares Company and its subsidiary, Centennial Bank, were acquired. For additional information on these acquisitions and other branch disposition activity, refer to pages 8 and 46.
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Operating Segments
The Company is managed in three operating segments. The Consumer segment includes the retail branch network, consumer installment lending, bankcard, student lending, and discount brokerage services. It provides services through a network of 191 full-service branches, an extensive ATM network, and the use of alternative delivery channels such as PC Banking and telephone banking. In 2002, this segment contributed 48% of total segment pre-tax income. The Commercial segment provides a full array of corporate lending, leasing, and international services, as well as business, government deposit and cash management services. In 2002, it contributed 41% of total segment pre-tax income. The Money Management segment provides traditional trust and estate tax planning services, and advisory and discretionary investment portfolio management services. This segment also manages the Company’s family of proprietary mutual funds, which are available for sale to both trust and general retail customers. Fixed income investments are sold to individuals and institutional investors through the Capital Markets group, which is also included in this segment. At December 31, 2002, the Money Management segment managed investments with a market value of $9.3 billion and administered an additional $7.4 billion in non-managed assets. Additional information relating to operating segments can be found on pages 28 and 60.
Supervision and Regulation
The Company, as a bank holding company, is primarily regulated by the Board of Governors of the Federal Reserve System under the Bank Holding Company Act of 1956 (BHC Act). Under the BHC Act the Federal Reserve Board’s prior approval is required in any case the Company proposes to acquire all or substantially all of the assets of any bank, acquire direct or indirect ownership or control of more than 5% of the voting shares of any bank, or merge or consolidate with any other bank holding company. The BHC Act also prohibits, with certain exceptions, the Company from acquiring direct or indirect ownership or control of more than 5% of any class of voting shares of any nonbanking company. Under the BHC Act, the Company may not engage in any business other than managing and controlling banks or furnishing certain specified services to subsidiaries and may not acquire voting control of nonbanking companies unless the Federal Reserve Board determines such businesses and services to be closely related to banking. When reviewing bank acquisition applications for approval, the Federal Reserve Board considers, among other things, each subsidiary bank’s record in meeting the credit needs of the communities it serves in accordance with the Community Reinvestment Act of 1977, as amended (CRA). The Missouri, Kansas and Nebraska bank charters have current CRA ratings of “outstanding”, and the Illinois charter has a “satisfactory” rating.
The Company is required to file with the Federal Reserve Board various reports and such additional information as the Federal Reserve Board may require. The Federal Reserve Board also makes regular examinations of the Company and its subsidiaries. The Company’s four banking subsidiaries are organized as national banking associations and are subject to regulation, supervision and examination by the Office of the Comptroller of the Currency (OCC). All banks are also subject to regulation by the Federal Deposit Insurance Corporation. In addition, there are numerous other federal and state laws and regulations which control the activities of the Company and its banking subsidiaries, including requirements and limitations relating to capital and reserve requirements, permissible investments and lines of business, transactions with affiliates, loan limits, mergers and acquisitions, issuance of securities, dividend payments, and extensions of credit. This regulatory framework is intended primarily for the protection of depositors and the preservation of the federal deposit insurance funds, and not for the protection of security holders. Statutory and regulatory controls increase a bank holding company’s cost of doing business and limit the options of its management to employ assets and maximize income.
Under Federal Reserve policy, the Company is expected to act as a source of financial strength to each of its bank subsidiaries and to commit resources to support each bank subsidiary in circumstances when it might not otherwise do so. The Federal Reserve Board may prohibit the payment of dividends by bank holding companies if their actions constitute unsafe or unsound practices. The OCC limits the payment of dividends by bank subsidiaries in any calendar year to the net profit of the current year combined with the retained net profits of the preceding two years. The payment of dividends by the bank subsidiaries may
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These laws and regulations are under constant review by various agencies and legislatures, and are subject to sweeping change. The Gramm-Leach-Bliley Financial Modernization Act of 1999 (GLB Act) contained major changes in laws that previously kept the banking industry largely separate from the securities and insurance industries. The GLB Act authorized the creation of a new kind of financial institution, known as a “financial holding company” and a new kind of bank subsidiary called a “financial subsidiary”, which may engage in a broader range of investment banking, insurance agency, brokerage, and underwriting activities. The GLB Act also included privacy provisions that limit banks’ abilities to disclose non-public information about customers to non-affiliated entities. Banking organizations are not required to become financial holding companies, but instead may continue to operate as bank holding companies, providing the same services they were authorized to provide prior to the enactment of the GLB Act.
In addition to its regulatory powers, the Federal Reserve impacts the conditions under which the Company operates by its influence over the national supply of bank credit. The Federal Reserve Board employs open market operations in U.S. Government securities, changes in the discount rate on bank borrowings, changes in the federal funds rate on overnight inter-bank borrowings, and changes in reserve requirements on bank deposits in implementing its monetary policy objectives. These instruments are used in varying combinations to influence the overall level of the interest rates charged on loans and paid for deposits, the price of the dollar in foreign exchange markets and the level of inflation. The monetary policies of the Federal Reserve have had a significant effect on the operating results of financial institutions in the past, most notably the strong decrease in interest rates which occurred in 2001 and the low rate environment in 2002. In view of changing conditions in the national economy and in the money markets, as well as the effect of credit policies of monetary and fiscal authorities, no prediction can be made as to possible future changes in interest rates, deposit levels or loan demand, or their effect on the financial statements of the Company.
Competition
The Company’s locations in regional markets throughout Missouri, Kansas and central Illinois face intense competition from hundreds of financial service providers. The Company competes with national and state banks for deposits, loans and trust accounts, and with savings and loan associations and credit unions for deposits. In addition, the Company competes with other financial intermediaries such as securities brokers and dealers, personal loan companies, insurance companies, finance companies, and certain governmental agencies. The methods of competition center around various factors, such as customer services, interest rates on loans and deposits, lending limits and customer convenience, such as location of offices. The passage of the GLB Act, which removed barriers between banking and the securities and insurance industries, has resulted in greater competition among these industries.
Employees
The Company and its subsidiaries employed 4,437 persons on a full-time basis and 773 persons on a part-time basis at December 31, 2002. The Company provides a variety of benefit programs including retirement and stock ownership plans as well as group life, health, accident, and other insurance. The Company also maintains training and educational programs designed to prepare employees for positions of increasing responsibility.
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Statistical Disclosure
The information required by Securities Act Guide 3 – “Statistical Disclosure by Bank Holding Companies” is located on the pages noted below.
The Missouri, Illinois, and Kansas bank subsidiaries maintain their main offices in various multi-story office buildings. These are owned by the bank or a subsidiary of the bank. The banks lease unoccupied premises to the public. The buildings, located in the downtown areas of the major market they serve, include:
The Nebraska credit card bank leases its offices in Omaha, Nebraska. Additionally, certain other installment loan and credit card functions operate out of leased offices in downtown Kansas City. The Company also has 185 branch locations in Missouri, Illinois and Kansas which are owned or leased, and an additional 148 off-site ATM locations.
The information required by this item is set forth in Item 8 under the caption “Commitments and Contingencies” on page 67.
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No matters were submitted during the fourth quarter of 2002 to a vote of security holders through the solicitation of proxies or otherwise.
The following table sets forth the high and low prices of actual transactions for the Company’s common stock (CBSH) and cash dividends paid for the periods indicated (restated for the 5% stock dividend distributed in December 2002).
Commerce Bancshares, Inc. common shares are publicly traded on The Nasdaq Stock Market (NASDAQ). NASDAQ is a highly-regulated electronic securities market comprised of competing Market Makers whose trading is supported by a communications network linking them to quotation dissemination, trade reporting, and order execution systems. The Company had 5,081 shareholders of record as of December 31, 2002.
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The required information is set forth below in Item 7.
The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes. The historical trends reflected in the financial information presented below are not necessarily reflective of anticipated future results.
Key Ratios
Selected Financial Data
Results of Operations
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Commerce Bancshares, Inc. and Subsidiaries (the “Company”) announced record earnings in 2002 of $199.5 million, an increase of $17.5 million, or 9.6%, over last year. This was the eighteenth consecutive year of record earnings for the Company. Earnings per share on a fully diluted basis amounted to $2.89 in 2002 compared with $2.60 last year, or an increase of 11.2%. Return on assets amounted to 1.61% compared with 1.55% last year and the return on equity totaled 14.71% compared to 14.88% last year. The efficiency ratio was 57.94% in 2002 compared with 58.10% in 2001.
The increase in net income over the previous year resulted from strong growth in net interest income of $31.2 million, or 6.7%, coupled with lower credit costs and good expense management. Non-interest income increased a modest 2.0% while non-interest expense grew by 3.4%. The provision for loan losses totaled $34.1 million and was 6.4% less than amounts recorded in the prior year. Net interest income grew mainly as a result of the continued re-pricing of deposit products, especially certificates of deposit, and overall growth in earning assets. The growth in non-interest income occurred mainly as a result of deposit account fees (up 8.1%), credit card fees (up 6.0%) and higher fees earned on bond and brokerage fees, offset by lower trust fees. Non-interest expense grew a modest 3.4% mainly as a result of growth in salaries and benefits of 6.1%, occupancy of 8.1% and higher costs for equipment and marketing. Offsetting these were lower costs for data processing, supplies, and goodwill amortization.
Net income in 2001 was $182.0 million, which was a 1.9% increase compared to 2000. Diluted earnings per share was $2.60, an increase of 3.6% over 2000. The increase in net income over 2000 resulted from 7.6% growth in non-interest income and good control over non-interest expense. Net interest income declined 2.7% because of the slowing economy and strong interest rate reductions by the Federal Reserve. During 2001, the Federal Reserve reduced the federal funds target rate eleven times in an effort to stimulate a slowing economy. These actions had the related effect of reducing the prime rate from 9.5% in early January 2001 to 4.75% by year end. The rate reductions caused a significant portion of the Company’s earning assets to reprice downward faster than its interest bearing liabilities, resulting in lower net interest income. Non-interest income rose $19.4 million over 2000, mainly in the areas of deposit account charges, trust fees, and trading account profits. Non-interest expense increased $3.8 million, or .9%, and included a 7.0% increase in salaries and employee benefits. The provision for loan losses was $1.3 million higher than in the previous year mainly as a result of higher commercial loan losses.
Effective January 2003, the Company acquired The Vaughn Group, Inc. (Vaughn), a leasing company based in Cincinnati, Ohio. Vaughn is a direct lessor with a lease portfolio of approximately $39 million consisting mainly of data processing hardware. In addition, Vaughn services approximately $425 million of lease agreements for other institutions, which involve capital equipment, ranging from production machinery to transportation equipment. The Company issued a combination of cash and stock to complete this purchase.
In March 2001, the Company acquired Breckenridge Bancshares Company and its subsidiary, Centennial Bank. The bank had three locations in the St. Louis area, with assets of $254 million, loans of $189 million, and deposits of $216 million. Common stock valued at $34.4 million was issued by the Company as consideration in the transaction. The acquisition was accounted for as a pooling of interests transaction; however, the Company’s financial statements were not restated because restated amounts did not differ materially from historical results.
The Company continually evaluates its network of bank branches throughout Missouri, Kansas and Illinois. As a result, the Company sold two bank branches and a separate branch facility during 2002. Pre-tax gains of $2.4 million were realized on these sales. These locations had loans of $15.0 million, deposits of $38.4 million, and premises of $2.9 million. In 2001, the Company sold the assets and liabilities of one bank branch and the premises of two other branches. Pre-tax gains of $2.2 million were realized on the 2001 sales, which included loans of $662 thousand, deposits of $5.3 million, and premises of $714 thousand. During 2000, the Company sold four bank branches with $42.7 million in loans and $71.5 million in deposits. Pre-tax gains of $5.9 million were realized on the 2000 transactions.
During 2002, the Company’s investment in a venture capital limited partnership, previously accounted for on the equity method, was reclassified as a consolidated subsidiary. Financial statements for
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The Company distributed a 5% stock dividend for the ninth consecutive year on December 13, 2002. All per share and average share data in this report has been restated to reflect the 2002 stock dividend.
Critical Accounting Policies
Critical accounting policies are those which are both most important to the portrayal of the Company’s financial condition and results, and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. The Company’s critical accounting policies relate to the allowance for loan losses, the valuation of certain non-marketable investments, and accounting for income taxes, all of which involve significant judgment by management.
The Company performs periodic and systematic detailed reviews of its lending portfolio to assess overall collectability. The level of the allowance for loan losses reflects the Company’s estimate of the collectability of the loan portfolio. While these estimates are based on substantive methods for determining allowance requirements, nevertheless, actual outcomes may differ significantly from estimated results. Extensive explanation of the methodologies used in establishing this reserve is provided in the Allowance for Loan Losses section of this discussion.
The Company, through its Small Business Investment subsidiaries, has numerous private equity and venture capital investments, which totaled $25.5 million at December 31, 2002. These private equity and venture capital securities are reported at estimated fair values in the absence of readily ascertainable fair values. Management believes that the cost of an investment is initially the best indication of estimated fair value unless there has been significant subsequent positive or negative developments that justify an adjustment to the fair value estimate. The values assigned to these securities where no market quotations exist are based upon available information and management’s judgment. Although management believes its estimates of fair value reasonably and conservatively reflect the fair value of these securities, key assumptions regarding the projected financial performance of these companies, the evaluation of the investee company’s management team, and other economic and market factors may affect the amounts that will ultimately be realized from these investments.
The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in the Company’s financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences, including the effects of IRS examinations and examinations by other state agencies, could materially impact the Company’s financial position and its results of operations.
Net Interest Income
Net interest income, the largest source of revenue, results from the Company’s lending, investing, borrowing, and deposit gathering activities. It is affected by both changes in the level of interest rates and changes in the amounts and mix of interest earning assets and interest bearing liabilities. The following table summarizes the changes in net interest income on a fully taxable equivalent basis, by major category
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Net interest income was $500.0 million in 2002, $468.8 million in 2001 and $481.6 million in 2000. Compared to the prior year, net interest income increased $31.2 million, or 6.7%, in 2002 compared to a decrease of $12.9 million, or 2.7%, in 2001. During 2002, the Company’s net interest income grew mainly as a result of the continued re-pricing of deposit products, especially certificates of deposit, and overall growth in earning assets. During the first three quarters of 2002, the interest rate environment remained somewhat stable, allowing for modest downward re-pricing of the Company’s loan portfolio. In addition, during 2002 average investment securities increased $1.12 billion, which added approximately $66 million in additional interest income. Also during the year, interest costs on interest bearing liabilities declined by approximately $136 million as a result of the re-pricing of almost all deposit products. With interest rates stable through October 2002, most of the re-pricing came from the Company’s certificate of deposit products, although certain money market deposits also began to re-price downward in late summer. In November 2002, the Federal Reserve lowered short-term rates by 50 basis points, which reduced interest income on large portions of the Company’s loan portfolio that were variably priced. Rates on deposits were
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During 2001, a series of rate reductions by the Federal Reserve caused a significant portion of the Company’s earning assets to reprice downward. Most of these earning assets were loans, whose interest rates are tied to variable rate indices or the federal funds rate. While these rate reductions also allowed the deposit base to re-price downward, the overall decline in deposit rates was not enough to offset the effects of the change in asset rates. The net effect of the rate declines was to lower 2001 net interest income by $22.5 million. The changes in the economy also had an impact on growth in both earning assets and liabilities. Compared to 2000, average deposit balances increased 5.9% during 2001, while average loans were essentially flat. The added liquidity from the deposit growth was invested in the longer term fixed rate investment securities portfolio. This added to the earning asset base, which improved net interest income in 2001.
The net yield on earning assets was 4.39% in 2002, 4.35% in 2001 and 4.74% in 2000. Average interest earning assets rose 5.7% in 2002 over 2001, compared to a 6.0% increase in 2001 over 2000. Average interest bearing liabilities increased 7.4% in 2002 compared to a 9.1% increase in 2001.
Total interest income was $652.6 million in 2002, $751.8 million in 2001 and $813.1 million in 2000. Tax equivalent interest income did not materially differ. Interest income declined $99.2 million, or 13.2%, in 2002 compared to the previous year. This decline was primarily due to decreases in rates on all loan products as a result of the large reduction in rates occurring mainly in 2001, offset by growth in earning assets. Interest rates, which declined throughout 2001, had the impact of reducing interest income on variably priced loans. Also, fixed rate loans which matured or were originated in 2001 and 2002 were impacted by lower rates. Average loan balances, which earn higher rates, decreased $48.2 million and also contributed to the lower interest income. Rates on investment securities were lower as maturing securities were reinvested in lower earning securities, however, average balances of investment securities grew $1.12 billion, contributing approximately $66 million of additional interest income. At December 31, 2002, average balances of investment securities comprised 31% of average earning assets compared to 23% in 2001. This growth helped to offset the effect of the lower rates described above. Average loans decreased slightly in 2002 compared to 2001, and comprised 68% of average earning assets, down from 72% in 2001.
Total interest income declined $61.3 million, or 7.5% in 2001 compared to 2000. Average loan balances were flat in 2001 compared to 2000, while loan yields declined 94 basis points. Increased liquidity provided by deposit growth allowed the Company to purchase investment securities, which increased an average of $291.3 million, and overnight investments in federal funds and repurchase agreements, which increased $314.3 million. However, average rates earned on investment securities and overnight investments fell 59 and 225 basis points, respectively, during 2001. The effect of interest rate declines on earning assets, especially loan rates, more than offset the income provided by higher average investment balances.
Total interest expense was $152.6 million in 2002, $283.0 million in 2001 and $331.5 million in 2000. Interest expense declined $130.4 million, or 46.1%, in 2002 compared to 2001. The average rate paid on interest bearing liabilities was 1.54% in 2002 compared to 3.06% in 2001. The lower interest rate environment described above resulted in an interest rate decline of 148 basis points on deposits, 191 basis points on overnight borrowings, and 212 basis points on longer-term borrowings. The decline in deposit rates affected all deposit products, with the largest effect on the Company’s Premium Money Market deposit accounts, where rates declined 194 basis points. A decline of $213.1 million in average retail certificates of deposit also contributed to lower interest expense. However, the average balance of interest checking and money market deposits rose $509.4 million, or 9.7%, during 2002.
In 2001, interest expense decreased $48.4 million, or 14.6%, from 2000. The decrease was due to rate declines of 68 basis points on deposits, 259 basis points on overnight borrowings, and 165 basis points on longer-term borrowings. The decline in deposit interest resulted mainly from rate reductions of 176 basis points paid on the Company’s Premium Money Market deposit accounts. Average interest bearing deposits grew $756.3 million, or 9.9%, during 2001.
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Provision for Loan Losses
The provision for loan losses was $34.1 million in 2002, compared with $36.4 million in 2001 and $35.2 million in 2000. The provision for loan losses is recorded to bring the allowance for loan losses to a level deemed appropriate by management based on the factors mentioned in the following “Allowance for Loan Losses” section of this discussion.
Non-Interest Income
Non-interest income increased $5.6 million, or 2.0%, during 2002 to $280.6 million. Trust fees declined $2.1 million, or 3.3%, because of the continuing decline in the value of trust account assets upon which fees are based. Most of the decline in trust fees occurred in the personal trust product line, while institutional trust fees increased somewhat. Deposit account fees increased 8.1%, or $6.8 million, in 2002 due to higher fee income in commercial cash management accounts and fees earned on deposit account overdrafts. Credit card fees increased $3.3 million, or 6.0%, mainly due to continuing growth in debit card fee income, which rose 15.0% over the previous year. Also, fees on credit cardholder transactions increased 7.2%. Trading account fees, which consist of fees from sales of fixed income securities, rose 4.1%, and were strong all year as a result of sustained demand by business and correspondent bank customers. Consumer brokerage service fees increased 5.8% on sales of annuities by the discount brokerage subsidiary. Mortgage banking revenues declined $1.9 million as a result of lower sales of mortgages to upstream correspondent banks. During the year, the Company retained more 15 year fixed rate loans it originated on its balance sheet than in previous years. This reduced sales to upstream banks and reduced profit. The Company continues to originate and sell all long-term fixed rate loans in excess of 15 years to upstream banks. Net gains on securities transactions amounted to $2.8 million in 2002, a decrease of $305 thousand from the previous year. Current year activity included gains of $6.0 million resulting from sales from the banks’ securities portfolios and losses of $3.2 million recognized on venture capital investments. Other non-interest income included a $1.5 million gain on the sale of the Company’s minority interest in an Illinois community bank. Also included were gains on sales of student loans. Student loan balances of $133.3 million were sold in 2002 compared to $233.3 million in 2001, which resulted in lower gains of $1.5 million. Sales of bank branches and facilities were comparable in 2002 and 2001, with gains of $2.4 million recorded in 2002 and $2.2 million in 2001.
In 2001, non-interest income totaled $275.0 million, which was a $19.4 million, or 7.6%, increase over 2000. Deposit account fees increased $13.5 million, or 19.0%, mainly due to growth in overdraft fees and commercial cash management revenue. Trust fees increased $4.2 million as a result of stronger personal trust business and included approximately $1.2 million in probate fees received from one trust customer. These increases offset the effect of an environment of declining trust account asset valuations upon which
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Non-Interest Expense
Non-interest expense was $452.9 million in 2002, an increase of $14.9 million, or 3.4%, over 2001. Salary expense grew $7.1 million, or 3.5%, due to higher full-time employee costs and growth in incentive payments. Employee benefit costs increased $7.3 million, or 23.6%, due to higher health care costs, higher 401K retirement expense, and an increase in pension expense. Net occupancy expense rose $2.6 million over last year, partly due to higher depreciation and operating costs resulting from a recently renovated office building, which was re-opened in October 2002. Marketing expense increased $2.1 million, or 16.2%, compared to the previous year as a result of added advertising costs for several consumer loan products. Data processing costs declined $2.2 million, largely due to the Company’s mainframe computer operations, which were consolidated in-house in the second quarter of 2002. Previously, this operation was out-sourced to an external vendor. Goodwill amortization was subject to new accounting rules, which discontinued the amortization of goodwill in 2002. This had the effect of lowering non-interest expense by $4.7 million in 2002 compared to 2001. Other non-interest expense included a $2.1 million charitable contribution of securities in 2002. In addition, losses related to check processing increased in 2002 compared to 2001 because of certain recoveries which were recorded in 2001.
Non-interest expense was $438.0 million in 2001, an increase of $3.8 million, or .9%, compared to 2000. Salaries expense increased $13.6 million over the previous year due to merit increases for full-time employees. Employee benefits expense increased $1.8 million mainly because of higher social security taxes and 401K retirement expense. Net occupancy and equipment costs grew 5.4% and 6.4%, respectively, over 2000 and were partly offset by declines in supplies and communication, data processing and marketing. Charitable contributions in 2001 declined as a result of a large contribution made in 2000.
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Income Taxes
Income tax expense was $94.0 million in 2002, compared to $87.4 million in 2001, and $89.3 million in 2000. Income tax expense increased 7.6% over 2001, compared to a 9.0% increase in pre-tax income. The effective tax rate on income from operations was 32.0%, 32.4% and 33.3% in 2002, 2001 and 2000, respectively. The effective tax rates were lower than the federal statutory rate of 35% mainly due to tax exempt interest on state and municipal obligations, state and federal tax credits realized, and various other tax initiatives. In 2002, the effective rate declined slightly because of the elimination of non-deductible goodwill amortization described above and the additional accrual of state and federal rehabilitation credits to be received on the renovation of an office building. The 2000 rate was lowered by the contribution of appreciated securities to a charitable organization in exchange for state tax credits, which resulted in a $2.0 million tax reduction. All of the above factors, tending to lower the effective tax rate, were partly offset by state and local income taxes.
Financial Condition
A schedule of average balances invested in each category of loans appears on page 32. Classifications of consolidated loans by major category at December 31 for each of the past five years are as follows:
At December 31, 2002, the Company elected to reclassify certain segments of its business, construction, business real estate and personal portfolios. The reclassifications were made to better realign the loan reporting with its related collateral and purpose. The adjustments also reclassified certain construction loans that had moved into amortizing term loans following project completion. The table below shows the effect of the reclassifications on the various lending categories at December 31, 2002. Because the information was not readily available, prior periods were not restated.
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The contractual maturities of loan categories at December 31, 2002, and a breakdown of those loans between fixed rate and floating rate loans are as follows:
Total loans increased $237.5 million, or 3.1%, during 2002 compared to a decline of $268.2 million, or 3.4%, during 2001. Excluding the reclassification effects mentioned above, growth in loans during 2002 came principally from personal banking, real estate construction, business, and credit card loans. Personal banking loans grew $122.2 million during the year mainly as a result of growth in home equity loan balances and higher totals for student and installment lending products. Real estate construction loans increased $80.4 million, or 19.5%, due to increased activity in the single-family construction area. Business loans increased $58.8 million, or 2.4%, mainly in the late third and early fourth quarters due to additional seasonal borrowings and higher line of credit usage. Credit card loans increased $15.8 million, or 3.1%, mainly at year end due to higher holiday activity. These increases were partly offset by a decline in personal real estate loans which were down $61.3 million, or 4.8%. This decline was the result of higher loan pay-offs of adjustable rate and other fixed rate loans in the portfolio due to the low rate environment that occurred during the year. The decline in total loans in 2001 compared to 2000 was primarily the result of reductions in business, personal real estate and personal banking loans. The overall decline in total loans during 2001 was partially offset by growth in business and construction real estate loans.
The Company currently generates approximately 32% of its loan portfolio in the St. Louis regional market and 28% in the Kansas City regional market. The portfolio is diversified from a business and retail standpoint, with 56% in loans to businesses and 44% in loans to individual consumers. A balanced approach to loan portfolio management and an historical aversion toward credit concentrations, from an industry, geographic and product perspective, have contributed to low levels of problem loans and loan losses.
Total business loans amounted to $2.26 billion at December 31, 2002. This group of loans is comprised primarily of loans to customers in the regional trade area of the bank subsidiaries in the central Midwest, encompassing the states of Missouri, Kansas, Illinois and adjacent Midwestern markets. The portfolio is diversified from an industry standpoint and includes businesses engaged in manufacturing, wholesaling, retailing, agribusiness, insurance, financial services, public utilities, and other service businesses. Emphasis is upon middle-market and community businesses with known local management and financial stability. The bank subsidiaries participate in credits of large, publicly traded companies when business
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The portfolio of loans in this category amounted to $404.5 million at December 31, 2002. The portfolio consists of residential construction, commercial construction and land development loans, predominantly in the local markets of the Company’s banking subsidiaries. Commercial construction loans are for small and medium-sized office and medical buildings, manufacturing and warehouse facilities, strip shopping centers, hotels and motels, and other commercial properties. Exposure to larger speculative office and rental space remains low. Residential construction and land development loans are primarily for projects located in the Kansas City and St. Louis metropolitan areas. The Company experienced $58 thousand net recoveries in 2002 compared to $49 thousand net charge-offs in 2001. Non-accrual loans in this category decreased to $301 thousand at year end 2002 compared to $501 thousand at year end 2001.
Total business real estate loans were $1.74 billion at December 31, 2002. This category includes mortgage loans for small and medium-sized office and medical buildings, manufacturing and warehouse facilities, strip shopping centers, hotels and motels, and other commercial properties. Emphasis is placed on owner-occupied and income producing commercial real estate properties which present lower risk levels. The borrowers and/or the properties are generally located in the local and regional markets of the affiliate banks. At December 31, 2002, non-accrual balances amounted to $10.6 million, or .6% of the loans in this category, compared to $5.4 million at year end 2001. The Company experienced net charge-offs of $296 thousand in 2002 and $90 thousand in 2001.
At December 31, 2002, there were $1.28 billion in outstanding personal real estate loans. The mortgage loans in this category are extended, predominately, for owner-occupied residential properties. The Company originates both adjustable rate and fixed rate mortgage loans. The Company retains adjustable rate mortgage loans, but ordinarily sells most fixed rate loans to other lenders and investors, although some 15 year fixed rate loans are retained. During 2002, in a low rate environment, the Company originated more fixed rate loans than variable rate loans. At the same time, its portfolio of higher rate loans declined as customers refinanced their debt. The combination of these two effects resulted in a net decline in these loans. The Company typically does not experience significant loan losses in this category. There were net charge-offs of $230 thousand in 2002 compared to $370 thousand in 2001. The non-accrual balances of loans in this category increased to $1.4 million at December 31, 2002, compared to $147 thousand at year end 2001. The five year history of net charge-offs in the personal real estate loan category reflects nominal losses, and credit quality is considered to be strong.
Total personal banking loans were $1.66 billion at December 31, 2002, and consisted of installment loans (mainly auto) of $1.09 billion, home equity loans of $305.3 million and student loans of $269.6 mil-
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Total credit card loans amounted to $526.1 million at December 31, 2002. The credit card portfolio is concentrated within regional markets served by the Company. The Company offers a variety of credit card products, including affinity cards, purchase cards, and normalized credit cards. It emphasizes its credit card relationship product, Special Connections, in which the customer maintains a deposit relation with a subsidiary bank. The Special Connections product allows the customer ATM access using the same card and provides certain pricing advantages. The Company has found this product to be more profitable by incurring fewer credit losses than other card products and it allows for better cross sale into other bank products. Approximately 61% of the households in Missouri that own a Commerce credit card product also maintain a deposit relationship with a subsidiary bank. Approximately 88% of the outstanding credit card loans have a floating interest rate. Net charge-offs amounted to $17.3 million in 2002, which was a $1.7 million decrease from 2001. The net charge-off ratios of 3.5% in 2002 and 3.9% in 2001 remain well below national loss averages. The Company refrains from national pre-approved mailing techniques which have caused some of the credit card problems experienced by other banking companies. Significant changes in loss trends are not currently anticipated by management.
Allowance for Loan Losses
The Company has an established process to determine the amount of the allowance for loan losses, which assesses the risks and losses inherent in its portfolio. This process provides an allowance consisting of an allocated and an unallocated component. To determine the allocated component of the allowance, the Company combines estimates of the reserves needed for loans evaluated on an individual basis with estimates of reserves needed for pools of loans with similar risk characteristics.
Loans subject to individual evaluation generally consist of commercial and commercial real estate loans. These loans are analyzed and assigned to risk categories according to the Company’s internal risk rating system. Loans with a greater risk of loss are identified and placed on the “watch list” for regular management review. Those loans judged to reflect the highest risk profiles are evaluated individually for the impairment of repayment potential and collateral adequacy, and in conjunction with current economic conditions and loss experience, allowances are estimated. Other loans identified on the Company’s “watch list” but not judged to be individually impaired from a repayment or collateral adequacy perspective are aggregated and reserves are recorded using migration models, that track actual portfolio movements from problem asset loan grades to loss over a 5 to 10 year period. In the case of other more homogeneous loan portfolios, including auto loans, residential mortgages, home equity loans and credit card loans, the determination of the allocated reserve is computed on a pooled basis. For these loan pools, historical loss ratios by loan type, current loss and past due experience, and management’s judgment of recent and forecasted economic effects on portfolio performance are factors utilized to determine the appropriate reserve amounts.
To mitigate the imprecision inherent in estimates of expected credit losses, the allocated component of the allowance is supplemented by an unallocated component. This portion of the allowance includes management’s determination of the amounts necessary to offset credit risk issues associated with loan concentrations, economic uncertainties, industry concerns, adverse market changes in estimated or ap-
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The Company’s estimate of the allowance for loan losses and the corresponding provision for loan losses rests upon various judgments and assumptions made by management. Factors that influence these judgments include past loan loss experience, current loan portfolio composition and characteristics, trends in portfolio risk ratings, levels of non-performing assets, prevailing regional and national economic conditions, and the Company’s ongoing examination process including that of its regulators. The Company has internal credit administration and loan review staffs that continuously review loan quality and report the results of their reviews and examinations to the Company’s senior management and Board of Directors. Such reviews also assist management in establishing the level of the allowance. The Company’s subsidiary banks continue to be subject to examination by the Office of the Comptroller of the Currency (OCC) and examinations are conducted throughout the year targeting various segments of the loan portfolio for review. In addition to the examination of subsidiary banks by the OCC, the Parent and its non-bank subsidiaries are examined by the Federal Reserve Bank.
The allowance for loan losses was $130.6 million and $130.0 million at December 31, 2002 and 2001, respectively, and was 1.66% and 1.70% of loans outstanding. The allowance for loan losses covered non-performing assets (defined as non-accrual loans and foreclosed real estate) by 442% at year end 2002 and 422% at year end 2001. Net charge-offs totaled $33.5 million in 2002 compared to $37.4 million in 2001. The ratio of net charge-offs to average loans outstanding in 2002 was .43% compared to .48% in 2001 and .38% in 2000. The provision for loan losses was $34.1 million, higher than 2002 net charge-offs by $645 thousand, compared to a provision of $36.4 million in 2001 and $35.2 million in 2000.
Credit card loans outstanding at December 31, 2002 amounted to $526.1 million, or 6.7% of total loans. Net charge-offs on these loans decreased to 3.51% of average credit card loans in 2002 compared to 3.88% in 2001. The Company’s net charge-off experience for its credit card portfolio has been significantly better than industry averages. Delinquency trends on credit card loans rose slightly in the fourth quarter of 2002 for both the Company and the industry, but the Company remains below industry delinquency averages. Also, delinquency rates on credit card loans at December 2002 were significantly lower than at the same time last year.
The Company considers the allowance for loans losses of $130.6 million adequate to cover losses inherent in the loan portfolio at December 31, 2002.
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The schedule which follows summarizes the relationship between loan balances and activity in the allowance for loan losses:
The following schedule provides a breakdown of the allowance for loan losses by loan category and the percentage of each loan category to total loans outstanding at year end:
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Risk Elements Of Loan Portfolio
Management reviews the loan portfolio continuously for evidence of problem loans. During the ordinary course of business, management becomes aware of borrowers that may not be able to meet the contractual requirements of loan agreements. Such loans are placed under close supervision with consideration given to placing the loan on non-accrual status, the need for an additional allowance for loan loss, and (if appropriate) partial or full loan charge-off. Loans are placed on non-accrual status when management does not expect to collect payments consistent with acceptable and agreed upon terms of repayment. Loans that are 90 days past due as to principal and/or interest payments are generally placed on non-accrual, unless they are both well-secured and in the process of collection, or they are 1-4 family first mortgage loans or consumer loans that are exempt under regulatory rules from being classified as non-accrual. After a loan is placed on non-accrual status, any interest previously accrued but not yet collected is reversed against current income. Interest is included in income after the loan is placed on non-accrual status only as interest is received and so long as management is satisfied there is no impairment of collateral values. The loan is returned to accrual status only when the borrower has brought all past due principal and interest payments current and, in the opinion of management, the borrower has demonstrated the ability to make future payments of principal and interest as scheduled.
The following schedule shows non-performing assets and loans past due 90 days and still accruing interest.
The effect on interest income in 2002 of loans on non-accrual status at year end is presented below:
Total non-accrual loans at year end 2002 decreased $754 thousand from 2001 levels. This decline resulted from a $7.4 million decrease in business non-accrual loans, partly offset by increases of $5.3 million in business real estate non-accrual loans and $1.3 million in personal real estate non-accrual balances. Real estate that was acquired in foreclosure, which is comprised mainly of small residential properties, decreased $475 thousand from year end 2001. Total non-performing assets remain low compared to the Company’s peers, with the non-performing assets to total loans ratio at .38%. Loans past due 90 days and
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At December 31, 2002, the banking subsidiaries held fixed rate residential real estate loans of approximately $41.1 million at lower of cost or market, which are to be sold to secondary markets within approximately three months.
There were no loan concentrations of multiple borrowers in similar activities at December 31, 2002, which exceeded 10% of total loans. The Company’s aggregate legal lending limit to any single or related borrowing entities is in excess of $125 million. The largest exposures generally do not exceed $70 million.
Investment Securities Analysis
During 2002, total investment securities increased $454.0 million to $4.12 billion (excluding unrealized gains/losses) compared to $3.67 billion at the previous year end. The increase was due to purchases of new securities with liquidity resulting from lower short-term investments and higher federal funds borrowings. The growth in investment securities occurred mainly in U.S. government and federal agency securities, which increased $294.8 million, and CMO’s and asset-backed securities, which increased $180.1 million. The average tax equivalent yield on total investment securities was 5.02% in 2002 and 5.68% in 2001.
At December 31, 2002, available for sale securities totaled $4.20 billion, which included a net unrealized gain in fair value of $155.0 million. The amount of the related after tax unrealized gain reported in stockholders’ equity was $96.1 million at year end 2002. Approximately 22% of the unrealized gain in fair value related to marketable equity securities held by Commerce Bancshares, Inc., the parent holding company (Parent). The rest of the unrealized gain related to CMO’s and asset-backed securities (45%) and U.S. government and federal agencies (32%) held by bank subsidiaries. The market value of the available for sale portfolio will vary as interest rates change. The unrealized gain in fair value at year end 2002 increased $89.0 million over year end 2001 because of the decline in market interest rates, and its effect on the fixed rate investments in the portfolio. Management expects normal maturities from the securities portfolio to meet most of the Company’s liquidity needs. Non-marketable securities include $45.4 million in Federal Reserve Bank stock and Federal Home Loan Bank stock held by bank subsidiaries as a result of debt and regulatory requirements. These securities are carried at cost. Other non-marketable securities are generally held by the Parent and non-bank subsidiaries due to regulatory restrictions. These include non-marketable venture capital investments, which are carried at estimated fair value.
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Investment securities at year end for the past two years are shown below:
A summary of maturities by category of investment securities and the weighted average yield for each range of maturities as of December 31, 2002, is presented in the Investment Securities note to the consolidated financial statements. U.S. government and federal agency obligations comprise 35% of the investment portfolio at December 31, 2002, with a weighted average yield of 3.95% and an estimated average maturity of 4.6 years; CMO’s and asset-backed securities comprise 57% with a weighted average yield of 5.32% and an estimated average maturity of 2.6 years.
Other debt and equity securities above include Federal Reserve Bank stock, Federal Home Loan Bank stock, corporate bonds, notes, mutual funds, commercial paper, venture capital investments, and corporate stock. The tax equivalent yield on these securities, computed on average balances invested, was 3.68% during 2002. Most of the investments in mutual funds, corporate notes and corporate stock at year end 2002 are held by the Parent and non-banking subsidiaries. Federal Reserve Bank stock and Federal Home Loan Bank stock are restricted securities held by bank subsidiaries, and lack a market.
The Company engages in venture capital activities through direct venture investments and two venture capital subsidiaries, which are licensed by the Small Business Administration. One of the subsidiaries, CFB Venture Fund I, Inc. (CFBI), is also qualified as a Missouri Certified Capital Company (CAPCO). This CAPCO certification expands its investment opportunities to Missouri businesses with less than $4 million in revenues. Total venture capital investments held by CFBI amounted to $11.4 million at December 31, 2002, and included CAPCO investments of $1.7 million. The second subsidiary, CFB Venture Fund II, L.P. (CFBII), is a limited partnership venture fund with 47% outside ownership and no outside debt. All funding commitments have been satisfied, and CFBII had total venture capital investments of $9.6 million at year end 2002. The Company also has direct investments in several external venture capital partnerships of $4.4 million at year end 2002. Many of the venture capital investments are not readily marketable. While the nature of these investments carries a higher degree of risk than the normal lending portfolio, management believes the potential for long-term gains in these investments outweighs the potential risks.
Deposits and Borrowings
Deposits are the primary funding source for the Company’s banks, and are acquired from a broad base of local markets, including both individual and corporate customers. Total deposits were $9.91 billion at December 31, 2002, compared to $10.03 billion last year, reflecting a decrease of $118.6 million, or 1.2%.
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The following table shows year end deposits by type as a percentage of total deposits.
Core deposits (defined as all non-interest and interest bearing deposits, excluding short-term C.D.’s of $100,000 and over) supported 82% of average earning assets in 2002 and 85% in 2001. Average balances by major deposit category for the last six years appear at the end of this discussion. Maturity schedules of time deposits outstanding at December 31, 2002, appear in the Interest Rate Sensitivity portion of this discussion and in the Deposits note to the consolidated financial statements.
Short-term borrowings consist mainly of federal funds purchased and securities sold under agreements to repurchase. Balances outstanding at year end 2002 were $1.46 billion, a $372.5 million increase over $1.09 billion outstanding at year end 2001. Balances in these accounts can fluctuate significantly on a day-to-day basis. The average balance of federal funds purchased and repurchase agreements increased $169.0 million in 2002 over 2001, and decreased $170.6 million in 2001 from 2000. The average rate paid on these borrowings was 1.28% during 2002 and 3.19% during 2001.
Subsidiary banks also borrow from the Federal Home Loan Bank (FHLB). At year end 2002 these advances totaled $322.7 million, of which $250.0 million is due in 2003. The debt maturing in 2003 may be refinanced or may be repaid with funds generated by the loan and securities portfolios. Of the FHLB advances outstanding at year end, $255.5 million had a floating rate and $67.2 million had a fixed rate. The average rate paid on FHLB advances was 2.52% during 2002 and 4.75% during 2001. The weighted average year end rate on outstanding FHLB advances at December 31, 2002, was 2.07%. Additional long-term debt includes $11.6 million borrowed from insurance companies to fund the CAPCO investments.
Liquidity and Capital Resources
The liquid assets of the Parent consist primarily of securities purchased under agreements to resell and available for sale securities, which include readily marketable equity securities, U.S. government and federal agency securities, commercial paper, and investments in liquid money market funds. These assets totaled $209.9 million at cost and $240.7 million at fair value at December 31, 2002 compared to $142.6 million at cost and $175.2 million at fair value at December 31, 2001. Total liabilities of the Parent at December 31, 2002 increased to $22.3 million over $13.4 million at December 31, 2001. These liabilities consisted mainly of accrued income taxes, salaries, and employee benefits. Most of the increase in liabilities occurred in income taxes payable. The Parent had no third-party short-term borrowings or long-term debt during 2002. Primary sources of funds for the Parent are dividends and management fees from its subsidiary banks, which were $199.8 million and $38.5 million, respectively, in 2002. The subsidiary banks may distribute dividends without prior regulatory approval that do not exceed the sum of net income for the current year and retained net income for the preceding two years, subject to maintenance of minimum capital requirements. The Parent’s commercial paper, which management believes is readily marketable, has a P1 rating from Moody’s and an A1 rating from Standard & Poor’s. No commercial paper was outstanding during the past three years. This credit availability, along with available secured short-term borrowings from an affiliate bank, should provide adequate funds to meet outstanding or future
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The liquid assets held by bank subsidiaries include available for sale securities, which consist mainly of investments in U.S. government, federal agency, mortgage-backed and asset-backed securities. The available for sale bank portfolio totaled $3.93 billion at December 31, 2002, including an unrealized net gain of $119.4 million. Investment securities expected to mature in 2003 and 2004 total approximately $432 million and $1.17 billion, respectively.
The Company continues to maintain a strong equity to assets ratio of 10.92%, based on 2002 average balances. At December 31, 2002, the Company and each of its banking subsidiaries exceeded the minimum risk based capital requirements established by banking regulatory agencies. These requirements specify ratios which represent capital, defined as Tier 1 and Total, as a percentage of assets and off-balance-sheet items which have been weighted according to broad risk categories. A leverage ratio compares Tier 1 capital to adjusted average assets. At December 31, 2002, the consolidated Tier 1 and Total risk based capital ratios were 12.67% and 14.05%, respectively, and the leverage ratio was 10.18%. The minimum ratios for well-capitalized banks are 6.00% for Tier 1 capital, 10.00% for Total capital and 5.00% for the leverage ratio.
The cash flows from the operating, investing and financing activities of the Company resulted in a net decrease in cash and due from banks of $113.8 million in 2002. Financing activities provided cash of $85.4 million, resulting from a $372.5 million increase in borrowings of federal funds, partly offset by a $115.9 million decline in deposits and FHLB advance repayments of $53.9 million, net of new borrowings. The Company’s treasury stock repurchase program required $83.9 million, and cash dividend payments amounted to $42.2 million. Cash of $461.9 million was used in investing activities, which included a $471.4 million net increase in investment securities, a $278.0 million net increase in loans, and a $358.1 million net decrease in overnight investments. Operating activities, which typically generate significant liquidity, provided cash of $262.7 million. Future short-term liquidity needs for daily operations are not expected to vary significantly and the Company maintains adequate liquidity to meet these cash flows. The Company’s sound equity base, along with its low debt level, common and preferred stock availability, and excellent debt ratings, provide several alternatives for future financing. Future acquisitions may utilize partial funding through one or more of these options.
Cash and stock requirements for acquisitions, funding of various employee benefit stock programs and dividends were as follows:
In January 2003, the Board of Directors authorized the Company to purchase additional shares of common stock under its stock repurchase program, which brought the total purchase authorization to 4,000,000 shares. The Company has routinely used these reacquired shares to fund the Company’s annual 5% stock dividends and various employee benefit programs. During 2002, the Company acquired approximately 2,002,000 shares under Board authorizations at an average price of $41.90.
Per share cash dividends paid by the Company increased 6.7% during 2002 compared to 2001. Total return to shareholders, including cash and stock dividends and changes in stock price, was 12.2% for the past three years and 3.7% for the past five years. In January 2003, the Board of Directors increased the cash dividend per share by 6.6% over 2002, making 2003 the 35th consecutive year the Company has increased cash dividends.
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During 2002, the Company contributed $19.3 million to its pension plan. The contribution was made to mitigate the effect of declining returns and valuations in the pension assets. The contribution had no significant effect on the Company’s overall liquidity. In determining pension expense, the Company makes several assumptions, including the discount rate and long-term rate of return on assets. These assumptions are determined at the beginning of the plan year based on interest rate levels and financial market performance. For 2002 these assumptions were as follows:
With the low interest rate and sluggish economic environment, the Company expects to decrease the discount rate to 6.75% and long-term rate of return on assets to 8.00% in determining 2003 pension expense. The Company estimates that the effects of these changes in assumptions will be to increase pension cost by less than $1.5 million.
Various commitments and contingent liabilities arise in the normal course of business which are not required to be recorded on the balance sheet. The most significant of these are loan commitments totaling $3.04 billion (excluding approximately $2.31 billion in unused approved lines of credit related to credit card loan agreements) and standby letters of credit, net of participations to non-affiliated companies, totaling $305.7 million at December 31, 2002. The Company has various other financial instruments with off-balance-sheet risk, such as commercial letters of credit and commitments to purchase and sell when-issued securities. Management does not anticipate any material losses arising from commitments and contingent liabilities and believes there are no material commitments to extend credit that represent risks of an unusual nature.
Interest Rate Sensitivity
The Asset/ Liability Management Committee measures and manages the Company’s interest rate risk sensitivity on a monthly basis to maintain stability in earnings throughout various rate environments. Three main analytical tools provide management insight into the Company’s exposure to changing rates: repricing or GAP reports, net interest income simulations, and market value analyses. These measurement tools indicate that the Company is currently within acceptable risk guidelines as set by management.
The schedule that follows shows a summary of the maturities or re-pricing opportunities of the Company’s earning assets and interest bearing liabilities. This schedule portrays the re-pricing risk within the Company’s balance sheet by taking the difference between maturities (or re-pricing periods) for interest earning assets and interest bearing liabilities. A negative sensitivity gap indicates that more liabilities will re-price within that particular time frame. If rates rise, liabilities will be re-pricing up faster than assets. A positive gap would indicate the opposite. GAP reports such as this typically capture only the re-pricing timing within the balance sheet and are less accurate in capturing other significant risks such as basis risk and embedded options risk. Basis risk involves the potential for the spread relationship between rates to change under different rate environments, while embedded options risk addresses the potential for the alteration of the level and/or timing of cash flows given changes in rates. Quantifying these additional risks within a re-pricing context would make the gap position in the first year more positive, as the recognition of mortgage prepayments would shorten the duration of assets and partial re-pricing of some deposits would lengthen the duration of liabilities.
The Company’s main interest rate measurement tool, income simulations, projects net interest income under various rate scenarios in order to quantify the magnitude and timing of potential rate-related changes in net interest income. Income simulations are able to capture more of the dynamics within the balance sheet such as basis risk and embedded options risk. Management has set guidelines specifying acceptable limits within which net interest income can change under various rate change scenarios. These rate movements include a “most likely” rate forecast provided by an outside vendor, as well as “shock” scenarios which are intended to capture interest rate risk under adverse conditions by immediately shifting rates up and down. Simulation results indicate that the Company is within all limits. Interest rate risk is also measured by simulating changes in net interest income under gradually rising and declining
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The Company also uses market value analyses to help identify longer-term risks that may reside on the current balance sheet. This is considered a secondary risk measurement tool by management. The Company measures the market value of equity as the net present value of all asset and liability cash flows discounted along the current LIBOR curve plus appropriate market risk spreads. It is the change in the market value of equity under different rate environments, which gives insight into the magnitude of risk to future earnings due to rate changes. Management has set limits concerning potential declines in the market value of equity within which it feels comfortable that risk is relatively low. Current results show that the Company is within these limits. Market value analyses also help management understand the price sensitivity of non-marketable bank products under different rate environments.
In 2001, the Federal Reserve sharply reduced short-term rates, and for most of 2002, the Federal Reserve held short-term rates flat, easing rates by 50 basis points in November. While most of the Company’s variably priced assets had been affected by rate reductions in 2001, its fixed rate loans continued to re-price downward during much of 2002 as loans matured or new loans were added. Total average loans grew approximately $52 million during the first six months of 2002 mainly due to growth in consumer and business loans, and the mix of new loans helped to keep earning asset yields relatively constant. Also through the first six months of 2002, certificate of deposit accounts continued to re-price downward and the Company experienced some run-off of these accounts as depositors looked for alternative higher yielding accounts. Other non-maturity deposits showed some balance growth and rates remained relatively constant. The combination of these effects for the first six months allowed the Company to improve its net interest income and overall margin, and the Company remained less asset sensitive. During the second half of 2002, rates on all deposits continued to decline and deposit growth slowed. Seasonal commercial lending increased and added purchases of investment securities occurred, funded mainly from short-term borrowings. As a result, net interest income improved. The recent reduction in short-term rates in November, however, limited the Company’s ability to lower deposit rates on all products. While certificates of deposit and money market accounts declined, rates on interest checking accounts (18% of interest bearing deposits) moved down only slightly. At the same time, large portions of the Company’s variably priced assets re-priced downward. The increase in fixed rate investment securities earlier in the year helped to offset some of this re-pricing risk.
Thus, with the growth in loans experienced this year, many of which are variably priced, coupled with fewer certificates of deposit and a larger investment securities portfolio, the Company has achieved a more balanced interest rate risk profile than in the previous year. Its main risk is that of falling interest rates, and the profile above shows that if rates fell by 100 basis points, net interest income would decline by $7.1 million. While it is unlikely that rates will be lowered to that extent in the future, it remains the largest risk to the Company’s net interest income.
The Company’s balance sheet is well diversified, with strong liquidity and low interest rate risk. Estimated maturities in the investment securities portfolio for 2003 are in excess of $430 million. The use of derivative products is limited and the deposit base is strong and stable. The loan to deposit ratio, while showing some growth towards the end of 2002, is still at relatively low levels, which should present the Company with opportunities to fund future loan growth at reasonable costs.
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The following is an analysis of sensitivity gaps of interest earning assets and interest bearing liabilities:
Repricing and Interest Rate Sensitivity Analysis
Derivative Financial Instruments
The Company maintains an overall interest rate risk management strategy that permits the use of derivative instruments to modify exposure to interest rate risk. The Company’s interest rate risk management strategy includes the ability to modify the re-pricing characteristics of certain assets and liabilities so that changes in interest rates do not adversely affect the net interest margin and cash flows. Interest rate swaps are used on a limited basis as part of this strategy. At present the Company has three outstanding swaps which are accounted for as fair value hedges of fixed rate loans. This accounting results in the changes in the fair values of the swaps and the hedged loans being offset against each other in current earnings.
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The Company enters into foreign exchange derivative instruments as an accommodation to customers and offsets the related foreign exchange risk by entering into offsetting third-party forward contracts with approved reputable counterparties. In addition, the Company takes proprietary positions in such contracts based on market expectations. This trading activity is managed within a policy of specific controls and limits. Most of the foreign exchange contracts outstanding at December 31, 2002, mature within 30 days, and the longest period to maturity is 12 months.
Additionally, interest rate lock commitments issued on residential mortgage loans intended to be held for resale are considered derivative instruments. The interest rate exposure on these commitments is economically hedged primarily with forward sale contracts in the secondary market.
The Company is exposed to credit risk in the event of nonperformance by counterparties to financial instruments. The Company controls the credit risk of its financial contracts through credit approvals, limits and monitoring procedures. Because the Company generally enters into transactions only with high quality counterparties, losses associated with counterparty nonperformance on derivative financial instruments have been immaterial. The amount of credit risk associated with these instruments is limited to the cost of replacing a contract in a gain position, on which a counterparty may default.
The following table summarizes the notional amounts and estimated fair values of the Company’s derivative instruments at December 31, 2002 and 2001. Notional amount, along with the other terms of the derivative, is used to determine the amounts to be exchanged between the counterparties. Because the notional amount does not represent amounts exchanged by the parties, it is not a measure of loss exposure related to the use of derivatives nor of exposure to liquidity risk. Positive fair values are recorded in other assets and negative fair values are recorded in other liabilities in the consolidated balance sheets.
The Company segregates financial information for use in assessing its performance and allocating resources among three operating segments. The results are determined based on the Company’s management accounting process, which assigns balance sheet and income statement items to each responsible segment. These segments are defined by customer base and product type. The management process measures the performance of the operating segments based on the management structure of the Company and is not necessarily comparable with similar information for any other financial institution. Each segment is managed by executives who, in conjunction with the Chief Executive Officer, make strategic business decisions regarding that segment. The three reportable operating segments are Consumer, Commercial and Money Management. Additional information is presented in the Segments note to the consolidated financial statements.
Beginning in 2002, the Company implemented a new funds transfer pricing method to value funds used (e.g., loans, fixed assets, cash, etc.) and funds provided (deposits, borrowings, and equity) by the business segments and their components. This new process assigns a specific value to each new source or use of funds with a maturity, based on current LIBOR interest rates, thus determining an interest spread at the time of the transaction. Non-maturity assets and liabilities are assigned to LIBOR based funding
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The Consumer segment includes the retail branch network, consumer finance, bankcard, student loans and discount brokerage services. Pre-tax income for 2002 was $129.2 million, a decrease of $51.5 million, or 28.5%, from 2001. Most of the decrease was due to lower allocated funding credits of $122.0 million, as discussed above. Direct net interest income increased $66.4 million, and charge-offs declined $4.1 million. Non-interest income rose $3.1 million, mainly due to higher credit card fees, deposit account charges, and brokerage related fees. Credit card fees were higher due to growth in debit card fees, deposit account charges increased due to higher overdraft and return items fees, and higher brokerage revenue resulted from increased sales of annuities. Non-interest expense increased $3.0 million mainly due to higher costs for salaries and employee benefits, marketing and check processing charges, partly offset by lower data processing charges. Total average assets directly related to the segment declined 1.7% from 2001. Average segment loans decreased 1.1% compared to 2001 mainly as a result of a decline in personal real estate loans, and average deposits increased slightly, .2%.
The Commercial segment provides corporate lending, leasing, international services, and corporate cash management services. Pre-tax income increased $7.7 million, or 7.4%, over 2001. Assigned funding costs declined $74.3 million compared to the previous year. Non-interest income rose $4.4 million, mainly in fees earned on commercial cash management accounts. Partly offsetting these effects was a $66.7 million, or 23.3%, decline in direct net interest income from the previous year. In addition, non-interest expense increased $4.2 million due to higher indirect costs for management fees and loan servicing costs. During 2002, total average loans decreased .2%, compared to a 2.7% increase during 2001. Average deposits increased 8.4% during 2002, compared to a 3.1% increase during 2001.
The Money Management segment consists of the trust and capital markets activities. The Trust group provides trust and estate planning services, and advisory and discretionary investment management services. It also provides investment management services to The Commerce Funds, a series of mutual funds with $2.03 billion in total assets. The Capital Markets group sells primarily fixed-income securities to individuals, corporations, correspondent banks, public institutions, and municipalities, and also provides investment safekeeping and bond accounting services. Pre-tax income for the segment was $29.3 million in 2002 compared to $31.9 million in 2001, a decrease of $2.6 million. The decrease was due to higher non-interest expense of $2.6 million, mainly in salaries and employee benefits. Non-interest income declined $864 thousand, mainly due to lower trust revenues but offset by higher bond trading revenues. Trust revenues declined as a result of lower asset valuations upon which fees are based, while bond trading revenues grew 4.1% from continued strong customer demand for fixed income products. The assigned credit for funds declined $2.6 million. Direct net interest income rose $3.4 million. Average assets decreased $123.2 million during 2002 because of lower overnight investments. Average deposits increased $164.6 million during 2002 and $87.6 million during 2001 due to increased sales of short-term certificates of deposit over $100 thousand to corporate customers.
Impact of Recently Issued Accounting Standards
In June 2002, the Financial Accounting Standards Board (FASB) issued Statement No. 146, “Accounting for Costs Associated with Exit or Disposal Activities”. The provisions of this Statement are effective for exit or disposal activities initiated after December 31, 2002. The Company does not believe that the adoption of Statement No. 146 will have a significant impact on its consolidated financial statements.
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In October 2002, the FASB issued Statement No. 147, “Acquisitions of Certain Financial Institutions”. This Statement provides guidance on the accounting for the acquisition of a financial institution and applies to all acquisitions except those between two or more mutual enterprises. Those transition provisions were effective on October 1, 2002. The scope of Statement No. 144 was amended to include long-term customer-relationship intangible assets such as depositor- and borrower-relationship intangible assets and credit cardholder intangible assets. The Company does not believe that the adoption of Statement No. 147 will have a significant impact on its consolidated financial statements.
In November 2002, the FASB issued Interpretation No. 45, “Requirements for Guarantees Including Indirect Guarantees of Indebtedness of Others”. This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The disclosure requirements in this Interpretation are effective for financial statements of interim or annual periods ending after December 15, 2002. The Company does not believe that the adoption of Interpretation No. 45 will have a significant impact on its consolidated financial statements.
In December 2002, the FASB issued Statement No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure”. This Statement, which amends Statement No. 123, “Accounting for Stock-Based Compensation”, provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition it requires more prominent and more frequent disclosures in financial statements about the effects of stock-based compensation.
Effective January 1, 2003, the Company voluntarily adopted the fair value recognition provisions of Statement No. 123 for stock-based employee compensation. All prior periods in future reports will be restated to reflect the compensation expense that would have been recognized had the recognition provisions of Statement No. 123 been applied to all awards granted to employees after January 1, 1995. Pro forma information under the provisions of Statement No. 123 may be found in the Summary of Significant Accounting Policies in the notes to consolidated financial statements.
In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities”. This Interpretation of Accounting Research Bulletin No. 51, Consolidated Financial Statements, elaborates on the financial statement disclosures to be made by enterprises involved with variable interest entities, including requiring consolidation of entities in which an enterprise has a controlling financial interest that is not controlled through voting interests. The requirements in this Interpretation are effective for variable interest entities created after January 31, 2003 and the first fiscal or interim period beginning after June 15, 2003 for variable interest entities acquired before that date. The Company does not believe that the adoption of Interpretation No. 46 will have a significant impact on its consolidated financial statements.
Effects of Inflation
The impact of inflation on financial institutions differs significantly from that exerted on industrial entities. Financial institutions are not heavily involved in large capital expenditures used in the production, acquisition or sale of products. Virtually all assets and liabilities of financial institutions are monetary in nature and represent obligations to pay or receive fixed and determinable amounts not affected by future changes in prices. Changes in interest rates have a significant effect on the earnings of financial institutions. Higher interest rates generally follow the rising demand of borrowers and the corresponding increased funding requirements of financial institutions. Although interest rates are viewed as the price of borrowing funds, the behavior of interest rates differs significantly from the behavior of the prices of goods and services. Prices of goods and services may be directly related to that of other goods and services while the price of borrowing relates more closely to the inflation rate in the prices of those goods and services. As a result, when the rate of inflation slows, interest rates tend to decline while absolute prices for goods and services remain at higher levels. Interest rates are also subject to restrictions imposed through monetary
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Corporate Governance
The Company has adopted a number of corporate governance measures. Information on corporate governance is available on the Company’s web site www.commercebank.com under Investor Relations.
Forward-Looking Statements
This report may contain “forward-looking statements” that are subject to risks and uncertainties and include information about possible or assumed future results of operations. Many possible events or factors could affect the future financial results and performance of the Company. This could cause results or performance to differ materially from those expressed in the forward-looking statements. Words such as “expects”, “anticipates”, “believes”, “estimates”, variations of such words and other similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in, or implied by, such forward-looking statements. Readers should not rely solely on the forward-looking statements and should consider all uncertainties and risks discussed throughout this report. Forward-looking statements speak only as of the date they are made. The Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events. Such possible events or factors include: changes in economic conditions in the Company’s market area, changes in policies by regulatory agencies, governmental legislation and regulation, fluctuations in interest rates, changes in liquidity requirements, demand for loans in the Company’s market area, and competition with other entities that offer financial services.
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AVERAGE BALANCE SHEETS – AVERAGE RATES AND YIELDS
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QUARTERLY AVERAGE BALANCE SHEETS – AVERAGE RATES AND YIELDS
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SUMMARY OF QUARTERLY STATEMENTS OF INCOME
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The information required by this item is set forth on pages 25 through 28 of Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations.
Statement of Management’s Responsibility
The management of Commerce Bancshares, Inc. is responsible for the preparation, integrity, and fair presentation of its published consolidated financial statements. The consolidated financial statements have been prepared by the Company in accordance with accounting principles generally accepted in the United States of America and, in the judgment of management, present fairly the Company’s financial position and results of operations. The financial information contained elsewhere in this report is consistent with that in the consolidated financial statements. The financial statements and other financial information in this report include amounts that are based on management’s best estimates and judgments giving due consideration to materiality.
The Internal Audit department of the Company reviews, evaluates, monitors and makes recommendations on both administrative and accounting control, which acts as an integral, but independent, part of the system of internal controls.
Through their audit the independent public accountants, KPMG LLP, appointed by the Board of Directors, upon the recommendation of the Audit Committee, provide an independent review of internal accounting controls and financial reporting. The independent public accountants have conducted such tests and related procedures as they have deemed necessary to form an opinion on the fairness of the presentation of the financial statements.
The Audit Committee of the Board of Directors, composed solely of directors who are not officers or employees of the Company, meets periodically with the management, internal auditors and independent public accountants to ensure that each is discharging its responsibilities. Both the internal auditors and the independent public accountants have free access to the Audit Committee without management present. The committee also reviews significant changes in (1) accounting policies, (2) internal accounting controls, and (3) financial statements prepared for public distribution.
The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safe-guarded and that transactions are executed in accordance with management’s authorization and recorded properly to permit the preparation of consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. Management recognizes that even a highly effective internal control system has inherent risks, including the possibility of human error and the circumvention or overriding of controls, and that the effectiveness of an internal control system can change with circumstances. However, management believes that the internal control system provides reasonable assurance that errors or irregularities that could be material to the consolidated financial statements are prevented or would be detected on a timely basis and corrected through the normal course of business. As of December 31, 2002, management believes that the internal controls are in place and operating effectively.
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INDEPENDENT AUDITORS’ REPORT
The Board of Directors Commerce Bancshares, Inc.:
We have audited the accompanying consolidated balance sheets of Commerce Bancshares, Inc. and Subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of income, stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2002. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Commerce Bancshares, Inc. and Subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America.
As discussed in the Intangible Assets and Goodwill note to the consolidated financial statements, the Company changed its method of accounting for goodwill in 2002.
January 31, 2003
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Commerce Bancshares, Inc. and Subsidiaries
CONSOLIDATED BALANCE SHEETS
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CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
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Summary of Significant Accounting Policies
Commerce Bancshares, Inc. (the Company) conducts its principal activities through its banking and non-banking subsidiaries from approximately 340 locations throughout Missouri, Illinois and Kansas. Principal activities include retail and commercial banking, investment management, securities brokerage, mortgage banking, credit related insurance, venture capital and real estate activities.
The Company follows accounting principles generally accepted in the United States of America (GAAP) and reporting practices applicable to the banking industry. The preparation of financial statements under GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and notes. While the consolidated financial statements reflect management’s best estimates and judgment, actual results could differ from those estimates. The consolidated financial statements include the accounts of the Company and its substantially wholly-owned subsidiaries (after elimination of all material intercompany balances and transactions). Certain amounts for prior years have been reclassified to conform to the current year presentation.
The Company adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets”, on January 1, 2002. This Statement established new accounting and reporting for acquired goodwill and other intangible assets. Under Statement No. 142, goodwill and intangible assets that have indefinite useful lives are not amortized, but are tested at least annually for impairment. Intangible assets that have finite useful lives, such as core deposit intangibles, continue to be amortized over their useful lives. Prior to the adoption of Statement No. 142, goodwill had been amortized using the straight-line method over periods of 15-25 years, as reflected in the accompanying 2001 and 2000 consolidated income statements. Core deposit intangibles have been amortized over a maximum of 10 years using accelerated methods for all periods presented.
When facts and circumstances indicate potential impairment of amortizable intangible assets, the Company evaluates the recoverability of the asset carrying value, using estimates of undiscounted future cash flows over the remaining asset life. Any impairment loss is measured by the excess of carrying value over fair value. Goodwill impairment tests are performed on an annual basis or when events or circumstances dictate. In these tests, the fair values of each reporting unit, or segment, is compared to the carrying amount of that reporting unit in order to determine if impairment is indicated. If so, the implied fair value of the reporting unit’s goodwill is compared to its carrying amount and the impairment loss is measured by the excess of the carrying value over fair value.
In the accompanying consolidated statements of cash flows, cash and cash equivalents include only “Cash and due from banks” as segregated in the accompanying consolidated balance sheets.
Interest on loans is accrued based upon the principal amount outstanding. Interest income is recognized primarily on the level yield method. Loan and commitment fees, net of costs, are deferred and recognized in income over the term of the loan or commitment as an adjustment of yield.
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Residential mortgage loans held for sale are valued at the lower of aggregate cost or fair value. The Company generally has commitments to sell fixed rate residential mortgage loans held for sale in the secondary market. Gains or losses on sales are recognized upon delivery in mortgage banking revenue.
It is the general policy of the Company to stop accruing interest income and recognize interest on a cash basis when any commercial or real estate loan is 90 days or more past due as to principal or interest and/or the ultimate collection of either is in doubt, unless the loan is well-secured and, in management’s judgment, considered to be fully collectible. Accrual of interest on consumer installment loans is suspended when any payment of principal or interest is more than 120 days delinquent. Credit card loans and the related accrued interest are charged off when the receivable is more than 180 days past due. When a loan is placed on non-accrual status, any interest previously accrued but not collected is reversed against current income. The Company classifies all non-accrual loans and loans 90 days delinquent and still accruing interest as impaired. Generally, the Company evaluates loans for impairment when a portion of a loan is internally risk rated as substandard or doubtful. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the underlying collateral.
The Company maintains an allowance to absorb probable loan losses inherent in the portfolio. Actual loan losses, net of recoveries, are deducted from the allowance. A provision for loan losses, which is a charge against earnings, is added to the allowance. The provision is based upon management’s estimate of the amount required to maintain an adequate allowance for losses, reflective of the risks in the loan portfolio. This estimate is based upon reviews of the portfolio, past loan loss experience, current economic conditions and such other factors, which in management’s judgment, deserve current recognition.
Securities classified as available for sale are carried at fair value. Their related unrealized gains and losses, net of tax, are reported in accumulated other comprehensive income, a component of stockholders’ equity. Premiums and discounts are amortized to interest income over the estimated lives of the securities. Realized gains and losses, including other-than-temporary declines in value, are calculated using the specific identification method and included in non-interest income.
Non-marketable securities include certain venture capital investments and stock acquired for various debt and regulatory requirements. Non-marketable venture capital investments are reported at estimated fair values, in the absence of readily ascertainable market values. Management believes that the cost of an investment is initially considered the best indication of estimated fair value. Subsequently, these investments are adjusted to reflect changes in valuation as a result of a public offering or other-than-temporary declines in value. Other non-marketable securities acquired for debt and regulatory purposes are accounted for at cost.
Trading account securities, which are bought and held principally for the purpose of resale in the near term, are carried at fair value. Gains and losses, both realized and unrealized, are recorded in non-interest income.
Land is stated at cost, and buildings and equipment are stated at cost less accumulated depreciation. Depreciation is computed using straight-line and accelerated methods. The Company currently assigns depreciable lives of 30 years for buildings, 10 years for improvements, and 3 to 8 years for equipment. Maintenance and repairs are charged to expense as incurred.
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Amounts provided for income tax expense are based on income reported for financial statement purposes and do not necessarily represent amounts currently payable under tax laws. Deferred income taxes are provided on temporary differences between the financial reporting bases and income tax bases of the Company’s assets and liabilities. Deferred tax assets and liabilities are measured using the tax rates and laws that are expected to be in effect when the differences are anticipated to reverse. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the change.
The Company and its eligible subsidiaries file consolidated income tax returns. Accordingly, amounts equal to tax benefits of those subsidiaries having taxable losses or credits are reimbursed by other subsidiaries that incur tax liabilities.
The Company is exposed to market risk, including changes in interest rates and currency exchange rates. To manage the volatility relating to these exposures, the Company’s risk management policies permit its use of derivative products. The Company manages potential credit exposure through established credit approvals, risk control limits and other monitoring procedures. The Company uses derivatives on a limited basis mainly to stabilize interest rate margins and hedge against interest rate movements, or to facilitate customers’ foreign exchange requirements. The Company more often manages normal asset and liability positions by altering the products it offers and by selling portions of specific loan or investment portfolios as necessary.
The Company adopted Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities”, and its amendments on January 1, 2001. The Statement required that all derivative financial instruments be recorded on the balance sheet at fair value, with the adjustment to fair value recorded in current earnings. Derivatives that qualify under the Statement in a hedging relationship are designated, based on the exposure being hedged, as fair value or cash flow hedges. Under the fair value hedging model, gains or losses attributable to the change in fair value of the derivative, as well as gains and losses attributable to the change in fair value of the hedged item, are recognized in current earnings. Under the cash flow hedging model, the effective portion of the gain or loss related to the derivative is recognized as a component of other comprehensive income. The ineffective portion is recognized in current earnings.
Upon the Company’s adoption of Statement No. 133, it recorded a transition adjustment that increased 2001 net income by $9,000. Because of its immateriality, the adjustment was not presented separately in the income statement as a cumulative effect of a change in accounting principle. The Company’s derivative usage is discussed in the Derivative Instruments note to the consolidated financial statements.
The Company accounts for stock-based awards to employees using the intrinsic value method of accounting in accordance with Accounting Principles Board Opinion No. 25 “Accounting for Stock Issued to Employees”. Under the intrinsic value method, because the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of grant, compensation expense is not recognized. This method is employed for all of the Company’s option plans except its restricted stock award plan, in which the market price of the underlying stock at grant is recorded as unearned compensation and amortized to expense over the vesting period. Had compensation cost for the Company’s other stock option plans been determined based upon the fair value at the grant date for awards under these plans consistent with the methodology prescribed under Statement of Financial Accounting Standards No. 123, “Accounting
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In determining the pro forma disclosures above, the fair value of options granted was estimated on the date of grant using the Black-Scholes option-pricing model. The Black-Scholes model was developed to estimate the fair value of traded options, which have different characteristics than employee stock options, and changes to the subjective assumptions used in the model can result in materially different fair value estimates. Below are the fair values of options granted using the Black-Scholes option-pricing model and the model assumptions.
All per share amounts in the above tables have been restated for the 5% stock dividend distributed in 2002.
Effective January 1, 2003, the Company voluntarily adopted the fair value recognition provisions of Statement No. 123 for stock-based employee compensation. All prior periods in future reports will be restated to reflect the compensation expense that would have been recognized had the recognition provisions of Statement No. 123 been applied to all awards granted to employees after January 1, 1995.
Purchases of the Company’s common stock are recorded at cost. Upon reissuance, treasury stock is reduced based upon the average cost basis of shares held.
Basic income per share is computed using the weighted average number of common shares outstanding during each year. Diluted income per share includes the effect of all dilutive potential common shares (primarily stock options) outstanding during each year. All per share data has been restated to reflect the 5% stock dividend distributed in December 2002.
Acquisitions
Effective January 2003, the Company acquired The Vaughn Group, Inc., a direct lessor of equipment which is based in Cincinnati, Ohio. The Vaughn Group, Inc. (Vaughn) has a lease portfolio of approximately
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Effective March 1, 2001, the Company acquired Breckenridge Bancshares Company and its subsidiary bank, Centennial Bank, in St. Ann, Missouri, with assets of $254 million, loans of $189 million, and deposits of $216 million. The Company issued common stock valued at $34.4 million as consideration in the transaction, which was accounted for as a pooling of interests. Financial statements for periods prior to the consummation of the acquisition have not been restated because such restated amounts do not differ materially from the Company’s historical financial statements. The following schedule summarizes pro forma consolidated financial data as if the Breckenridge acquisition had been consummated on January 1, 2000.
Loans and Allowance for Loan Losses
Major classifications of loans at December 31, 2002 and 2001 are as follows:
At December 31, 2002, the Company elected to reclassify certain segments of its business, construction, business real estate and personal portfolios. The reclassifications were made to better realign the loan reporting with its related collateral and purpose. The reclassifications also corrected certain construction loans that had moved into amortizing term loans following project completion. The reclassification increased business real estate loans by $209.6 million, personal real estate loans by $55.6 million and personal banking loans by $26.0 million, while business loans decreased $202.6 million and construction real estate loans decreased $88.6 million.
Loans to directors and executive officers of the Parent and its significant subsidiaries and to their associates are summarized as follows:
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Management believes all loans to directors and executive officers have been made in the ordinary course of business with normal credit terms, including interest rate and collateral considerations, and do not represent more than a normal risk of collection. There were no outstanding loans at December 31, 2002, to principal holders of the Company’s common stock.
The Company’s lending activity is generally centered in Missouri and its contiguous states. The Company maintains a diversified portfolio with limited industry concentrations of credit risk. Loans and loan commitments are extended under the Company’s normal credit standards, controls, and monitoring features. Most loan commitments are short and intermediate term in nature. Loan maturities, with the exception of residential mortgages, generally do not exceed five years. Collateral is commonly required and would include such assets as marketable securities and cash equivalent assets, accounts receivable and inventory, equipment, other forms of personal property, and real estate. At December 31, 2002, unfunded loan commitments totaled $3,037,111,000 (excluding $2,310,239,000 in unused approved lines of credit related to credit card loan agreements) which could be drawn by customers subject to certain review and terms of agreement. At December 31, 2002, loans of $935,201,000 were pledged at the Federal Home Loan Bank (FHLB) by subsidiary banks as collateral for borrowings and letters of credit obtained to secure public deposits. Additional loans of $267,531,000 were pledged at the Federal Reserve as collateral for discount window borrowings. There were no discount window borrowings at December 31, 2002.
A summary of the allowance for loan losses is as follows:
Impaired loans include all non-accrual loans and loans 90 days delinquent and still accruing interest. The net amount of interest income recorded on such loans during their impairment period was not significant. The Company had ceased recognition of interest income on loans with a book value of $28,065,000 and $28,819,000 at December 31, 2002 and 2001, respectively. The interest income not recognized on non-accrual loans was $2,609,000, $2,437,000 and $1,805,000 during 2002, 2001 and 2000, respectively. Loans 90 days delinquent and still accruing interest amounted to $22,428,000 and $19,699,000 at December 31, 2002 and 2001, respectively. Average impaired loans were $49,010,000 during 2002, $46,340,000 during 2001 and $41,500,000 during 2000.
The following table presents information on impaired loans at December 31:
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Investment Securities
A summary of the available for sale investment securities by maturity groupings as of December 31, 2002 follows below. The weighted average yield for each range of maturities was calculated using the yield on each security within that range weighted by the amortized cost of each security at December 31, 2002. Yields on tax exempt securities have not been adjusted for tax exempt status.
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The unrealized gains and losses by type are as follows:
The following table presents proceeds from sales of securities and the components of net securities gains.
Investment securities with a par value of $636,549,000 and $551,954,000 were pledged at December 31, 2002 and 2001, respectively, to secure public deposits and for other purposes as required by law. Additional investment securities with a par value of $1,525,000 and $22,493,000 were pledged at December 31, 2002 and 2001, respectively, at the Federal Reserve as collateral for discount window borrowings. Except for U.S. government and federal agency obligations, no investment in a single issuer exceeds 10% of stockholders’ equity.
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Land, Buildings and Equipment
Land, buildings and equipment consist of the following at December 31, 2002 and 2001:
Depreciation expense of $28,140,000, $25,458,000 and $24,599,000 for 2002, 2001 and 2000, respectively, was included in net occupancy expense, equipment expense and other expense in the consolidated income statements. Repairs and maintenance expense of $15,861,000, $15,529,000 and $14,579,000 for 2002, 2001 and 2000, respectively, was included in net occupancy expense, equipment expense and other expense. Interest expense capitalized on construction projects was $494,000, $747,000 and $433,000 in 2002, 2001 and 2000, respectively.
Intangible Assets and Goodwill
Effective January 1, 2002, the Company adopted Statement of Accounting Standards No. 142, “Goodwill and Other Intangible Assets”. Statement No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually. It also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment. The reviews performed in 2002 revealed no impairment in the Company’s intangible assets.
The following table presents information about the Company’s intangible assets.
As of December 31, 2002, the Company does not have any intangible assets that are not currently being amortized. Aggregate amortization expense on intangible assets for the years ended December 31, 2002 and 2001 was $2,323,000 and $3,040,000, respectively. Estimated annual amortization expense for the years 2003 through 2007 is as follows.
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As required by Statement No. 142, the Company discontinued recording goodwill amortization effective January 1, 2002. The following table compares results of operations as if no goodwill amortization had been recorded in 2001 or 2000.
Statement No. 142 also required the Company to perform an assessment of whether there was an indication that goodwill was impaired as of January 1, 2002. To accomplish this, the Company first identified its reporting units, which were determined to be the three reportable segments of Consumer, Commercial, and Money Management. The carrying value of each reporting unit was then established by assigning assets and liabilities, including the existing goodwill and intangible assets, to those reporting units as of January 1, 2002. The fair value of each reporting unit was determined and compared to the carrying amount of the reporting unit. Because the fair value of each of the reporting units exceeded the carrying value of the unit, no impairment of reporting unit goodwill was indicated. As a result, no impairment loss was recognized as a cumulative effect of a change in accounting principle in the Company’s 2002 consolidated statement of income.
During the second quarter of 2002, the Company sold several bank branches. Goodwill and other intangible assets, net of accumulated amortization, amounting to $1,300,000 were reversed in the determination of the gain recorded.
Deposits
At December 31, 2002, the scheduled maturities for time open and certificates of deposit were as follows:
Regulations of the Federal Reserve System require reserves to be maintained by all banking institutions according to the types and amounts of certain deposit liabilities. These requirements restrict usage of a portion of the amounts shown as consolidated “Cash and due from banks” from everyday usage in operation of the banks. The minimum reserve requirements for the subsidiary banks at December 31, 2002, totaled $96,005,000.
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Borrowings
Short-term borrowings of the Company consisted mainly of federal funds purchased and securities sold under agreements to repurchase. The following table presents balance and interest rate information on these and other short-term borrowings.
Debt of the Company which had an original term of over one year consisted of the following at December 31, 2002.
Banking subsidiaries of the Company are members of the FHLB and have access to term financing from the FHLB. These borrowings are secured under a blanket collateral agreement including primarily residential mortgages as well as all unencumbered assets and stock of the borrowing bank. Rates in effect on these borrowings at December 31, 2002, ranged from 1.5% on floating rate debt to 7.1% on fixed rate debt. Approximately $67,221,000 of FHLB advances outstanding at December 31, 2002, have a fixed interest rate.
In 2001, the Company acquired trust preferred securities as a result of its purchase of Breckenridge Bancshares Company (Breckenridge). Breckenridge had previously formed a wholly owned grantor trust subsidiary (the Trust) to issue preferred securities representing undivided beneficial interests in the assets of the Trust and to invest the gross proceeds of such preferred securities into notes of Breckenridge. The sole assets of the Trust are $4,000,000 aggregate principal amount of the 10.87% subordinated debenture notes due 2030 which are redeemable beginning in 2010. The notes were assumed by the Company as part of the acquisition. Such securities qualify as Tier 1 Capital for regulatory purposes.
Other long-term debt includes funds borrowed from third-party insurance companies by a venture capital subsidiary, a Missouri Certified Capital Company, to support its investment activities. Because the insurance companies receive tax credits, the borrowings do not bear interest. This debt is secured by assets of the subsidiary and letters of credit from an affiliate bank.
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Cash payments for interest on deposits and borrowings during 2002, 2001 and 2000 on a consolidated basis amounted to $164,147,000, $296,302,000 and $320,071,000, respectively.
Income tax expense (benefit) from operations for the years ended December 31, 2002, 2001 and 2000 consists of:
Income tax expense (benefit) allocated directly to stockholders’ equity for the years ended December 31, 2002, 2001 and 2000 consists of:
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The tax effect of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2002 and 2001 are presented below.
Actual income tax expense differs from the amounts computed by applying the U.S. federal income tax rate of 35% as a result of the following:
Cash payments of income taxes, net of refunds and interest received, amounted to $102,635,000, $87,984,000 and $92,247,000 on a consolidated basis during 2002, 2001 and 2000, respectively. The Parent had net receipts of $14,968,000, $2,930,000 and $1,622,000 during 2002, 2001 and 2000, respectively, from tax benefits.
Employee Benefit Plans
Employee benefits charged to operating expenses aggregated $38,190,000, $30,887,000 and $29,043,000 for 2002, 2001 and 2000, respectively. Substantially all of the Company’s employees are covered by a noncontributory defined benefit pension plan. Participants are fully vested after five years of service and the benefits are based on years of participation and average annualized earnings. The Company’s funding policy is to make contributions to a trust as necessary to provide for current service and for
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At December 31, 2001, the Company recorded a liability and offsetting charge to stockholders’ equity, net of deferred taxes, of $3,474,000 for the pension plan’s unfunded accumulated benefit obligation (ABO), as required by Statement of Financial Accounting Standards No. 87, “Employers’ Accounting for Pensions”. As a result of the Company’s contributions in 2002, the fair value of the plan assets exceeded the ABO, and the liability was reversed in the accompanying 2002 consolidated financial statements.
Certain key executives also participate in a second pension plan that the Company funds only as retirement benefits are disbursed. This executive plan had an ABO of $556,000 at the September 30, 2002 valuation date, but carries no segregated assets. In the tables presented below, the two pension plans are presented on a combined basis.
The following items are components of the net pension cost for the years ended December 31, 2002, 2001 and 2000.
The following table sets forth the pension plans’ funded status, using valuation dates of September 30, 2002 and 2001.
The above prepaid pension cost includes an accrued benefit liability for the executive plan of $720,000 and $646,000 at September 30, 2002 and 2001, respectively. Employer contributions made after the
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Assumptions used in computing the plans’ funded status were:
At December 31, 2002, approximately 56% of plan assets were invested in corporate equities, 19% in corporate bonds, and 18% U.S. government and agency securities.
In addition to the pension plans, substantially all of the Company’s employees are covered by a contributory defined contribution plan (401K), the Participating Investment Plan. Under the plan, the Company makes matching contributions, which aggregated $4,955,000 in 2002, $3,738,000 in 2001 and $3,210,000 in 2000.
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Stock Option Plans, Restricted Stock Awards and Directors Stock Purchase Plan*
The Company has reserved 11,247,119 shares of its common stock for issuance under various stock option plans offered to certain key employees of the Company and its subsidiaries. Options are granted, by action of the Board of Directors, to acquire stock at fair market value at the date of the grant, for a term of 10 years.
At December 31, 2002, 2,686,809 shares remain available for option grants under these programs. The following tables summarize option activity over the last three years and current options outstanding.
The Company has a restricted stock award plan under which 349,044 shares of common stock were reserved, and 94,330 shares remain available for grant at December 31, 2002. The plan allows for awards to key employees, by action of the Board of Directors, with restrictions as to transferability, sale, pledging, or assigning, among others, prior to the end of the restriction period. The restriction period may not exceed 10 years. The Company issued awards totaling 19,016 shares in 2002, 44,758 shares in 2001 and 29,130 shares in 2000, resulting in deferred compensation amounts of $771,000, $1,535,000 and $782,000, respectively. Approximately $692,000, $683,000 and $289,000 was amortized to salaries expense in 2002, 2001 and 2000, respectively. Unamortized deferred compensation of $1,800,000, $1,749,000 and $1,179,000 has been recorded as a reduction of stockholders’ equity at December 31, 2002, 2001 and 2000, respectively.
The Company has a directors stock purchase plan whereby outside directors of the Company and its subsidiaries may elect to use their directors’ fees to purchase Company stock at market value each month end. Remaining shares available for this plan total 154,903 at December 31, 2002. In 2002, 15,496 shares were purchased at an average price of $40.33 and in 2001, 18,053 shares were purchased at an average price of $34.23.
Comprehensive Income
Statement of Financial Accounting Standards No. 130 requires the reporting of comprehensive income and its components. Comprehensive income is defined as the change in equity from transactions and other events and circumstances from non-owner sources, and excludes investments by and distributions to owners. Comprehensive income includes net income and other items of comprehensive income meeting the
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The amount of income tax expense or benefit allocated to each component of other comprehensive income is as follows:
The end of period components of accumulated other comprehensive income (loss) are as follows:
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Segments
The Company segregates financial information for use in assessing its performance and allocating resources among three operating segments. The Consumer segment includes the retail branch network, consumer finance, bankcard, student loans and discount brokerage services. The Commercial segment provides corporate lending, leasing, and international services, as well as business, government deposit and cash management services. The Money Management segment provides traditional trust and estate tax planning services, and advisory and discretionary investment management services.
The Company’s business line reporting system derives segment information by specifically attributing most assets and income statement items to a segment. The Company’s internal funds transfer pricing methodology makes specific assignment of an interest spread to each new source or use of funds with a maturity date. Income and expense that directly relate to segment operations are recorded in the segment when incurred. Expenses that indirectly support the segments are allocated based on the most appropriate method available.
The Company’s reportable segments are strategic lines of business that offer different products and services. They are managed separately because each line services a specific customer need, requiring different performance measurement analyses and marketing strategies.
The following tables present selected financial information by segment and reconciliations of combined segment totals to consolidated totals. There were no material intersegment revenues between the three segments.
Segment Income Statement Data
The segment activity, as shown above, includes both direct and allocated items. Amounts in the “Other/ Elimination” column include activity not related to the segments, such as that relating to administrative functions, the investment securities portfolio, and the effect of certain expense allocations to the segments.
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Segment Balance Sheet Data
The above segment balances include only those items directly associated with the segment. The “Other/ Elimination” column includes unallocated bank balances not associated with a segment (such as investment securities, federal funds sold, goodwill and core deposit intangible), balances relating to certain other administrative and corporate functions, and eliminations between segment and non-segment balances. This column also includes the resulting effect of allocating such items as float, deposit reserve and capital for the purpose of computing the cost or credit for funds used/provided.
Beginning in 2002, the Company implemented a new funds transfer pricing method to value funds used (e.g., loans, fixed assets, cash, etc.) and funds provided (deposits, borrowings, and equity) by the business segments and their components. This new process assigns a specific value to each new source or use of funds with a maturity, based on current LIBOR interest rates, thus determining an interest spread at the time of the transaction. Non-maturity assets and liabilities are assigned to LIBOR based funding pools. Previous methodology used funding pools based on average rates to assign and determine value. The new method should provide a more accurate means of valuing fund sources and uses in a varying interest rate environment. The change in profitability methods mainly affected the Consumer segment and had the effect of lowering the credit for funds allocation to the Consumer segment by $119.3 million in 2002. Segment results for prior periods were not restated for the change in the profitability measurement method.
Common Stock
On December 13, 2002, the Company distributed a 5% stock dividend on its $5 par common stock for the ninth consecutive year. All per share data in this report has been restated to reflect the stock dividend. The table below is a summary of share activity in 2002.
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Basic income per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding during the year. Diluted income per share gives effect to all dilutive potential common shares that were outstanding during the year. The shares used in the calculation of basic and diluted income per share, which have been restated for all stock dividends, are as follows:
Under a Rights Agreement dated August 23, 1988, as amended in the amended and restated rights agreement with Commerce Bank, N.A. as rights agent, dated as of July 19, 1996, certain rights have attached to the common stock. Under certain circumstances relating to the acquisition of, or tender offer for, a specified percentage of the Company’s outstanding common stock, holders of the common stock may exercise the rights and purchase shares of Series A Preferred Stock or, at a discount, common stock of the Company or an acquiring company.
In January 2003, the Board of Directors approved additional purchases of the Company’s common stock, bringing the total purchase authorization to 4,000,000 shares. The Company has routinely used these reacquired shares to fund employee benefit programs and annual stock dividends.
Regulatory Capital Requirements
The Company is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory actions by regulators that could have a direct material effect on the Company’s financial statements. The regulations require the Company to meet specific capital adequacy guidelines that involve quantitative measures of the Company’s assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company’s capital classification is also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Company and its banking subsidiaries to maintain minimum amounts and ratios of Tier 1 capital to total average assets (leverage ratio), and minimum ratios of Tier 1 and Total capital to risk-weighted assets (as defined). To meet minimum, adequately capitalized regulatory requirements, an institution must maintain a Tier 1 capital ratio of 4.00%, a Total capital ratio of 8.00% and a leverage ratio of 4.00%. The minimum required ratios for well-capitalized banks (under prompt corrective action provisions) are 6.00% for Tier 1 capital, 10.00% for Total capital and 5.00% for the leverage ratio.
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The capital amounts and ratios for the Company (on a consolidated basis) and its three full-service banking subsidiaries at the last two year ends are as follows:
Management believes that the Company meets all capital requirements to which it is subject at December 31, 2002.
Fair Value of Financial Instruments
Statement of Financial Accounting Standards No. 107, “Disclosures about Fair Value of Financial Instruments”, requires disclosure of the carrying amounts and estimated fair values for financial instruments held by the Company. Fair value estimates, the methods used and assumptions made in computing those estimates, and the carrying amounts recorded in the balance sheet are set forth below.
Fair values are estimated for various groups of loans segregated by 1) type of loan, 2) fixed/adjustable interest terms and 3) performing/non-performing status. The fair value of performing loans is calculated by discounting all simulated cash flows. Cash flows include all principal and interest to be received, taking embedded optionality such as the customer’s right to prepay into account. Discount rates are computed for each loan category using implied forward market rates adjusted to recognize each loan’s approximate credit risk. Fair value of impaired loans approximates their carrying value because such loans are recorded at the appraised or estimated recoverable value of the collateral or the underlying cash flow.
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The fair values of the debt and equity instruments in the available for sale and trading sections of the investment security portfolio are estimated based on prices published in financial newspapers or bid quotations received from securities dealers. The fair value of those equity investments for which a market source is not readily available is estimated at carrying value.
A schedule of investment securities by category and maturity is provided in the Investment Securities note to the consolidated financial statements. Fair value estimates are based on the value of one unit without regard to any premium or discount that may result from concentrations of ownership, possible tax ramifications or estimated transaction costs.
The carrying amounts of federal funds sold and securities purchased under agreements to resell and cash and due from banks approximate fair value. Federal funds sold and securities purchased under agreements to resell generally mature in 90 days or less.
The carrying amounts of accrued interest receivable and accrued interest payable approximate their fair values because of the relatively short time period between the accrual period and the expected receipt or payment due date.
The fair value of derivative financial instruments is based on the estimated amounts that the Company would receive or pay to terminate the contracts at the reporting date (i.e., mark-to-market value). Fair values are based on dealer quotes or pricing models.
Statement 107 specifies that the fair value of deposits with no stated maturity is equal to the amount payable on demand. Such deposits include savings and interest and non-interest bearing demand deposits. These fair value estimates do not recognize any benefit the Company receives as a result of being able to administer, or control, the pricing of these accounts. The fair value of certificates of deposit is based on the discounted value of contractual cash flows. Discount rates are based on the Company’s approximate cost of obtaining similar maturity funding in the market.
Federal funds purchased and securities sold under agreements to repurchase mature or reprice within 90 days; therefore, their fair value approximates carrying value. The fair value of long-term debt is estimated by discounting contractual maturities using an estimate of the current market rate for similar instruments.
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The estimated fair values of the Company’s financial instruments are as follows:
The fair value of letters of credit and commitments to extend credit is based on the fees currently charged to enter into similar agreements. The aggregate of these fees is not material. These instruments are also referenced in the consolidated financial statement note on Commitments and Contingencies.
Fair value estimates are made at a specific point in time based on relevant market information. They do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no market exists for many of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, risk characteristics and economic conditions. These estimates are subjective, involve uncertainties and cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
Derivative Instruments
One of the Company’s primary risks associated with its lending activity is interest rate risk. Interest rates contain an ever-present volatility, as they are affected by the public’s perception of the economy’s health at any one point in time, as well as by specific actions of the Federal Reserve. These fluctuations can either compress or enhance fixed rate interest margins depending on the liability structure of the funding organization. Over the longer term, rising interest rates have a negative effect on interest margins as funding sources become more expensive relative to these fixed rate loans that do not reprice as quickly with the change in interest rates. However, in order to maintain its competitive advantage, in certain circumstances the Company offers fixed rate commercial financing whose term extends beyond its traditional three to five year parameter. This exposes the Company to the risk that the fair value of the fixed rate loan may fall if market interest rates increase. To reduce this exposure for certain specified loans, the Company enters into interest rate swaps, paying interest based on a fixed rate in exchange for interest based on a variable rate. During 2002 and 2001, the Company had three swaps which were designated as
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The Company’s mortgage banking operation makes commitments to extend fixed rate loans secured by 1-4 family residential properties, which are considered to be derivative instruments. These commitments have an average term of 60 to 90 days. The Company’s general practice is to sell such loans in the secondary market. During the term of the loan commitment, the value of the loan commitment, which includes mortgage servicing rights, changes in inverse proportion to changes in market interest rates. The Company obtains forward sale contracts with investors in the secondary market in order to manage these risk positions. Most of the contracts are matched to a specific loan on a “best efforts” basis, in which the Company is obligated to deliver the loan only if the loan closes. Hedge accounting has not been applied to these activities. During 2002, the change in fair value of the commitments was an unrealized gain of $429,000, and the change in fair value of the forward contracts was an unrealized loss of $979,000, netting to an unrealized loss of $550,000 for this activity. Changes in these fair values resulted in an unrealized gain of $874,000 during 2001. These unrealized gains and losses were recorded in mortgage banking revenue.
The Company’s foreign exchange activity involves the purchase and sale of forward foreign exchange contracts, which are commitments to purchase or deliver a specified amount of foreign currency at a specific future date. This activity enables customers involved in international business to hedge their exposure to foreign currency exchange rate fluctuations. The Company minimizes its related exposure arising from these customer transactions with offsetting contracts for the same currency and time frame. In addition, the Company uses foreign exchange contracts, to a limited extent, for trading purposes, including taking proprietary positions. Risk arises from changes in the currency exchange rate and from the potential for counterparty nonperformance. These risks are controlled by adherence to a foreign exchange trading policy which contains control limits on currency amounts, open positions, maturities and losses, and procedures for approvals, record-keeping, monitoring and reporting. Hedge accounting has not been applied to these foreign exchange activities. The changes in fair value of the foreign exchange derivative instruments resulted in net unrealized losses of $34,000 in 2002 and unrealized gains of $24,000 in 2001, and were recorded in other non-interest income.
At December 31, 2002, the total notional amount of derivatives held by the Company amounted to $218,145,000. Derivatives with positive fair values of $7,752,000 were recorded in other assets and derivatives with negative fair values of $9,760,000 were recorded as other liabilities at December 31, 2002. Changes in the fair values of the derivatives and hedged loans were recognized in current earnings. These changes resulted in an after tax net loss of $361,000 in 2002 compared to an after tax net gain of $510,000 in 2001.
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Commitments and Contingencies
The Company leases certain premises and equipment, all of which were classified as operating leases. The rent expense under such arrangements amounted to $4,122,000, $3,948,000 and $3,697,000 in 2002, 2001 and 2000, respectively. A summary of minimum lease commitments follows:
All leases expire prior to 2055. It is expected that in the normal course of business, leases that expire will be renewed or replaced by leases on other properties; thus, the future minimum lease commitments are not expected to be less than the amounts shown for 2003.
The Company engages in various transactions and commitments with off-balance-sheet risk in the normal course of business to meet customer financing needs. The Company uses the same credit policies in making the commitments and conditional obligations described below as it does for on-balance-sheet instruments. The following table summarizes these commitments at December 31:
Commitments to extend credit are legally binding agreements to lend to a borrower providing there are no violations of any conditions established in the contract. As many of the commitments are expected to expire without being drawn upon, the total commitment does not necessarily represent future cash requirements. Refer to the consolidated financial statements note on Loans and Allowance for Losses for further discussion.
Issuance of standby and commercial letters of credit beneficially assist customers engaged in a wide range of commercial enterprise and international trade. Standby letters of credit serve as payment assurances to a third party in the event the bank’s customer fails to perform its financial and/or contractual obligations. Most expire over the next 12 months and are secured by 1) a line of credit with, 2) a certificate of deposit held by, 3) marketable securities held by, or 4) a deed of trust held by a banking subsidiary. Commercial letters of credit generally finance the purchase of imported goods and provide a payment engagement against presentation of documents meeting the terms and conditions set forth in the letter of credit instrument.
Transactions involving securities described as “when-issued” are treated as conditional transactions in a security authorized for issuance but not yet actually issued. Purchases and sales of when-issued securities for which settlement date has not occurred are not to be reflected in the financial statements until settlement date.
In the normal course of business, the Company had certain lawsuits pending at December 31, 2002. In the opinion of management, after consultation with legal counsel, none of these suits will have a significant effect on the financial condition and results of operations of the Company.
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Parent Company Condensed Financial Statements
Following are the condensed financial statements of Commerce Bancshares, Inc. (Parent only) for the periods indicated:
Condensed Balance Sheets
Condensed Statements of Income
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Condensed Statements of Cash Flows
Dividends paid by the Parent were substantially provided from subsidiary bank dividends. The subsidiary banks may distribute dividends without prior regulatory approval that do not exceed the sum of net income for the current year and retained net income for the preceding two years, subject to maintenance of minimum capital requirements. The Parent charges fees to its subsidiaries for management services provided, which are allocated to the subsidiaries based primarily on total average assets. The Parent makes advances to non-banking subsidiaries and subsidiary bank holding companies. Advances are made to the Parent by subsidiary bank holding companies for investment in temporary liquid securities. Interest on such advances is based on market rates.
In 2001, the Parent paid $28,115,000 in cash for direct investments in several subsidiaries as part of a reorganization of the Company’s internal ownership structure. The Parent’s data processing fees paid to affiliates increased in 2001 over 2000 due to a change in the allocation formula between the Parent and its subsidiaries, which resulted in higher fees assessed to the Parent.
At December 31, 2002, the Parent had a $20,000,000 line of credit for general corporate purposes with a subsidiary bank. During 2002, the Parent had no borrowings from the subsidiary bank.
Available for sale investment securities held by the Parent, which consist primarily of short term investments in mutual funds, U.S. government and federal agency securities, common stock and commercial paper, included an unrealized gain in fair value of $30,772,000 at December 31, 2002. The corresponding net of tax unrealized gain included in stockholders’ equity was $19,042,000. Also included in stockholders’ equity was the unrealized net of tax gain in fair value of investment securities held by subsidiaries, which amounted to $77,051,000 at December 31, 2002.
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There were no changes in or disagreements with accountants on accounting and financial disclosure.
The information required by Item 401 and 405 of Regulation S-K regarding executive officers is included below under the caption “Executive Officers of the Registrant” and under the captions “Election of Directors” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the definitive proxy statement, which is incorporated herein by reference.
Executive Officers of the Registrant
The following are the executive officers of the Company, each of whom is designated annually, and there are no arrangements or understandings between any of the persons so named and any other person pursuant to which such person was designated an executive officer.
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The information required by Item 402 of Regulation S-K regarding executive compensation is included under the captions “Executive Compensation”, “Retirement Benefits”, “Compensation Committee Report on Executive Compensation”, and “Compensation Committee Interlocks and Insider Participation” in the definitive proxy statement, which is incorporated herein by reference.
The information required by Item 403 of Regulation S-K is covered under the caption “Voting Securities and Ownership Thereof by Certain Beneficial Owners and Management” in the definitive proxy statement, which is incorporated herein by reference.
The information required by Item 404 of Regulation S-K is covered under the caption “Election of Directors” in the definitive proxy statement, which is incorporated herein by reference.
Within the 90 days prior to the filing of this report, the Company carried out an evaluation under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as defined in Rule 13a-14(c) under the Securities Exchange Act of 1934. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective. There were not any significant changes in internal controls or in other factors that could significantly affect these controls subsequent to
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(a) The following documents are filed as a part of this report:
(b) Reports on Form 8-K:
(c) The exhibits filed as part of this report and exhibits incorporated herein by reference to other documents are listed in the Index to Exhibits (pages E-1 through E-2.)
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Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized this 12th day of March 2003.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on the 12th day of March 2003.
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CERTIFICATION
I, David W. Kemper, certify that:
1. I have reviewed this annual report on Form 10-K of Commerce Bancshares, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors:
6. The registrant’s other certifying officers and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
March 12, 2003
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I, A. Bayard Clark, certify that:
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3 – Articles of Incorporation and By-Laws:
4 – Instruments defining the rights of security holders, including indentures:
10 – Material Contracts (Each of the following is a management contract or compensatory plan arrangement):
E-1
21 – Subsidiaries of the Registrant
23 – Independent Accountants’ Consent
24 – Power of Attorney
99.1 – Certification of CEO pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
99.2 – Certification of CFO pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
E-2