UNITED STATESSECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-K
Commission File Number 1-6887
BANK OF HAWAII CORPORATION (Exact name of registrant as specified in its charter)
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:None
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, and (2) has been subject to such filing requirements for the past 90 days.
Yes ý No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 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 check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act.)
The aggregate market value of the registrant's voting stock held by non-affiliates is approximately $1,685,995,541, based on the June 30, 2003 closing price of said stock on the New York Stock Exchange ($33.15 per share).
As of February 20, 2004, there were 54,699,024 shares of Common Stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement relating to the Annual Meeting of Shareholders to be held April 30, 2004, are incorporated by reference into Part III of this Report.
Bank of Hawaii Corporation Form 10-K
INDEX
PART I
Item 1. Description of Business
General
Bank of Hawaii Corporation (the "Company") is a Delaware corporation and a bank holding company.
The Company's banking subsidiary, Bank of Hawaii (the "Bank"), was organized under the laws of Hawaii on December 17, 1897 and has its headquarters in Honolulu, Hawaii. Its deposits are insured by the Federal Deposit Insurance Corporation (the "FDIC"). The only other subsidiary of the Company is Bancorp Hawaii Capital Trust I, a guarantor trust.
Through the Bank, the Company provides a diversified range of banking financial services and products primarily in Hawaii and the Pacific Islands (Guam and nearby islands and American Samoa). The Bank's subsidiaries include Bank of Hawaii Leasing, Bankoh Investment Services, Pacific Century Life Insurance Company, Triad Insurance Agency, Bank of Hawaii Insurance Services, and Bank of Hawaii International. The Bank's subsidiaries are engaged in equipment leasing, insurance and insurance agency services, securities brokerage and investment services.
The Company is aligned into the following business segments: Retail Banking, Commercial Banking, Investment Services Group, and Treasury and Other Corporate. Additional financial and other information about the Company's business segments is presented in the Business Segments section of Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") and Note 18 to the Consolidated Financial Statements in this report, which is incorporated by reference in this Item.
The Company divested most of its foreign operations by the end of 2001. Additional information on foreign activities are presented in Table 12 of MD&A and Note 19 to the Consolidated Financial Statements in this report, which is incorporated by reference in this Item.
The Company's annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports can be found on its internet site at http://www.boh.com as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission (the "SEC"). The SEC maintains an internet site, http://www.sec.gov, that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC.
The Company's Corporate Governance Guidelines, the Charters of the Audit Committee, the Human Resources and Compensation Committee, the Executive and Strategic Planning Committee, and the Nominating and Corporate Governance Committee and the Code of Business Conduct and Ethics will be available on the Company's website by April 30, 2004. Upon written request to the Corporate Secretary at 130 Merchant Street, Honolulu, Hawaii, 96813, the information is available in print to any shareholder.
Competition
The Company, the Bank and its subsidiaries are subject to substantial competition from banks, savings associations, credit unions, mortgage companies, finance companies, mutual funds, brokerage firms, insurance companies and other providers of financial services, including financial service subsidiaries of commercial and manufacturing companies. The Company also competes with certain non-financial institutions and governmental entities that offer financial products and services. Some of the Company's competitors are not subject to the same level of regulation and oversight that are required of banks and bank holding companies.
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Supervision and Regulation
The following discussion describes certain material elements of an extensive regulatory framework applicable to bank holding companies and their subsidiaries and provides certain information specific to the Company.
This regulatory framework is intended primarily for the protection of depositors, federal deposit insurance funds and the banking system as a whole, and not for the protection of security holders. To the extent that this information describes statutory and regulatory provisions, it is qualified in its entirety by reference to those provisions. Any change in applicable laws or regulations may have a material effect on the business of the Company and its subsidiaries.
The Company is registered as a bank holding company ("BHC") under the Bank Holding Company Act of 1956, as amended (the "BHC Act"), and is subject to the supervision of and to examinations by the Board of Governors of the Federal Reserve Bank System (the "FRB"). The Company is also registered as a bank holding company under the Hawaii Code of Financial Institutions (the "Code") and is subject to the registration, reporting, and examination requirements of the Code.
The BHC Act prohibits, with certain exceptions, a BHC from acquiring beneficial ownership or control of more than 5% of the voting shares of any company, including a bank, without the FRB's prior approval and from engaging in any activity other than those of banking, managing or controlling banks or other subsidiaries authorized under the BHC Act, or furnishing services to or performing services for its subsidiaries. Among the permitted activities is the ownership of shares of any company the activities of which the FRB determines to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.
Subject to certain limits, under the Riegle-Neal Interstate Banking and Branching Efficiency Act (the "Riegle-Neal Act") an adequately capitalized and adequately managed BHC may acquire control of banks in any state. An interstate acquisition may not be approved if immediately following the acquisition the BHC would control 30 percent or more of the total FDIC-insured deposits in that state (or such lesser or greater amount set by the state), unless the acquisition is the BHC's initial entry into the state. An adequately capitalized and adequately managed bank may apply for permission to merge with an out-of-state bank and convert all branches of both parties into branches of a single bank. An interstate bank merger may not be approved, if immediately following the acquisition, the acquirer would control 30 percent or more of the total FDIC-insured deposits in that state (or such lesser or greater amount set by the state), unless the acquisition is the acquirer's initial entry into the state. Banks are also permitted to open newly established branches in any state in which it does not already have banking branches if such state enacts a law permitting such de novo branching.
Hawaii has enacted a statute that authorizes out-of-state banks to engage in mergers with Hawaii banks or acquisitions of substantially all of their assets, following which any such out-of-state bank may operate the branches of the Hawaii bank it has acquired. The Hawaii bank must have been in continuous operation for at least five years unless it is subject to or in danger of becoming subject to certain types of supervisory action. This statute does not permit out-of-state banks to acquire branches of Hawaii banks other than through an "interstate merger transaction" under the Riegle-Neal Act (except in the case of a bank that is subject to or in danger of becoming subject to certain types of supervisory action) or to open branches in Hawaii on a de novo basis.
Under the Gramm-Leach-Bliley Act, a BHC may elect to become a financial holding company and thereby engage in a broader range of financial and other activities than are permissible for traditional BHCs. In order to qualify for the election, all of the depository institution subsidiaries of the BHC must be well capitalized and well managed and all of its insured depository institution subsidiaries must have achieved a rating of "satisfactory" or better under the Community Reinvestment Act. Financial holding companies are permitted to engage in activities that are "financial in nature" or incidental or complementary thereto
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as determined by the FRB. The Gramm-Leach-Bliley Act identifies several activities as "financial in nature," including, among others, insurance underwriting and agency, investment advisory services, merchant banking and underwriting and dealing or making a market in securities. The Company has not elected to become a financial holding company.
Subsidiary Bank
The Bank is subject to supervision and examination by the Federal Reserve Bank of San Francisco and the State of Hawaii Department of Commerce and Consumer Affairs Division of Financial Institutions. Depository institutions, including the Bank, are subject to extensive federal and state regulation that significantly affect their business and activities. Regulatory bodies have broad authority to implement standards and to initiate proceedings designed to prohibit depository institutions from engaging in unsafe and unsound banking practices. The standards relate generally to operations and management, asset quality, interest rate exposure and executive compensation. The agencies are authorized to take action against institutions that fail to meet such standards.
Source of Strength Doctrine
Under FRB policy, a BHC is expected to serve as a source of financial and management strength to its subsidiary banks and to commit resources to support its subsidiary banks in circumstances where it might not do so absent such a policy. This support may be required at times when the BHC may not have the resources to provide it. Under this policy, a BHC is expected to stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial adversity and to maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks.
Capital Requirements
The Company and the Bank are subject to risk-based capital requirements and guidelines imposed by the banking regulatory agencies.
As an additional means to identify problems in the financial management of depository institutions, the Federal Deposit Insurance Corporation Improvement Act ("FDICIA") requires federal bank regulatory agencies to establish certain non-capital safety and soundness standards.
FDICIA requires federal bank regulatory agencies to take "prompt corrective action" with respect to FDIC-insured depository institutions that do not meet minimum capital requirements. A depository institution's treatment for purposes of the prompt corrective action provisions will depend upon how its capital levels compare to various capital measures and certain other factors, as established by regulation.
For further information regarding the minimum capital requirements applicable to the Company and the Bank, see Note 11 to the Consolidated Financial Statements, which is incorporated by reference in this Item.
Dividend Restrictions
The Company is a legal entity separate and distinct from the Bank. The Company's principal source of funds to pay dividends on its common stock and debt service on its debt is dividends from the Bank. Various federal and state statutory provisions and regulations limit the amount of dividends the Bank may pay to the Company without regulatory approval, including requirements to maintain capital above regulatory minimums. The FRB is authorized to determine the circumstances when the payment of dividends would be an unsafe or unsound practice and to prohibit such payments. The right of the Company, its stockholders and creditors to participate in any distribution of the assets or earnings of its subsidiaries also is subject to the prior claims of creditors of those subsidiaries.
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For information regarding the limitations on Bank dividends, see Note 11 to the Consolidated Financial Statements, which is incorporated by reference in this Item.
Other Transfers of Funds
The Bank is subject to restrictions under federal law that limit the transfer of funds or other items of value to the Company and any non-bank subsidiaries (including affiliates) in so-called "covered transactions." In general, covered transactions include loans and other extensions of credit, investments and asset purchases, as well as other transactions involving the transfer of value from the Bank to an affiliate or for the benefit of an affiliate. Unless an exemption applies, covered transactions by the Bank with a single affiliate are limited to 10% of the Bank's capital and surplus and, with respect to all covered transactions with affiliates in the aggregate, to 20% of the Bank's capital and surplus.
FDIC Insurance
The FDIC has adopted a premium schedule under which the actual assessment rate for a particular institution depends in part upon the risk classification the FDIC assigns to that institution. The FDIC may increase an institution's insurance premiums or terminate insurance upon a finding that the institution has engaged in unsafe and unsound practices.
Employees
At January 31, 2004, the Company and its subsidiaries had approximately 2,700 employees.
Item 2. Properties
The principal offices of the Company and each of its business segments are located in the Financial Plaza of the Pacific building in Honolulu, Hawaii, which is owned primarily by the Company. The land under the office building is leased. The Company and its subsidiaries own and lease other premises, consisting of branch offices and operating facilities located in Hawaii and the Pacific Islands which are primarily used by the Retail Banking and Commercial Banking business segments.
Item 3. Legal Proceedings
The Company and its subsidiaries are defendants in various legal proceedings arising from normal business activities. In the opinion of management, after reviewing these proceedings with counsel, the aggregate liability, if any, resulting from these proceedings is not expected to have a material effect on the Company's consolidated financial position or results of operations.
Item 4. Submission of Matters to a Vote of Security Holders
No matter was submitted during the fourth quarter of 2003 to a vote of security holders through solicitation of proxies or otherwise.
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Executive Officers of Registrant:
All listed officers are executive officers of the Company and the Bank.
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PART II
Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters
The common stock of the Company is traded on the New York Stock Exchange (NYSE Symbol: BOH) and quoted daily in leading financial publications. As of February 20, 2004, there were 9,653 common shareholders of record.
Information regarding the historical market prices of the Company's common stock and dividends declared on that stock are included below.
Market Prices, Book Values and Common Stock Dividends Per Share
The Board of Directors of the Company considers on a quarterly basis the feasibility of paying a cash dividend to its shareholders. General practice is to declare a dividend in the beginning of a quarter to be paid prior to the end of the quarter and is based, in part, on the expected earnings for the quarter. For additional information regarding the limitation on the Company's ability to pay dividends, see "Dividend Restrictions" under "Supervision and Regulations" in Item 1 of this report and Note 11 to the Consolidated Financial Statements, which are incorporated by reference in this Item.
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Item 6. Selected Financial Data
Summary of Selected Consolidated Financial Data1
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Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
This report contains forward-looking statements concerning, among other things, the economic environment in the Company's service area, the expected level of loan loss provisioning, anticipated savings of our systems replacement project, the effect of our new three-year plan, and anticipated dividends, revenues and expenses during 2004 and beyond. The Company believes the assumptions underlying its forward-looking statements are reasonable. However, any of the assumptions could prove to be inaccurate and actual results may differ materially from those projected for a variety of reasons, including, but not limited to: 1) unanticipated changes in business and economic conditions, the competitive environment, fiscal and monetary policies, or legislation in Hawaii and the other markets the Company serves; 2) changes in the Company's credit quality or risk profile which may increase or decrease the required level of allowance for loan and lease losses; 3) changes in market interest rates that may affect the Company's credit markets and ability to maintain its net interest margin; 4) changes to the amount and timing of the Company's anticipated equity repurchases; 5) inability to achieve expected benefits of the Company's business process changes due to adverse changes in implementation processes or costs, operational savings, or timing; 6) real or threatened acts of war or terrorist activity affecting business conditions; and 7) adverse weather and other natural conditions impacting the Company and its customers' operations. Words such as "believes," "anticipates," "expects," "intends," "targeted" and similar expressions are intended to identify forward-looking statements but are not exclusive means of identifying such statements. The Company does not undertake any obligation to update forward-looking statements to reflect later events or circumstances.
Critical Accounting Policies
The Company's Consolidated Financial Statements were prepared in accordance with accounting principles generally accepted in the United States and follow general practices within the financial services industry it operates. The most significant accounting policies followed by the Company are presented in Note 1 to the Consolidated Financial Statements, which is incorporated by reference in this Item. Application of these principles requires management to make estimates, assumptions and judgments that affect the amounts reported in the financial statements. Critical accounting estimates are defined as those that require assumptions to be made that are "highly uncertain" at the time the estimate was made and where the impact of the selection of the estimate or a change in the estimate from period to period would have a material impact on the financial statements. Based on the potential impact to the financial statements of the valuation methods, estimates, assumptions and judgments used, management identified the determination of the Allowance for Loan and Lease Losses (the "Allowance"), the valuation of mortgage servicing rights and the valuation of leased asset residuals to be the accounting estimates that are the most subjective and/or judgmental.
Allowance for Loan and Lease Losses
The Company maintains an Allowance in an amount adequate to cover management's estimate of probable credit losses based on analyses of historical loss experience supplemented by judgmental expectations of the impact of economic conditions as of a given balance sheet date. The determination of the amount of the Allowance is a critical accounting estimate as it requires the use of estimates and significant judgment related to the amount and timing of expected future cash flows on impaired loans, estimated loss rates on homogenous portfolios and deliberation on economic factors and trends. It is possible that the Allowance could have been reduced or increased if the Company had judged economic conditions and other factors and risks to be more or less favorable. See further discussion on Allowance in "Corporate Risk Profile—Allowance for Loan and Lease Losses."
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Mortgage Servicing Rights Valuation
When mortgage loans are sold with servicing retained, a servicing asset is established and accounted for based on estimated fair values. Such values are determined using discounted cash flow modeling techniques, which require management to make estimates and assumptions regarding the amount and timing of expected future cash flows, loan repayment rates, costs to service and interest rates that contemplate the risk involved. Because the value of these assets is sensitive to changes in the estimates and assumptions made, the valuation of mortgage servicing rights is considered a critical accounting estimate. Had the Company assumed that interest rates would decrease and prepayment rates remain at record high levels, then the value of the mortgage servicing rights could have been lower. Note 6 to the Consolidated Financial Statements, which includes further discussion on the accounting for these assets and a sensitivity analysis, is incorporated by reference in this Item.
Residual Valuation of Leased Assets
Lease financing receivables include a residual value component, which represents the estimated value of leased assets upon lease expirations. The valuation of leased assets is considered a critical accounting estimate due to the subjectivity surrounding the future valuation. The determination of expected value at lease termination is derived from a variety of sources, including equipment valuation services, appraisals and publicly available market data on recent sales transactions on similar equipment. The length of time until termination and the cyclical nature of equipment values are important variables considered in making this determination. Residual values could have been lower, therefore reducing the value of the recorded leases, if the Company had assumed that current uncertainties in the airline industry would continue indefinitely or that there will be a greater incidence of airlines using the bankruptcy process to lower aircraft lease rates or eliminate unused aircraft. These values could also affect the level of the Allowance. Note 5 to the Consolidated Financial Statements includes further discussion on the accounting for these assets and is incorporated by reference in this Item.
Overview
The end of 2003 marked the successful completion of the Company's 2001-2003 strategic plan. The objectives of this plan were to: improve credit risk management; intelligently allocate capital resources; solidify performance in core markets; improve customer service; increase financial returns; and maintain a strong capital position. The Company undertook several initiatives in an effort to meet these objectives, the most significant of which were: (1) the credit risk management process was strengthened and the quality of the Company's credit portfolios was improved; (2) underperforming businesses, including banking operations in California, Asia and the South Pacific, were divested in 2001; (3) the Information Technology Systems Replacement Project ("Systems Replacement Project") was completed in 2003 and has resulted in lower operating costs, an integrated technology platform and improved customer service; and (4) a share repurchase program, which began in July 2001 returned excess capital to the shareholders. Each of these initiatives is further discussed in the following sections of this report.
Net income for 2003 was $135.2 million, or $2.21 per diluted share, compared to $121.2 million, or $1.70 per diluted share, in 2002. For the year, the net interest margin increased 24 basis points to 4.23%, largely due to improvements in the mix of deposit liabilities and a lower cost of funds. The Company did not recognize a provision for loan and lease losses in 2003. Non-interest income for 2003 of $198.7 million increased slightly from 2002; however the individual components changed as fee and insurance income improved while the low interest rate environment and stock market performance led to a decline in mortgage banking income and income from trust and asset management, respectively. Non-interest expenses for 2003 decreased 3% to $357.9 million from $369.2 million in 2002. Excluding the costs of the Systems Replacement Project, the Company achieved a 6% reduction in non-interest expenses in 2003 from 2002.
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Analysis of Statement of Income
Comparisons between 2002 and 2001 may not be meaningful due to the divestiture of businesses in 2001. Certain 2002 and 2001 information has been reclassified to conform to 2003 presentation.
Net Interest Income
Net interest income on a taxable equivalent basis decreased by $4.4 million or 1% from 2002. The decrease in net interest income was primarily a result of the lower interest rate environment, in particular the low interest rates earned on mortgage loans and short-term investments which were at the lowest levels in several decades. The lower level of interest income was partially offset by a reduction in interest expense, including a reduction in interest paid on deposits, which declined by 44% in spite of a 5% increase in average interest bearing deposits, and interest paid on short and long-term borrowings, which decreased due to a reduction in the borrowings.
Average interest earning assets in 2003 decreased $617.2 million, or 7%, from 2002 primarily due to an $872.7 million decrease in Interest Bearing Deposits which was used for stock repurchases and debt reductions. Average interest bearing liabilities in 2003 decreased $536.3 million or 8% from 2002 mainly due to reductions in short-term borrowings and long-term debt.
The net interest margin was 4.23% in 2003, a 24 basis point increase from 3.99% in 2002. The improvement was attributable to extending the maturities of certain short-term investments and reductions in time deposits, short-term borrowings and debt, all of which lowered the Company's cost of funds.
Average balances, related income and expenses, and resulting yields and rates are presented in Table 1. An analysis of changes in net interest income is presented in Table 2.
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Table 1Consolidated Average Balances and Interest Rates—Taxable Equivalent Basis
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Table 2Analysis of Changes in Net Interest Income—Tax Equivalent Basis
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Provision for Loan and Lease Losses
Because of continued improvements in nearly all indicators of the Company's credit quality, and management's assessment of economic conditions and risks, no Provision for Loan and Lease Losses ("Provision") was recognized in 2003. A Provision of $11.6 million was recognized in the first six months of 2002.
Based on current conditions, the Company does not expect to record a Provision in 2004. However, the actual amount of the Provision depends on determinations of credit risk that are made near the end of each quarter.
Non-Interest Income
Total non-interest income in 2003 was relatively unchanged from 2002; however, the components of non-interest income changed. Service charges, fees and insurance income increased in 2003, while trust and asset management fees and mortgage banking income declined.
Table 3 presents the major components of non-interest income.
Table 3Non-Interest Income
Trust and Asset Management income declined in 2003 from 2002 due primarily to a decline in the market value of assets under management and lower investment advisory fees on money market assets due to declining short-term interest rates. Although the stock market experienced some recovery in 2003, the S&P 500 Index, a leading market indicator, did not recover to the peak levels of early 2002.
During 2003, mortgage interest rates declined to near record lows. As a result, mortgage loan activity was strong with high levels of loan originations, but also high levels of loan prepayments. Because production was 75% higher in 2003 than in 2002, sales of newly originated loans and related gains increased 86% in 2003. Net servicing income declined 371% in 2003 compared to 2002 due to increased amortization of mortgage servicing rights resulting from the high level of prepayments. In addition, a $4.4 million market value gain was recognized in 2002, reversing a December 31, 2001 valuation loss in loans held for sale.
Service Charges on Deposit Accounts increased from the prior year, primarily due to a 16% increase in average demand deposits. In addition, overdraft fees increased from a new fee structure implemented in late 2002. Account analysis fees increased as a result of customers receiving lower offsetting earnings credits in the lower interest rate environment.
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Fees, Exchange and Other Service Charges increased from 2002, mainly due to a $3.0 million prepayment fee on a commercial real estate loan in 2003. Also contributing to the increase were merchant transaction and card fees, a result of increased merchant sales volumes, and home equity and consumer loan fees from 2003 marketing campaigns.
The increase in insurance income was mainly due to new business, favorable retention rates, increased premiums and experience adjustments.
Annuity and Brokerage income declined in 2003 due to the overall decline in the industry attributable to the low interest rate environment and uncertainty surrounding the stock market. Income from Bank Owned Life Insurance increased in 2003 due to additional policies of approximately $40 million that were purchased at the end of 2002. Other income decreased mainly due to the write-off of venture investments of $0.9 million in 2003 compared to a $0.8 million gain in 2002. The 2003 decline was also a result of 2002 gains on debt repurchases, and an adjustment to the gain on the South Pacific sale. These declines were partially offset by a gain on sale of leased equipment in 2003. In 2001, net pre-tax gains of $173.4 million were recognized relating to the divestitures of non-strategic businesses. Table 4 presents the details of these gains and losses:
Table 4
Also in 2001, gains on investment securities included $28.4 million from the sale of a stock investment in an ATM processor, Star Systems, Inc., and $3.7 million from the sale of Bank of Queensland stock.
Non-Interest Expense
The decline in overall non-interest expense in 2003 compared to 2002 was largely attributable to benefits of the Systems Replacement Project. This project resulted in decreased salaries, depreciation, equipment maintenance and software license fees.
Table 5 shows the major components of non-interest expense.
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Table 5Non-Interest Expense
Total salaries and benefits in 2003 were relatively unchanged from 2002, although base salaries declined $9.2 million, or 7%. Largely offsetting the decline in base salaries were increases in incentive compensation and stock based compensation, which increased by $2.8 million and $4.6 million, respectively. Incentive compensation increased over the prior year due to the achievement of performance goals in several lines of business and the improvement in the Company's overall performance. The increase in stock based compensation was primarily due to additional restricted stock grants in 2003 and the accelerated vesting of grants due to the achievement of targeted Company performance goals. Total expense related to restricted stock increased $2.1 million over 2002's level. In addition, restricted stock units were awarded in 2003, resulting in $2.6 million expense.
The decline in salaries, net occupancy and net equipment expense in 2002 from 2001 was primarily due to the divested businesses. In addition, in 2002 the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets, which eliminated goodwill amortization.
In the third quarter of 2003, the Company completed its Systems Replacement Project. In 2002, the Company entered into a technology services agreement with Metavante Corporation, which now serves as the Company's primary technology systems provider. The Company converted its key systems, including loans and deposits, to Metavante's computer system. The new system enhances customer service and convenience, as well as improves the Company's efficiency. This seven year outsourcing arrangement is similar to those used by other Hawaii banks. The conversion is expected to provide annual cost savings of
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approximately $17.0 million compared to 2002 second quarter expense levels. The following table presents the costs incurred on the Systems Replacement Project.
Table 6
In 2002, restructuring and other related costs were mainly employee and lease termination costs related to the closure of branches in the Pacific Islands and the completion of the 2001 divestitures. In 2001, restructuring and other related costs were comprised primarily of foreign currency translation losses, the write-down of goodwill related to the sale of banking operations, and employee termination costs. The employee termination costs in 2001 related largely to severance for employees of the divested operations and the Hawaii-based personnel who supported those businesses. See Note 3 to the Consolidated Financial Statements, which is incorporated by reference in this Item for additional information.
The decrease in professional fees was mainly due to a decline in legal fees and consulting services for the System Replacement Project, a new payroll system, and compensation plans. The Company also experienced declines in education and advertising expenses and recognized a gain on transfer of an affinity mileage program. In addition, a $2.5 million gain on the sale of foreclosed real estate reduced these expenses in 2003.
Income Taxes
The 2003 provision for income taxes reflected an effective tax rate of 34.6%, compared to effective rates of 35.4% and 50.9% in 2002 and 2001, respectively. The unusually high rate in 2001 was a result of a higher level of non-tax-deductible costs associated with the divestitures, the most significant of which was $83.6 million of goodwill associated with the Company's California subsidiary bank.
Operating Results and Performance Ratios excluding Divested Businesses, Systems Replacement Project, Restructuring and Goodwill
The Company completed its Systems Replacement Project in 2003 and its divestitures in 2002. To enhance comparability between years, Table 7 presents pro-forma financial results excluding costs for the Systems Replacement Project, restructuring, goodwill amortization, income from divested business and gains on sales:
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Table 7
Business Segments
The Company's business segments are defined as Retail Banking, Commercial Banking, Investment Services Group and Treasury and Other Corporate. The management accounting 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. This process uses various techniques to assign balance sheet and income statement amounts to the business segments, including allocations of overhead, the Provision and capital. This process is dynamic and requires certain allocations based on judgment and subjective factors. Unlike financial accounting, there is no comprehensive, authoritative guidance for management accounting that is equivalent to accounting principles generally accepted in the United States. Results for prior periods have been reclassified to facilitate comparability with the 2003 presentation.
The business segments are primarily managed with a focus on performance measures, including risk adjusted return on capital ("RAROC") and net income after capital charge ("NIACC"). RAROC is the ratio of net income to risk-adjusted equity. Equity is allocated to each business segment based on an assessment of its inherent risk. NIACC is net income less a charge for allocated capital. The cost of capital is determined by multiplying management's estimate of the shareholder's minimum required rate of return on capital invested (currently 11%) by the segment's allocated equity. The Company assumes a cost of capital that is equal to a risk-free rate plus a risk premium of an equity investment in the Company. The net interest income of the business segments reflects the results of a funds transfer pricing process that matches assets and liabilities with similar interest rate sensitivity and maturity characteristics and reflects the allocation of net interest income related to the Company's overall asset and liability management activities on a proportionate basis. The basis for the allocation of net interest income is a function of management decisions and assumptions which are subject to change based on changes in current interest rate and market conditions. The Provision charged to the Treasury and Other Corporate segment represents changes in the level of the Allowance. The Provision recorded in the Retail Banking, Commercial Banking and Investment Services Group segments represents actual net charge-offs of these segments.
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On a consolidated basis, the Company considers NIACC a measure of value creation. For the year ended December 31, 2003, consolidated NIACC was a positive $20.7 million, compared to a negative NIACC of $18.5 million in 2002, a result of improved financial performance and more efficient use of capital.
Financial results for each of the segments are presented in Table 8 and Note 18 of the Consolidated Financial Statements, which is incorporated by reference in this Item.
The following table summarizes NIACC and RAROC results for the Company's business segments:
Table 8Business Segment Selected Financial Information
n.m.—not meaningful.
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Retail Banking
The Company's Retail Banking segment offers a broad range of financial products and services to consumers and small businesses. Loan and lease products include residential mortgage loans, home equity lines of credit, automobile loans and leases and installment loans. Deposit products include checking, savings and time deposit accounts. The Retail Banking segment also provides merchant services to its small business customers. Products and services from the Retail Banking segment are delivered to customers through 74 Hawaii branch locations and over 500 ATMs, e-Bankoh (on-line banking service), and a 24-hour telephone banking service.
The improvement in the segment's financial measures in 2003 as compared to 2002 was primarily due to an increase in net interest income and non-interest income, as well as a decrease in non-interest expense and Systems Replacement Project costs. These positive trends were partially offset by an increase in the Provision in 2003. The increase in net interest income for the segment was reflective of higher average loan balances, largely a result of strong growth in the segment's automobile, direct personal, small business and home equity portfolios, augmented by a purchase of home equity loans in December 2002. Also contributing to the increase in net interest income was lower interest expense on deposit accounts, reflective of the lower interest rate environment in 2003. The increase in non-interest income was primarily due to an increase in fees and service charges on deposit accounts. The decrease in non-interest expense was primarily due to reductions in technology support, depreciation and advertising costs. The increase in the Provision in 2003 was primarily due to increased charge-offs in the segment's growing automobile, direct personal and small business loan portfolios.
The improvement in the segment's financial measures in 2002 as compared to 2001 was primarily due to an increase in net interest income as well as a decrease in non-interest expense and the Provision. The increase in net interest income was primarily due to the declining interest rate environment in 2002, which resulted in a reduction of interest expense on deposit accounts. Non-interest expense decreased primarily due to reductions in technology spending, incentive compensation and marketing costs. Also contributing to the decrease in non-interest expense in 2002 was improved efficiency in the deployment of staffing models in the branch network. These positive trends were partially offset by the recording of Systems Replacement Project costs in 2002.
Commercial Banking
The Commercial Banking segment offers products including corporate banking and commercial real estate loans, lease financing, auto dealer financing, deposit and cash management products and property and casualty insurance products. Lending, deposit and cash management services are offered to middle-market and large companies in Hawaii. Commercial real estate mortgages are focused on customers that include investors, developers and builders primarily domiciled in Hawaii. The Commercial Banking unit also serves customers through its 14 branches in the Pacific Islands. As part of the initiatives for improving efficiency, the representative office in Tokyo was closed in 2003.
The improvement in the segment's financial measures for 2003 compared to 2002 was a result of decreases in the Provision and non-interest expense and an increase in non-interest income, moderately offset by lower net interest income. The increase in non-interest income is attributed to an increase in prepayment fees on commercial real estate loans, insurance income and other fees. The decline in the Provision is a result of improved credit quality of the loan portfolio. The decline in non-interest expense was due to cost management initiatives that reduced staffing levels and other direct expenses as well as the realization of benefits from the System Replacement Project, and reduced allocated expenses from support units within the Company.
The improvement in these financial measures for 2002 compared with 2001 was primarily due to an increase in other non-interest income as well as decreases to non-interest expense and the Provision. These improvements were partially offset by a decrease in net interest income. Net interest income in 2002
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declined from 2001 due to the low interest rate environment during 2002 and a decrease in commercial loan balances. The decrease in commercial loan balances was in line with the Company's overall initiative to improve credit quality. The increase in other non-interest income was primarily due to foreign exchange income; prepayment, renegotiation and secondary marketing transaction income from the Commercial Real Estate unit; service charges on deposit accounts from commercial customers on analyzed checking accounts; and gains on disposal of leased assets and other lease financing arrangements. The reduction in the Provision reflected the improvement in the credit quality of the commercial loan portfolio. Total non-interest expense declined in 2002 from 2001 due to decreases in salaries, benefits and product and business development expenses.
Investment Services Group
The Investment Services Group includes private banking, trust services, asset management, institutional investment advice and retail brokerage. A significant portion of this segment's income is derived from fees, which are generally based on the market values of assets under management. The private banking and personal trust group assists individuals and families in building and preserving their wealth by providing investment, credit and trust expertise to high-net-worth individuals. The asset management group manages portfolios and creates investment products. Institutional sales and service offers investment advice to corporations, government entities and foundations. Also included in the segment is Bankoh Investment Services, Inc., a full service brokerage offering equities, mutual funds, life insurance and annuities.
The decline in the segment's financial measures for 2003 as compared to 2002 was primarily due to a decrease in non-interest income. Non-interest bearing deposit balances decreased, resulting in a decline in net interest income. The decline in non-interest income was due primarily to a decrease in trust and asset management fee income which resulted from declines in the value of assets under management and from decreased sales and fee income. The decrease in non-interest expense was mainly due to a decrease in outside service fees and commissions.
The improvement in these financial measures for 2002 compared to 2001 was primarily due to an increase in net interest income and a decrease in non-interest expense, partially offset by a decrease in non-interest income. Net interest income increased, primarily as a result of lower rates paid on deposit balances in the private client services area. Non-interest income declined from 2001 to 2002 due primarily to a decrease in trust and asset management fee income which resulted from declines in the value of assets under management as the stock market continued to decline. The decrease in non-interest expense was due to decreases in professional fees and the identification and reduction of other expenses to coincide with the reduced other non-interest income during 2002.
Treasury and Other Corporate
The primary income earning component of this segment is Treasury, which consists of corporate asset and liability management activities, including interest rate risk management and foreign exchange business. This segment's assets and liabilities (and related net interest income) consist of interest bearing deposits, investment securities, federal funds sold and purchased, government deposits and short and long-term borrowings. The primary source of foreign exchange income relates to customer driven currency requests from merchants and island visitors. The net residual effect of transfer pricing of assets and liabilities is included in Treasury, along with eliminations of inter-company transactions.
This segment also includes divisions that provide a wide-range of support (Technology and Operations, Human Resources, Finance and Legal and Risk Management) to the other income earning segments. Expenses incurred by these support units are charged to the business segments through an internal cost allocation process. This segment also includes the System Replacement Project expenses that are not incurred by or allocated to the Retail Banking, Commercial Banking and Investment Services Group segments.
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The improvement in the segment's financial measures in 2003 compared to 2002 was primarily due to a significant decline in the capital charge. Continued share repurchase activity has led to the reduction of excess capital thereby lowering the related charge for capital. Partially offsetting the positive impact of the reduction of excess capital was an increase in expenses for the Systems Replacement Project and other non-interest expenses not allocated to the segments. The negative amount in the Provision reflects the overall reduction in the Company's Allowance.
The charge for excess capital generated by the 2001 divestitures was the primary driver of the decrease in NIACC in 2002 compared to 2001. Additionally, non-interest expenses increased in 2002 due to systems conversion related costs and other costs not allocated to the segments. The negative amount in the Provision was due to the overall reduction in the Company's Allowance.
Divestiture Businesses and Corporate Restructuring Related Activities
The amounts reported in 2002 for these categories primarily consist of costs related to branch closures in the Pacific Islands.
For 2001, this category includes the results of the Company's strategic plan to improve credit quality and to divest underperforming businesses. It includes the impact of the sales of the divested businesses and restructuring and other related costs. It also includes losses associated with the accelerated resolution of credit problems undertaken in 2001.
Balance Sheet Analysis
Investment Securities
The Company's investment portfolio is managed in an effort to provide liquidity and interest income, offset interest rate risk positions and provide collateral for various purposes. As of December 31, 2003, the portfolio totaled $2.7 billion, compared with $2.5 billion as of December 31, 2002. The increase reflected the deployment of excess liquidity into longer term assets. Held to maturity investment securities were in an unrealized loss position at December 31, 2003. The Company believes the loss is temporary. See Note 4 to the Consolidated Financial Statements, which is incorporated by reference in this Item, for further information.
See Table 9 for the maturity distribution, market value and weighted-average yield to maturity of investment securities.
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Table 9Supplementary Data—Maturity Distribution, Market Value andWeighted-Average Yield to Maturity of Investment Securities
Loans and Leases
Loans and Leases totaled $5.8 billion as of December 31, 2003 and comprise the largest category of earning assets for the Company. The 7% increase in loans in 2003 over 2002 was primarily attributable to increases in residential and commercial mortgages, home equity loans, and other consumer loans. Note 5 to the Consolidated Financial Statements, which is incorporated by reference in this Item, presents the composition of the loan portfolio by major loan categories. See the Credit Risk section for additional information.
A geographic distribution of the loan and lease portfolio as of December 31, 2003 is presented in Table 10 based on the location of borrowers.
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Table 10Geographic Distribution of Loan and Lease Portfolio
Table 11Maturities and Sensitivities of Loans to Changes in Interest Rates1
Deposits
Total deposits were $7.3 billion at December 31, 2003, a 6% increase over the prior year-end. Increases were experienced in demand and savings deposits while time deposits continued to decline as the Company continued to reduce these higher cost funds. See Note 8 to the Consolidated Financial Statements, which is incorporated by reference in this Item, for additional deposit information.
Borrowings
Short-term borrowings include funds purchased, securities sold under agreements to repurchase, commercial paper, and other short-term borrowings. The Company continued to reduce short-term borrowings and long-term debt in 2003. See Notes 9 and 10 to the Consolidated Financial Statements,
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which are incorporated by reference in this Item, for more information on short-term borrowings and long-term debt.
Foreign Activities
During 2003, the Company continued to maintain U.S. dollar placements with foreign entities, as a tax efficient investment structure for short-term funds. The Company divested substantially all of its foreign operations in 2001 and closed a representative office in Japan in 2003.
The Company's foreign lending included both local currency and cross-border lending. Local currency loans are those that are funded and will be repaid in the currency of the borrower's country. Cross- border lending, on the other hand, involves loans that will be repaid in a currency other than that of the borrower's country. This type of lending involves greater risk because the borrower's ability to repay is additionally dependent on changes in the currency exchange rate. Credit limits have been established for each country. These credit limits are monitored and reviewed on a regular basis.
Table 12 presents, for the last three years, a geographic distribution of assets for which the Company has cross-border exposure exceeding 0.75% of total assets.
See Note 19 to the Consolidated Financial Statements, which is incorporated by reference in this Item, for additional information on foreign activities.
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Table 12Geographic Distribution of Cross-Border International Assets1
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Corporate Risk Profile
Credit Risk
Credit Risk is defined as the risk that borrowers or counter parties will not be able to repay their obligations to the Company. Credit exposures reflect legally binding commitments for loans, leases, banker's acceptances, financial and standby letters of credit and overnight overdrafts.
The Company's asset quality continued to improve in 2003 as evidenced by lower levels of internally criticized loans, non-performing assets, and a continued lower trend in the level of net charge-offs. The ratio of non-performing assets to total loans and foreclosed assets was 0.55% at December 31, 2003. As a percent of average loans, year-to-date net charge-offs were 0.25%.
In Hawaii, the economy remained strong with 2003 stable tourism, a strong real estate market, and a construction industry that is expected to continue to grow for the foreseeable future. Hawaii currently has low unemployment and positive job growth.
The Company's lower risk position relative to a year ago reflects the execution of portfolio strategy to shift to lower risk industries as well as reduce large borrower concentrations and syndicated national credits. Portfolio monitoring is an ongoing process for early identification and disengagement from deteriorating credits. In addition, overall risk in the Hawaii portfolio has been generally stable, primarily due to resiliency of the Hawaii economy. In the consumer portfolios, higher net charge-offs were due to a combination of organic growth seasoning and non-recurring charge-offs. Consumer charge-offs of $4.6 million were recognized in 2003 for the remaining balance of the portfolios of four Pacific Island branches where operations were previously discontinued.
Although the Company's credit risk profile continues to improve overall, two components, air transportation and Guam, continue to carry higher risk characteristics. Information about these components is summarized in Table 13. Risk in the air transportation industry, while recently showing less negative trends, continues to remain high as the industry struggles with elevated cost structures, growing competition from low cost carriers, potential global mergers and marketing alliances, and continued uncertainty in the geopolitical environment. The Company's exposure is generally characterized as improving based on specific borrower and industry analysis. As of December 31, 2003, 16% of the Company's total air transportation outstandings are internally classified.
In the Guam portfolio, which is materially dependent on tourism and military spending, economic uncertainty remains. The local portfolio has performed adequately despite continued economic stress. Internally classified exposure was reduced by 39% from the prior year through active disengagement while experiencing negligible loss. Targeted lending to select commercial borrowers is active, while the consumer lending business is leading portfolio growth. Within Guam's hotel industry portfolio of $17.7 million at December 31, 2003, one credit with $6.0 million in exposure, or 34% of the portfolio, was guaranteed by an offshore financial institution with limited exposure to tourism.
At December 31, 2003, the largest syndicated loan outstanding totaled $24.1 million to a prominent Hawaii based hotel operator while the second largest was $22.6 million to a Hawaii shopping center operator. The 10 largest syndicated loans outstanding totaled $138.0 million, 56% of total syndicated loans, and consisted of loans in the real estate, hospitality and television cable industries. As of December 31, 2003, one syndicated unfunded commitment, which had $6.1 million in exposure (less than 1% of total syndicated unfunded commitments), was internally classified.
The Company's other large concentrations include eight exposures larger than $25.0 million. The borrowers are major companies, most with Hawaii operations. Four, with exposures totaling $136.5 million, are collateralized by real estate and other assets, and are substantionally funded. Three of the remaining four exposures are commercial paper backup lines to investment grade companies and are undrawn. The remaining line of credit is to a local trust with an A+ rating.
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Table 13 summarizes concentrations of credit exposures.
Table 13Selected Concentrations of Credit Exposure1
Non-Performing Assets
Non-performing assets ("NPAs") consist of non-accrual loans, including those held for sale and foreclosed real estate. The net decrease in NPAs in 2003 from 2002 includes $15.4 million of loans that returned to accrual status, $15.1 million of payments and pay-offs and $6.9 million of charge-offs. The decrease in non-performing assets also included a $3.8 million sale of the Company's largest parcel of foreclosed real estate in 2003. In 2003, inflows of $21.9 million slowed significantly from the prior year level of $75.9 as the economy rebounded and the Company made significant progress in the positive resolution of several borrowers. See Table 14 for a five year history of non-performing assets.
At December 31, 2003, the ratio of non-performing assets to total loans and foreclosed assets was 0.55%, a decline from 1.01% at December 31, 2002. As of December 31, 2003, 55.2% of total NPAs were concentrated in commercial loans (29.3% in commercial real estate) and 29.3% were secured by residential real estate. This compares to the prior year concentrations of 56.6% in commercial loans (38.2% in commercial real estate and construction) and 25.6% secured by residential real estate. NPAs in Guam were reduced by over 50% to $12.7 million from $25.9 million in the prior year primarily due to payments from a number of commercial borrowers. As a percent of total NPAs, Guam loans represented 40%, a decline from 48% in 2002.
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Loans Past Due 90 Days or More and Still Accruing Interest
Accruing loans past due 90 days or more totaled $3.5 million at December 31, 2003, an increase from $1.8 million at December 31, 2002. They mainly consist of residential mortgages in Guam and Other Consumer loans, reflecting growth and seasoning in the portfolio.
Table 14 presents a five-year history of non-performing assets and accruing loans past due 90 days or more.
Table 14Non-Performing Assets and Accruing Loans Past Due 90 Days or More
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Detailed below is foregone interest on non-accrual loans.
Table 15Foregone Interest on Non-Accrual Loans
The Company maintains an Allowance adequate to cover management's estimate of probable credit losses inherent in its lending portfolios based on a comprehensive quarterly analysis of historical loss experience supplemented by judgmental expectations of portfolio performance and economic conditions as of a given balance sheet date. Note 1 to the Consolidated Financial Statements, which is incorporated by reference in this Item, describes the methodologies used to develop the Allowance.
The Allowance was $129.1 million at December 31, 2003, a decrease of $13.8 million from December 31, 2002. The ratio of the Allowance to loans and leases outstanding was 2.24% at December 31, 2003 compared with 2.67% at year-end 2002. Allowance coverage of non-accrual loans of 473% at December 31, 2003 increased from 318% in the prior year. Current year Allowance coverage of net charge-offs of 9.4 times improved from 5.2 times in 2002. See Note 5 to the Consolidated Financial Statements, which is incorporated by reference in this Item, for changes in the Allowance during the last five years.
Net charge-offs for 2003 of $13.8 million, or 0.25% of total average loans, decreased significantly from $27.7 million, or 0.51% of total average loans, in 2002. Current year charge-offs included loans of $5.2 million, primarily consumer, reflecting the remaining balance of the portfolios of the Pacific Island branches where operations were previously discontinued. The 2003 improvement in net charge-offs reflects management's continued execution of portfolio strategies to shift to lower risk industries, reduce large borrower concentrations and selected syndicated national credits, as well as enhanced credit underwriting and collections in the consumer businesses. In addition, 2002 results included an $8.8 million charge-off of a United States air carrier that declared bankruptcy.
Due to continued improvements in the Company's credit quality and management's assessment of economic conditions and risks, no Provision was recorded during 2003, resulting in a reduction of the Allowance equal to net charge-offs. While management has allocated a portion of the Allowance to specific loan categories based on methodologies indicated above, the adequacy of the Allowance must be considered in its entirety. Allowance allocations by loan category are presented in Table 16.
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Table 16Allocation of Allowance for Loan and Lease Losses
Table may not add due to rounding.
The Allowance is considered adequate by management at December 31, 2003, based on an ongoing analysis of estimated probable credit losses, credit risk profiles, economic conditions, coverage ratios and other relevant factors.
Market Risk
Market risk is the potential of loss arising from adverse changes in interest rates and prices. The Company is exposed to market risk as a consequence of the normal course of conducting its business activities. Financial products that expose the Company to market risk include investment securities, loans, deposits, debt and derivative financial instruments. The Company's market risk management process involves measuring, monitoring, controlling and managing risks that can significantly impact the Company's financial position and operating results. In this management process, market risks are balanced with expected returns in an effort to enhance earnings performance and shareholder value, while limiting the volatility of each. The activities associated with these market risks are categorized into "trading" and "other than trading."
The Company's trading activities include foreign currency and foreign exchange contracts that expose the Company to a minor degree of foreign currency risk. These transactions are primarily executed on behalf of customers and at times for the Company's own account.
The Company's "other than trading" activities include normal business transactions that expose the Company's balance sheet profile to varying degrees of market risk. The Company's primary market risk exposure is interest rate risk. A key element in the process of managing market risk involves oversight by senior management and the Board of Directors as to the level of such risk assumed by the Company in its balance sheet. The Board of Directors reviews and approves risk management policies, including risk limits and guidelines and delegates oversight functions to the Asset Liability Management Committee ("ALCO"). The ALCO, consisting of senior business and finance officers, monitors the Company's market
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risk exposure and as market conditions dictate, modifies balance sheet positions. The ALCO may also direct the use of derivative instruments.
Interest Rate Risk
The Company's balance sheet is sensitive to changes in the general level of interest rates. This interest rate risk arises primarily from the Company's normal business activities of making loans and taking deposits. Many other factors also affect the Company's exposure to changes in interest rates, such as general economic and financial conditions, customer preferences, and historical pricing relationships.
The earnings of the Company and its principal subsidiary are affected not only by general economic conditions, but also by the monetary and fiscal policies of the United States and its agencies, particularly the Federal Reserve System. The monetary policies of the Federal Reserve System influence to a significant extent the overall growth of loans, investments and deposits; the level of interest rates earned on assets and paid for liabilities; and interest rates charged on loans and paid on deposits. The nature and impact of future changes in monetary policies are often not predictable.
A key element in the Company's ongoing process to measure and monitor interest rate risk is the utilization of a net interest income ("NII") Monte Carlo simulation model. This model is used to estimate the amount that NII will change over a one-year time horizon under various interest rate scenarios. These estimates are based on assumptions on the behavior of loan and deposit volumes as a function of pricing, prepayment speeds on mortgage-related assets, and principal amortization and maturities on other financial instruments. The model specification includes embedded optionality. While such assumptions are inherently uncertain, management believes that these assumptions are reasonable. As a result, the NII simulation model captures the dynamic nature of the balance sheet and provides a sophisticated estimate rather than a precise prediction of NII's exposure to higher or lower interest rates.
Table 17 presents, as of December 31, 2003, 2002 and 2001, the estimate of the change in NII from a gradual 200 basis point increase or decrease in interest rates, moving in parallel fashion for the entire yield curve, over the next 12-month period relative to the measured base case scenario for NII. The resulting estimate in NII exposure was within the approved ALCO guidelines.
Table 17Market Risk Exposure to Interest Rate Changes
To enhance and complement the results from the NII simulation model, the Company also reviews other measures of interest rate risk. These measures include the sensitivity of market value of equity and the exposure to basis risk and non-parallel yield curve shifts. There are inherent limitations to these measures but used along with the NII simulation model, the Company obtains a better overall insight for managing its exposure to changes in interest rates.
In managing interest rate risks, the Company uses several approaches to modify its risk position. Approaches that are used to shift balance sheet mix or alter the interest rate characteristics of assets and liabilities include changing product pricing strategies, modifying investment portfolio characteristics, or using financial derivative instruments. The use of financial derivatives, as detailed in Note 16 to the
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Consolidated Financial Statements, which is incorporated by reference in this Item, has been limited over the past several years.
Liquidity Management
Liquidity is managed in an effort to ensure that the Company has continuous access to sufficient, reasonably priced funding. Funding requirements are impacted by loan refinancings and originations, liability settlements and issuances and off-balance sheet funding commitments. The Company considers and complies with various regulatory guidelines regarding required liquidity levels and periodically monitors its liquidity position in light of the changing economic environment and customer activity. Based on periodic liquidity assessments, the Company may alter its assets, liabilities and off-balance sheet positions. The Company's ALCO monitors sources and uses of funds and modifies asset and liability positions as liquidity requirements change. This process, combined with the Company's ability to raise funds in money and capital markets and through private placements, provides flexibility in managing the exposure to liquidity risk.
In an effort to ensure that its liquidity needs are met, the Company actively manages both the asset and liability sides of the Statement of Condition. The primary sources of liquidity are available-for-sale investment securities, interest bearing deposits and cash flows from loans and investments, as well as the ability to sell or securitize certain assets. With respect to liabilities, liquidity is generated through growth in deposits and other funding. During 2003, the Company continued to use funds generated from the divestiture program to repurchase stock (see "Capital Management") and reduce debt where possible. In 2003, $106.7 million in subordinated notes were redeemed at maturity. In addition, excess liquidity was deployed into longer term assets. The Company has not utilized off-balance sheet financing arrangements as a source of liquidity. It is not expected that such arrangements will be used significantly in the future. In 2004, $90.5 million in privately placed notes mature. Depending on liquidity position at the time of maturity, the payment will be made from cash flow or new borrowings or both.
Off-Balance Sheet Arrangements and Aggregate Contractual Obligations
The Company's contractual obligations and other commitments as of December 31, 2003 are summarized in Table 18. See Note 7 to the Consolidated Financial Statements, which is incorporated by reference in this Item, for additional information on Capital and Operating Lease obligations; Note 9 for additional information on Short-Term Borrowings; and Note 10 for additional information on Long-Term Debt.
Table 18Off-Balance Sheet Arrangements
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Contractual Obligations
The Company obtains funding through federal funds, securities sold under agreements to repurchase and commercial paper. The Company issues commercial paper in various denominations with maturities of generally 90 days or less. During 2003, the Company issued commercial paper only in the Hawaii marketplace.
Securities sold under agreements to repurchase are financing transactions, under which securities are pledged as collateral for short-term borrowings. These transactions are normally with governmental entities. Historically, these governmental entities have provided a stable source of funds.
The Bank is a member of the Federal Home Loan Bank of Seattle (the "FHLB"), which provides an additional source for short and long-term funding. Borrowings from the FHLB were $68.5 million and $42.5 million at the end of 2003 and 2002, respectively.
Additionally, the Bank maintains a $1 billion senior and subordinated bank note program. Under this facility, the Bank may issue additional notes provided that the aggregate amount outstanding does not exceed $1 billion. Subordinated notes outstanding under this bank note program totaled $124.7 million at December 31, 2003 and 2002.
The largest Purchase Obligation included in the above table is the seven year outsourcing agreement with Metavante Corporation for technology services. Total payments over the remaining term of this contract will be approximately $52.2 million. Other contracts included in Purchase Obligations consist of service agreements for the Company's asset management system, ATM system, and cash management system.
Capital Management
The Company and the Bank are subject to regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can cause certain mandatory and discretionary actions by regulators that, if undertaken, could have a material effect on the Company's financial statements. Under Capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative and qualitative measures. These measures were established by regulation to ensure capital adequacy. At December 31, 2003 and 2002, the Company and the Bank were well capitalized under this regulatory framework. There have been no conditions or events since December 31, 2003 that management believes have changed either the Company's or the Bank's capital classifications. Note 11 to the Consolidated Financial Statements, which is incorporated by reference in this Item, provides additional information about the regulatory capital framework and the Company's capital amounts and ratios.
As of December 31, 2003, $31.4 million of 8.25% Capital Securities that mature in 2026 were outstanding. These securities qualify as Tier I Capital for regulatory accounting purposes, but are classified as long-term
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debt in the Consolidated Statements of Condition. In addition, the Company had subordinated debt of $124.7 million at the end of 2003 that qualifies as Total Capital for regulatory purposes.
At year-end 2003, the Company's shareholders' equity was $793.1 million, a decrease of $222.6 million, or 22%, from year-end 2002. The decline in shareholders' equity resulted from stock repurchases that totaled $330.0 million and dividends paid of $50.6 million, partially offset by current year earnings and stock issuance under various stock-based employee benefit plans. Table 19 presents a five-year history of activities and balances in the Company's capital accounts, along with key capital ratios.
During 2003, the Company's Board of Directors approved share repurchase programs that authorized the repurchase of an additional $200.0 million in common stock. This authorization, combined with the Company's previously announced authorization of $800.0 million, brings the total authorized repurchase amount to $1.0 billion. Through December 31, 2003, the Company had repurchased 29.8 million shares under these programs at an average cost of $28.68 per share for a total of $855.0 million. From January 1, 2004 through February 20, 2004, the Company repurchased an additional 0.6 million shares at an average cost of $43.64 per share for a total of $25.5 million. Remaining buyback authority was $119.5 million at February 20, 2004.
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Table 19Equity Capital
Fourth Quarter Results and Other Matters
Net income in the fourth quarter of 2003 was $38.7 million, an increase of 34% from net income of $28.9 million in the fourth quarter of last year. Diluted earnings per share for the fourth quarter of 2003 were $0.66, an increase of $0.22, or 50%, from $0.44 per diluted share for the same period last year.
Net interest income for the fourth quarter of 2003 on a fully taxable equivalent basis was $93.4 million, an increase of 3%, or $2.3 million, from the third quarter of 2003, primarily due to higher yields on investment securities. Net interest income increased 4%, or $3.2 million, from the fourth quarter of 2002 as a result of lower interest expense on deposits and a decline in short-term borrowings.
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The net interest margin was 4.35% for the fourth quarter of 2003, a 20 basis point increase from 4.15% in the previous quarter and a 30 basis point increase from 4.05% in the same quarter last year. The net interest margin improvement was largely due to lengthening the maturities of certain short-term investments, reductions in time deposits and short-term borrowings, and debt repurchases, which lowered the Company's cost of funds.
The return on average assets for the fourth quarter of 2003 improved to 1.66% from 1.20% in the comparable period in 2002. Return on average equity for the fourth quarter of 2003 improved to 18.59% from 10.72% in the same quarter last year.
Due to continued improvements in the Company's credit quality and economic conditions, the Company did not recognize a Provision during the fourth quarter of 2003 and has not recognized a Provision for the last six quarters. This resulted in a $3.6 million reduction in the Allowance, which equaled the amount of net charge-offs for the 2003 fourth quarter.
Non-interest income was $49.4 million for the fourth quarter, a decrease of $0.3 million from the same period in 2002. The decrease was largely due to a decline in gains on mortgage loan sales.
Non-interest expense for the fourth quarter of 2003 was $83.4 million, a decrease of $13.3 million, or 14%, from the comparable period in 2002. Non-interest expense of $96.7 million for the fourth quarter of 2002 included Systems Replacement Project and net restructuring and other related costs of $7.4 million. Excluding these items, non-interest expenses declined $5.9 million, or 7%, from the same quarter last year, largely due to savings associated with the Systems Replacement Project.
During the fourth quarter of 2003, the Company repurchased 1.6 million shares of common stock at a total cost of $64.2 million under the share repurchase program. The average cost per share was $40.27 during the quarter.
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Table 20Consolidated Quarterly Results of Operations
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2004-2006 Plan
In January 2004, the Company announced its plan for 2004-2006 which continues to build on the strategy of maximizing shareholder value over time.
There are five key elements of the new plan: 1) accelerate revenue growth in our island markets; 2) better integrate our business segments; 3) continue to develop our management teams; 4) improve operating efficiency; and 5) maintain a culture of dependable risk and capital management. The Company currently estimates that its net income for 2004 should be approximately $157 million. Based on current conditions, the Company does not expect to record a Provision in 2004; however, the actual amount of the Provision will depend on determinations of credit risk that will be made near the end of each quarter. Earnings per share and return on equity projections continue to be dependent upon the terms and timing of share repurchases. A summary of the Company's anticipated financial results as previously announced are included in Table 21.
Table 212004 - 2006 Plan
Item 7a. Qualitative and Quantitative Disclosures about Market Risk
See the Market Risk section in the Management's Discussion and Analysis of Financial Condition and Results of Operations beginning on page 31 of this report.
Item 8. Financial Statements and Supplementary Data
Consolidated Quarterly Results of Operations—See Table 20 included in Item 7 of this report.
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REPORT OF INDEPENDENT AUDITORS
Shareholders and Board of DirectorsBank of Hawaii Corporation
We have audited the accompanying consolidated statements of condition of Bank of Hawaii Corporation and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2003. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Bank of Hawaii Corporation and subsidiaries at December 31, 2003 and 2002, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States.
/s/ERNST & YOUNG LLP
Honolulu, HawaiiJanuary 26, 2004
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Bank of Hawaii Corporation and Subsidiaries Consolidated Statements of Income
See accompanying notes to Consolidated Financial Statements.
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Bank of Hawaii Corporation and Subsidiaries Consolidated Statements of Condition
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Bank of Hawaii Corporation and Subsidiaries Consolidated Statements of Shareholders' Equity
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Bank of Hawaii Corporation and Subsidiaries Consolidated Statements of Cash Flows
During the years ended December 31, 2003, 2002, and 2001, interest payments of $82,827,000, $162,338,000, and $411,282,000, respectively, and income tax payments of $23,150,000, $11,234,000, and $92,270,000, respectively, were made.
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Note 1—Summary of Significant Accounting Policies
Bank of Hawaii Corporation (the "Company") is a bank holding company providing a broad range of financial products and services to customers in Hawaii and the Pacific Islands (Guam, nearby islands and American Samoa). The majority of the Company's operations consist of customary commercial and consumer banking services including, but not limited to, lending, leasing, deposit services, trust and investment activities, brokerage services, insurance products and trade financing. During 2001, the Company divested most of its business in Asia, the South Pacific and the U.S. Mainland as part of its strategic plan to increase shareholder value.
The accounting and reporting principles of the Company conform to accounting principles generally accepted in the United States ("GAAP") and prevailing practices within the financial services industry. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts in the financial statements and accompanying notes. Actual results may differ from those estimates and such differences could be material to the financial statements.
Certain prior period amounts have been reclassified to conform to current year presentation.
The following is a description of the significant accounting policies of the Company:
Consolidation
The Consolidated Financial Statements of the Company include the accounts of the Company and its subsidiaries. The Company's principal subsidiary is Bank of Hawaii (the "Bank"). All significant intercompany accounts and transactions have been eliminated in consolidation.
The Company has investments in low income housing projects and sponsors the Bank of Hawaii Charitable Foundation. These entities are not consolidated in the Company's financial statements. The Company also has investments in leveraged leases, as discussed in Note 5.
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents include cash and non-interest bearing deposits, interest bearing deposits and funds sold. All amounts are readily convertible to cash and have maturities less than ninety days.
Investment securities are accounted for according to their purpose and holding period. Debt securities that may not be held to maturity and marketable equity securities are classified as securities available for sale and are reported at fair value, with unrealized gains and losses, after applicable taxes, reported as a component of cumulative other comprehensive income. Debt securities that management has the positive intent and ability to hold to maturity are classified as held to maturity and are reported at amortized cost. Trading securities are those securities acquired for the purpose of funding the Company's liabilities associated with certain compensation plans. These securities are included in Other Assets and are carried at fair value with unrealized holding gains and losses recognized currently in income. Non-marketable equity securities (Federal Reserve Bank and Federal Home Loan Bank stock) are accounted for at cost and included in Other Assets.
The estimated fair value of a security is determined based on current quotations. Declines in the value of debt securities and marketable equity securities that are considered other than temporary are recorded in non-interest income. Realized gains and losses are recorded in non-interest income using the specific identification method.
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Loans Held for Sale
Loans held for sale, principally mortgage loans, are valued on an aggregate basis at the lower of carrying amount or fair value.
Loans are reported at the principal amount outstanding, net of unearned income. Interest income is recognized on an accrual basis. Loan origination fees, certain direct costs, unearned discounts and premiums are deferred and amortized into interest income as an adjustment to yield using methods that approximate the effective yield method over the term or estimated life of the loan. Loan commitment fees are generally deferred and amortized into fee income over the commitment period. Other credit-related fees are recognized as fee income, a component of non-interest income, when earned.
Direct financing leases are carried at the aggregate of lease payments receivable plus estimated residual value of the leased property, less unearned income. Leveraged leases, which are a form of financing leases, are carried net of nonrecourse debt. Unearned income on direct financing and leveraged leases is amortized over the lease term by methods that approximate the interest method. Residual values on leased assets are reviewed regularly for other than temporary impairment.
Non-Performing Loans and Leases
Generally, commercial loans are placed on non-accrual status upon becoming past due 90 days or more for principal or interest, (unless well secured and in the process of collection), when terms are renegotiated below market levels, or where a substantial doubt about full repayment of principal and or interest is evident. Residential, home equity, and small business loans are placed on non-accrual status when any extension of credit is past due 120 days for principal or interest or upon taking a partial charge-off, or where a substantial doubt about full repayment of principal or interest is evident.
When a loan is placed on non-accrual status, the accrued and unpaid interest receivable is reversed and the loan is accounted for on the cash or cost recovery method until qualifying for return to accrual status. A loan may be returned to accrual status when all delinquent interest and principal become current in accordance with the terms of the loan agreement.
Loans are charged-off when it is probable that a loss has been incurred and when it is possible to make a reasonable estimate of the loss. For commercial loans, a charge-off is determined on a judgmental basis after due consideration of the debtor's prospects for repayment and the fair value of collateral is deemed deficient. For residential mortgage and home equity loans, a partial charge-off is required at 120 days delinquent if the estimated fair value (sales price minus all costs to acquire title, to hold and to sell) is less than the loan balance. Other consumer loans are charged-off upon becoming past due 120 days.
The Allowance for Loan and Lease Losses (the "Allowance") is a valuation allowance for probable credit losses inherent in the portfolio as of a given balance sheet date. In accordance with accounting and regulatory guidance, the Company maintains an Allowance adequate to cover management's estimate of probable credit losses based on analyses of historical loss experience supplemented by judgmental expectations of portfolio performance and economic conditions. Changes to the absolute level of the Allowance are recognized through charges to the Provision for Loan and Lease Losses. Losses represent a charge or reduction to the Allowance while recoveries are credited or added back. Credit exposures covered by the Allowance include legally binding commitments for loans, leases, banker's acceptances, financial and standby letters of credit and overnight overdrafts.
The Allowance is composed of an allocated and a general component. The allocated component represents an estimate of probable credit loss inherent to specific portfolios and borrowers. It is segmented
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between a baseline component based on historical loss experience and specific borrower evaluations, and a judgmental management adjustment component. Management adjustments are based on relevant observable data applied as necessary to reflect risk of probable loss not captured in the historical analyses. The general component addresses market and regulatory expectations through maintenance of appropriate coverage ratios of loans, non-accruals and net charge-offs, current economic conditions and positioning in the credit cycle, uncertainty from geo-political issues, overall concentration and correlation risk, overall delinquency and impairment trends and imprecision in the estimation process.
To estimate the baseline component, portfolios are segmented based on similar risk characteristics. A range of estimated losses is calculated based on historical loss rates and average delinquency flows to loss. For those commercial borrowers that are on non-accrual status and borrowers identified by management as exhibiting above average levels of risk, impairment is measured on individual loans in accordance with Statement of Financial Accounting Standards ("SFAS") No. 114, "Accounting by Creditors for Impairment of a Loan" as amended by SFAS No. 118, "Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures." Commercial borrowers not individually impaired are collectively evaluated for impairment based on line-of-business and internal risk rating segmentation. Loss estimates are calculated based on analysis of historical risk rating migrating to loss. Consumer and small business portfolios are evaluated for impairment collectively, based on product and geography. Both consumer and commercial loss models are updated quarterly.
Management adjustments are applied to the baseline component based on assessments and expectations of portfolio performance not captured in the historical loss rates. Relevant factors considered in the assessment based on observable data include, but are not limited to: a formal Company-wide rolling quarterly forecast of asset quality metrics including net charge-offs; growth rates; extent of portfolio seasoning; specific historical events; downside scenarios for specific borrowers; existing and emerging trends in delinquency and impairment; expectations of portfolio performance in terms of directionality, volatility, and stress-testing; borrower, industry, and geographical concentrations; credit management changes; changes in underwriting, charge-off or collection policies and procedures; coverage tests of classified and criticized exposure; and pending accounting or regulatory changes.
Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is computed using the straight line method over lives of three to fifty years for premises and improvements, and three to ten years for equipment.
Foreclosed Real Estate
Foreclosed Real Estate consists of properties acquired through foreclosure proceedings or acceptance of a deed-in-lieu of foreclosure. These properties are carried at the lower of cost or fair value based on current appraisals less selling costs. Losses arising at the time of acquiring such property are charged against the Allowance. Subsequent declines in property value are recognized through charges to non-interest expense.
Mortgage Servicing Rights
Mortgage servicing rights are recognized as assets when mortgage loans are sold and the rights to service those loans are retained. The assets are recorded at their relative fair values on the date the loans are sold and are carried at the lower of the initial recorded value, adjusted for amortization, or fair value. The assets are amortized in proportion to and over the period of estimated net servicing income.
An impairment analysis is performed on a periodic basis by estimating the fair value of the mortgage servicing rights and comparing that value to the carrying amount. The assets are stratified by certain risk characteristics, primarily loan type and note rate. The Company estimates the fair value using a discounted cash flow model to calculate the present value of estimated future net servicing income. The model uses
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factors such as loan prepayment rates, costs to service, ancillary income, impound account balances and interest rate assumptions in its calculations.
Goodwill
Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired. Goodwill is assessed at least annually for impairment in accordance with SFAS No. 142, Goodwill and Other Intangible Assets ("SFAS No. 142") that the Company adopted on January 1, 2002. Prior to the adoption of SFAS No. 142, goodwill was amortized over 15-25 years. There was no impairment of goodwill in 2003 or 2002.
The following table presents pro forma net income and earnings per share, and a reconciliation of reported net income to pro forma net income, excluding goodwill amortization that was recognized in 2001, prior to the adoption of SFAS No. 142.
Asset Impairments
Under Company policy, which is in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets ("SFAS No.144"), which the Company adopted on January 1, 2002, long-lived assets are evaluated for impairment based on their future use. For an asset that is to be held and used, an impairment loss, which is measured as the difference between the carrying amount and fair value of the asset, is recognized only if the carrying value of the long-lived asset is not recoverable from its undiscounted cash flows. For a long-lived asset to be disposed of by sale an asset is measured at the lower of its carrying amount or fair value less cost to sell and depreciation is ceased. There was no impairment of long-lived assets in 2003 or 2002; however, in 2003 and 2002 depreciation was accelerated on assets related to the systems replacement project, as further discussed below.
Information Technology Systems Replacement Project
The Company accounted for the Information Technology Systems Replacement Project under SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities ("SFAS No. 146"), which the Company adopted during 2002. The costs associated with this project included employee termination benefits, costs to terminate contracts, asset abandonments and professional fees. Termination benefits for employees not required to render service beyond a minimum retention period were recognized at fair value at the communication date. Termination benefits for employees that were required to render service beyond a minimum retention period were recognized ratably over the remaining service period. Costs to terminate a contract before the end of its term were recognized and measured at fair value when the contract terminated. Professional fees were expensed ratably over the conversion period. Depreciation expense on assets abandoned was accelerated and recognized over the shortened life.
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The Company files a consolidated federal income tax return with the Bank and its subsidiaries. Deferred income taxes are provided to reflect the tax effect of temporary differences between financial statement carrying amounts and the corresponding tax basis of assets and liabilities. Deferred taxes are calculated by applying enacted statutory tax rates and tax laws to future years in which temporary differences are expected to reverse. The impact on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that the rate change is enacted. A deferred tax valuation reserve is established if it is more likely than not that a deferred tax asset will not be realized.
The Company's tax sharing policy provides for the settlement of income taxes between each relevant subsidiary as if the subsidiary had filed a separate return. Payments are made to the Company by subsidiaries with tax liabilities, and subsidiaries that generate tax benefits receive payments for those benefits as used.
Earnings Per Share
Basic earnings per share ("EPS") is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the dilutive impact of stock options and uses the average share price during the period in determining the number of incremental shares to be added to the weighted average number of common shares outstanding. There were no adjustments to net income (the numerator) for purposes of computing basic EPS. A reconciliation of the weighted average common shares outstanding for computing diluted EPS for 2003, 2002 and 2001 follows:
Risk Management Instruments
The Company has authorization from its Board to use off-balance sheet derivative financial instruments as an end-user in connection with its risk management activities to accommodate the needs of customers. The Company has not qualified for any of the hedge accounting methods (i.e., fair value, cash flows or net investment in foreign operations) addressed under SFAS No. 133, Accounting for Certain Derivative Instruments and Certain Hedging Activities. All risk management derivative instruments are carried at fair value and the associated unrealized gains and losses are recognized currently in income. Over the past few years, the Company has not used interest rate swaps as a risk management tool. During 2003, only limited use of foreign exchange contracts was required to mitigate foreign currency risk.
Stock-Based Compensation
The Company has employee and director stock option plans that are more fully described in Note 14. The Company accounts for its stock-based compensation plans in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees ("APB No. 25") and related interpretations. Generally, stock-based employee compensation expense is not reflected in net income as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation ("SFAS No. 123").
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Stock Repurchases
Acquisition of the Company's common stock is recorded at cost.
Advertising Costs
The Company recognizes its advertising costs as incurred. Advertising costs were $4.6 million, $6.0 million, and $6.5 million in 2003, 2002 and 2001, respectively.
International Operations
As of December 31, 2001, the Company had curtailed most of its international operations. The Bank has operations that are conducted in the Pacific Islands that are denominated in U.S. dollars. These operations are classified as domestic.
Recent Accounting Standards
In January 2003, the Financial Accounting Standards Board ("FASB") issued Interpretation 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 ("FIN 46"), which was revised in December 2003. FIN 46 provides a new framework for identifying a variable interest entity ("VIE") and determining when a company should include assets, liabilities, noncontrolling interest and results of activities of a VIE in its consolidated financial statements. For companies with special-purpose entities, as defined, FIN 46 was effective immediately. For companies with other types of VIEs, FIN 46 is effective for periods ending after March 15, 2004. The Company is currently evaluating the impact of FIN 46; however, it is not expected that the adoption of FIN 46 will have a material impact on the Company's financial position or results of operations.
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In December 2003, the FASB revised SFAS No. 132, Employers' Disclosures about Pensions and Other Postretirement Benefits ("SFAS No. 132") to require additional disclosures including (a) the percentages of each major category of plan assets held, (b) the accumulated benefit obligation, and (c) narrative disclosure of investment strategies. These disclosures were effective for financial statements with fiscal years ending after December 15, 2003. Additional disclosure of information about estimated future benefit payments are effective for fiscal years ending after June 15, 2004. The disclosure for components of net benefit cost for interim periods required by this Statement are effective for interim periods beginning after December 15, 2003.
Note 2—Information Technology Systems Replacement Project
In July 2002, the Company entered into contracts with Metavante Corporation to provide for technology services, including professional services to convert existing systems to Metavante systems. The conversion was completed in the third quarter of 2003. The following summarizes costs incurred in connection with the transition to this outsourcing arrangement:
Changes in related liability balances during the years ended December 31, 2003 and 2002 were as follows:
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The Company incurred expenses of $3.6 million in 2003 under the technology services contract that became effective in July 2003. The Company's actual payments under the contract will depend upon future transaction volumes. Based upon the estimated future transaction volumes used in the contract, estimated payments in future years are:
Note 3—Divestiture Program and Restructuring Charges
In April 2001, the Company announced a 2001-2003 strategic plan designed to maximize shareholder value by strengthening its Hawaii and Pacific Islands operations and divesting most other operations. By the end of 2001, the Company had sold its credit card portfolio, its California banking subsidiary, its investment in the Bank of Queensland Limited in Australia, and its South Pacific operations. Also in 2001, the Company's Asian branches were closed.
In 2002, four branch offices in the Federated States of Micronesia and in the Republic of the Marshall Islands were closed and First Savings and Loan Association of America ("First Savings"), a wholly owned subsidiary of the Company, was merged into the Bank.
In connection with the implementation of the 2001 strategic plan and the divestiture program, the Company recognized restructuring and other related costs as follows:
Divestiture Program and Restructuring Charges
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The following schedule reflects the activity in the related liability balances:
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Note 4—Investment Securities
The following presents the details of the investment securities portfolio:
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The following presents an analysis of the contractual maturities of the investment securities portfolio as of December 31, 2003:
Investment securities of $1.4 billion and $1.6 billion carrying value which approximated fair value, were pledged to secure deposits of public (governmental) entities and repurchase agreements at December 31, 2003 and 2002, respectively.
Gross gains and losses and proceeds from sales and maturities of securities available for sale for the years ended December 31, 2003, 2002 and 2001 were as follows:
The following presents temporarily impaired investment securities that have been impaired for less than twelve months as of December 31, 2003:
As of December 31, 2003, no investment security had been impaired for more than 12 months.
The Company does not believe unrealized losses as of December 31, 2003 represent an other-than-temporary impairment. The unrealized losses reported for mortgage-backed securities relate primarily to securities issued by the Federal National Mortgage Association, Federal Home Loan
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Mortgage Corporation and private institutions. These unrealized losses are primarily attributable to changes in interest rates and individually were 0.7% or less of their respective amortized cost basis. The Corporation has both the intent and ability to hold the securities contained in the previous table for a time necessary to recover the amortized cost.
Income taxes related to 2003 net realized gains and losses on the sale of investment securities were $718,500. The cumulative other comprehensive income from net unrealized gains on investment securities was $10.8 million (net of taxes) as of December 31, 2003.
Note 5—Loans and the Allowance for Loan and Lease Losses
The loan portfolio was comprised of the following at December 31:
Total loans and leases were net of unearned income totaling $173.3 million and $182.0 million as of December 31, 2003 and 2002, respectively.
The Company's lending activities are concentrated in its primary geographic markets of Hawaii and the Pacific Islands.
Commercial and mortgage loans totaling $452.0 million and $629.1 million were pledged to secure certain public deposits and Federal Home Loan Bank advances at December 31, 2003 and 2002, respectively.
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The aggregate amount of gains (losses) on sales of commercial and mortgage loans (including adjustments to transfer loans to held for sale) is shown below. Adjustments to transfer commercial loans to loans held for sale at the lower of cost or fair value were charged to the Allowance.
The Company is the lessor in various leveraged lease agreements under which airplanes, rail cars and water-craft, with estimated economic lives ranging from 20 to 36 years, are leased for terms up to 20 years. The Company's equity investment typically represents approximately 22% of the purchase price, with the remaining percentage being furnished by third-party financing in the form of long-term debt that provides for no recourse against the Company and is secured by a first lien on the asset. The residual value of the asset is estimated at the beginning of the lease, based on appraisals and other methods, and is reviewed at least annually for impairment. At the end of the lease term, the asset is returned to the Company. For federal income tax purposes, the Company receives the investment tax credit and has the benefit of tax deductions for depreciation on the entire leased asset and for interest on the long-term debt. During the early years of the lease, those deductions exceed the lease rental income, resulting in income tax deductions. In the later years of the lease, rental income will exceed the deductions and taxes will be payable. Deferred taxes are provided to reflect this timing difference. The investment in leverage leases at December 31, 2003, of $363.4 million is included in the Commercial Lease Financing total of $436.0 million shown in the loan portfolio table.
The Company's net investment in leveraged leases was comprised of the following:
Certain directors and executive officers of the Company and its subsidiary companies, companies in which they are principal owners, and trusts in which they are involved, have loans with the Bank. These loans were made in the ordinary course of business at normal credit terms, including interest rate and collateral requirements. At December 31, 2003 and 2002, such loans amounted to $54.2 million and $34.4 million, respectively. During 2003, the activity in these loans included new borrowings of $26.7 million and
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repayments of $4.5 million. The loan balances were also reduced by $2.4 million as a result of changes in the parties considered insiders.
Activity in the Allowance was as follows for the years ended December 31:
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Details of the Foreign Allowance, which is included in the table above, was as follows:
Non-accrual loans as of December 31, 2003 and 2002 totaled $27.3 million and $45.0 million, respectively. Loans past due 90 days or more and still accruing interest totaled $3.5 million and $1.8 million as of December 31, 2003 and 2002, respectively.
The following table presents information on impaired loans as of December 31:
Note 6—Mortgage Servicing Rights
As of December 31, 2003 and 2002, the Company's portfolio of residential loans serviced for third parties totaled $2.9 billion and $3.9 billion, respectively. The servicing portfolio is comprised primarily of fixed rate loans concentrated in Hawaii.
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Changes in the carrying value of mortgage servicing rights are summarized in the following table:
The key factors used in determining the fair value of mortgage servicing rights at December 31, 2003 and 2002 are presented below:
A sensitivity analysis of the current fair value of mortgage servicing rights to immediate 10% and 20% adverse changes in assumptions as of December 31, 2003 and 2002 are presented in the table that follows.
These sensitivities are hypothetical and should be used accordingly. Estimated changes in fair value are based on assumptions and generally cannot be extrapolated. Also, in this table, the effect of a variation in a particular assumption on the fair value of the servicing rights is calculated without changing other assumptions. In reality, changes in one factor may result in changes in another, which may affect the sensitivities.
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Note 7—Premises and Equipment and Other Assets and Liabilities
The following is a summary of premises and equipment:
Depreciation and amortization (including capital lease amortization) included in non-interest expense totaled $28.8 million, $34.6 million and $42.7 million in 2003, 2002 and 2001, respectively.
The Company leases certain branch premises and equipment with lease terms extending through 2052. Most of the leases for premises provide for a base rent over a specified period with renewal options thereafter. Portions of certain properties are subleased for periods expiring in various years through 2010. Lease terms generally provide for the Company to pay taxes, maintenance and other operating costs.
Future minimum payments for capital leases and for non-cancelable operating leases with initial or remaining terms of one year or more consisted of the following at December 31, 2003:
Minimum future rentals receivable under subleases for non-cancelable operating leases amounted to $5.0 million at December 31, 2003.
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Rental expense for all operating leases for the years ended December 31, 2003, 2002 and 2001 is presented below:
The following are included in Other Assets and Liabilities as of December 31, 2003 and 2002:
Note 8—Deposits
Time deposits with balances of $100,000 or more totaled $621.2 million and $804.4 million at December 31, 2003 and 2002, respectively. Deposits of public (governmental) entities totaling $11.1 million require collateralization by acceptable securities.
Maturities of time deposits of $100,000 or more at December 31, 2003 were as follows:
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Note 9—Short-Term Borrowings
Details of short-term borrowings for 2003, 2002 and 2001 were as follows:
Funds Purchased generally mature on the day following the date of purchase.
Securities Sold Under Agreements to Repurchase are accounted for as financing transactions and the obligations to repurchase these securities are recorded as liabilities in the Consolidated Statements of Condition. The securities underlying the agreements to repurchase continue to be reflected as assets of the Company and are delivered to and held in collateral accounts with third party trustees. At December 31, 2003, the weighted average contractual maturity of these agreements was 50 days and consisted of transactions with public (governmental) entities, primarily the State of Hawaii ($304.5 million), and local municipalities ($168.3 million). A schedule of maturities of repurchase agreements as of December 31, 2003 follows:
Commercial Paper is issued in various denominations generally maturing 90 days or less from date of issuance.
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At December 31, 2003, Other Short-Term Borrowings consisted primarily of Treasury Tax and Loan Balances. Treasury Tax and Loan Balances represent tax payments collected on behalf of the U.S. Government, which are callable at any time and bear market interest rates.
A line of credit totaling $25.0 million was previously maintained for working capital purposes but was discontinued in January 2002. Fees related to this line were $11,000 in 2002.
Note 10—Long-Term Debt
Amounts outstanding for Long-Term Debt as of December 31, 2003 and 2002 were as follows:
As of December 31, 2003, subordinated notes issued by the Bank, bearing a fixed interest rate of 6.875%, was outstanding. The note, with $124.7 million outstanding, was issued in 1999 under the Bank's $1 billion note program and matures in 2009. Under the terms of this program, the Bank may issue additional notes provided that at any time the aggregate amount outstanding does not exceed $1.0 billion.
Bancorp Hawaii Capital Trust I, a grantor trust wholly-owned by the Company, issued $100 million 8.25% Capital Securities (the "Securities"). The Securities bear a cumulative fixed interest rate of 8.25% and mature on December 15, 2026. Interest payments are semi-annual. The Company is subject to an expense agreement with the trust obligating the Company to pay any costs, expenses or liabilities of the trust, other than obligations of the trust to pay amounts due pursuant to the terms of the Securities. The sole assets of the trust are Junior Subordinated Debt Securities (the "Debt") issued by the Company to the trust. The Debt is redeemable prior to the stated maturity at the Company's option. The Securities are subject to mandatory redemption upon repayment of the related Debt at their stated maturity dates, or their earlier redemption at a redemption price equal to their liquidation amount plus accrued distributions to the date fixed for redemption and the premium, if any, paid by the Company upon concurrent repayment of the related Debt. The Company has issued guarantees for the payment of distributions and payments on liquidation or redemption of the Securities, but only to the extent of funds held by the trust. The guarantees are junior subordinated obligations of the Company. Distributions to securities holders may be deferred for up to five consecutive years. During any such deferral period the Company's ability to pay dividends on its common shares will be restricted. The Federal Reserve has announced that certain cumulative preferred securities having the characteristics of the Securities qualify as minority interest, and are included in Tier 1 capital for bank holding companies. During 2002, the Company repurchased $68.6 million of the Securities. No repurchases were made in 2003.
Privately placed notes issued by the Company, including fair value adjustments, totaled $90.5 million at December 31, 2003 and mature in 2004. These notes carry seven year terms and bear floating interest rates of 10 to 25 basis points above the three-month LIBOR rate, which was 1.15% at December 31, 2003. In July 2002, the note holder exercised the option to change to a fixed 6.99% rate on $40.0 million.
Federal Home Loan Bank ("FHLB") advances bear interest at rates from 4.0% to 6.68% and mature from 2004 through 2010. FHLB advances that mature within the next year ($6.0 million) were classified as
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Current Maturities of Long-Term Debt on the Consolidated Statements of Condition. At December 31, 2003, mortgage loans totaling $92.2 million and FHLB stock totaling $59.0 million were pledged to secure these advances.
Capitalized lease obligations relate to office space at the headquarters of the Company. The lease began in 1993 and has a 60 year term. Lease payments are fixed at $605,000 per year from 2003 to 2007, $665,000 per year from 2008 to 2012 and are negotiable thereafter.
As of December 31, 2003, future principal payments on long-term debt are expected to be:
Note 11—Shareholders' Equity
The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are 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 the Bank to maintain minimum amounts and ratios of Total and Tier I capital. Tier I capital is common shareholders' equity plus qualifying capital securities and minority interest, reduced by unrealized gains and losses accumulated in other comprehensive income and certain intangible assets. Total capital is Tier I capital plus qualifying subordinated debt, allowable allowance for loan losses and any investment in an unconsolidated subsidiary. Three capital ratios are used to measure capital adequacy: Tier I capital divided by risk-weighted assets, as defined; Total capital divided by risk-weighted assets; and the leverage ratio, which is Tier I capital divided by average assets.
As of December 31, 2003, the Company and the Bank were well-capitalized under the regulatory framework for prompt corrective action. There were no conditions or events since year-end that management believes have changed the Company's or the Bank's capital ratings.
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The table below sets forth the minimum required capital for well-capitalized institutions and the actual capital amounts and ratios for the Company and the Bank at December 31, 2003 and 2002:
Federal Reserve Board regulations require the Bank to maintain reserve balances based on the amount of deposits held. The required reserve balance was $41.2 million and $21.1 million at December 31, 2003 and 2002, respectively.
The Bank is subject to federal regulatory restrictions that limit cash dividends and loans to the Company. These restrictions generally require advanced approval from the Bank's regulator for payment of dividends in excess of earnings for the prior three years. Special dividends of $200.0 million and $235.0 million were paid in 2003 and 2002, respectively, by the Bank from capital released by the divestiture and risk reduction programs. Because of these special dividends, which were used by the Company for share repurchases, advanced approval is required for future dividends. Such approval has been granted for an amount up to the level of the Bank's income for 2004, subject to the absence of any adverse material change in the Bank's financial condition.
The components of accumulated other comprehensive income (net of tax), which is a component of equity, were:
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The following table presents the changes to accumulated other comprehensive income (loss) and the related tax effect allocated to each component:
During 2003, the Company's Board of Directors approved share repurchase programs that authorized the repurchase of an additional $200.0 million in common stock. This authorization, combined with the Company's previously announced authorization of $800.0 million, brings the total authorized repurchase amount to $1.0 billion. Shares repurchased under these programs are held in Treasury for reissue in connection with stock compensation plans and for general corporate purposes. During 2003, 2002 and 2001, the Company repurchased 9.7 million, 11.8 million and 8.3 million shares, respectively under these programs at an average cost of $28.68 per share for a total of $855.0 million. Remaining buyback authority was $145.0 million at December 31, 2003.
Note 12—Commitments and Contingencies
The Company is a defendant in various legal proceedings and, in addition, there were various other contingent liabilities arising in the normal course of business. After consultation with legal counsel,
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management does not anticipate that the disposition of these proceedings and contingent liabilities will have a material effect upon the Consolidated Financial Statements.
Note 13—Employee Benefits
Defined Contribution Plans
Effective July 1, 2002, the Company created the Bank of Hawaii Retirement Savings Plan (the "Savings Plan") by merging its deferred compensation profit sharing plan with its defined contribution money purchase plan. The Savings Plan has three Company contribution components: (1) 401(k) matching; (2) a 3% fixed amount based on eligible compensation; and (3) a discretionary value sharing contribution. Under the 401(k) component, participating employees may contribute up to 50% of their eligible compensation (within federal limits) to the Savings Plan. The Company makes matching contributions on behalf of participants each calendar quarter equal to $1.25 for each $1.00 contributed by participants, up to 2% of the participants' eligible compensation, and $0.50 for every $1.00 contributed by participants over 2% up to 5% of the participants' eligible compensation. In addition, all eligible members receive an annual 3% fixed contribution and a discretionary value sharing contribution that is linked to the Company's financial goals. These contributions are made regardless of whether the member contributes to the Savings Plan and is invested in accordance with the participant's selection of investment options available under the Savings Plan. The Company also has a non-qualified Savings Plan which covers certain employees for amounts exceeding the limits under the plan. Total expense under the Savings Plans was $11.5 million in 2003 and $7.3 million for the six months in 2002 that the Savings Plans were in effect.
Prior to July 1, 2002, a deferred compensation profit sharing plan ("Profit Sharing Plan") was provided for the benefit of all employees of the Company and its subsidiaries who met the Profit Sharing Plan's eligibility requirements. Contributions to the Profit Sharing Plan were at the sole discretion of the Company's Board of Directors. Participants in the Profit Sharing Plan received up to 50% of their annual allocation in cash. The remaining amounts were deferred and could be invested in various options including mutual funds, a collective trust, and common stock of the Company. The Company's contribution to the Profit Sharing Plan totaled $3.7 million in 2001. The Profit Sharing Plan also provided for a company match of $1.25 for each $1.00 in 401(k) contributions made by qualified employees up to a maximum of 2% of the employee's compensation. For 2002 and 2001, matching contributions under this plan totaled $1.5 million and $2.9 million, respectively.
Also prior to July 1, 2002, the Company had a defined contribution money purchase plan ("Money Purchase Plan") under which it contributed 4% of an employee's compensation for employees meeting certain eligibility and vesting requirements. The Money Purchase Plan had a one year eligibility requirement and a five year vesting period. For 2002 and 2001, the Company contributed $2.7 million and $5.1 million, respectively, to the Money Purchase Plan.
Defined Benefit Plans (Pension Plans)
In 1995, the Company froze its non-contributory, qualified defined benefit retirement plan ("Retirement Plan") and excess retirement plan ("Excess Plan"), which covered employees of the Company and participating subsidiaries who met certain eligibility requirements.
Retirement Plan assets primarily consist of a collective investment fund and marketable securities including stocks, U.S. Government agency securities, U.S. Government Treasuries, Corporate Bonds, a money market fund, and mutual funds. The assets of the Retirement Plan include investments in a Bank of Hawaii collective investment fund and securities of related parties (Pacific Capital Funds mutual funds and a money market fund). The Asset Management Group of the Bank, an SEC-registered investment adviser, manages the Pacific Capital Funds mutual funds and the money market fund. The Bank manages the Bank of Hawaii collective investment fund. The fair value of securities of related parties was $21.5 million and $20.9 million as of December 31, 2003 and 2002, respectively.
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The Excess Plan is a non-qualified excess retirement benefit plan which covers certain employees of the Company and participating subsidiaries. The unfunded Excess Plan recognizes the liability to participants for amounts exceeding the limits allowed under the Retirement Plan. Because the Excess Plan is unfunded, it has no plan assets. The projected benefit obligation, accumulated benefit obligation and accrued benefit liability each totaled $5.7 million as of December 31, 2003 and $5.6 million as of December 31, 2002.
Postretirement Benefit Plans
The Company's postretirement benefit plan provides retirees with life, dental and medical insurance coverage. The retiree life insurance benefit for participants who retire after 2003 was terminated as of December 31, 2003, which resulted in a curtailment gain of $2.5 million. Employees who were retired as of December 31, 2003 are still eligible for the life insurance benefits. The costs of providing postretirement benefits are "shared costs" where both the employer and former employees pay a portion of the premium. Most employees of the Company and its subsidiaries who have met the eligibility requirements are covered by this plan. The Company recognizes the transition obligation over 20 years, ending in 2013. The Company has no segregated assets to provide postretirement benefits.
The Company uses a December 31 measurement date for all its plans.
The following table sets forth the change in benefit obligation, change in fair value of plan assets, funded status, and net amount recognized in the Consolidated Statements of Condition for the aggregated pension plans (Retirement Plan and Excess Plan) and postretirement benefit plan for the years ended December 31, 2003 and 2002.
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At December 31, 2003, the accumulated benefit obligations for the aggregated pension plans exceeded the fair value of Plan Assets. Included in other comprehensive income was a charge of $0.9 million, net of deferred taxes, related to this obligation.
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Components of net periodic benefit cost for the aggregated pension plans and the postretirement benefit plan are presented in the following table for the years ended December 31, 2003, 2002 and 2001.
Assumptions used to determine benefit obligations as of December 31, 2003 and 2002 for the aggregated pension plans and postretirement benefit plan were as follows:
Assumptions used to determine the net periodic benefit cost for the aggregated pension plans and postretirement benefit plan for years ended December 31, 2003, 2002 and 2001 were as follows:
In determining the long-term rate of return for plan assets the Company reviews historical returns, the asset composition of the Plan and the interest rate environment.
The health care cost trend rate assumption used was 6%. A one percent change in this assumption (with all other assumptions remaining constant) would impact the service and interest cost components of the net periodic postretirement benefit cost and the postretirement benefit obligation for 2003 as follows:
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The percentages of the Retirement Plan assets by major category, based upon their fair values, as of December 31, 2003 and December 31, 2002 were as follows:
The Retirement Plan's assets include investments in funds managed by the Bank as of December 31, 2003 as follows:
The Retirement Plan's investment objective is to provide its participants with retirement income and to assist retirees in coping with inflation. To achieve this goal, the Investment Committee of the Retirement Plan seeks a return on investment which will enhance the purchasing power of the principal amount of these assets over the long term through capital appreciation and reinvestment of income. The Investment Committee seeks a compounded annual total rate of return greater than the return of the "Market Index" or plus 400 basis points above the return of 90-day Treasury Bills, whichever is higher, on a trailing three year basis. The "Market Index" is composed of 60% S&P 500, 15% Russell 2000 Index, and 25% Lehman Brothers Government/Corporate Bond Index. The Investment Committee of the Retirement Plan seeks to protect the Retirement Plan assets through prudent asset allocation, manager selection, and periodic review. Investments in stocks and fixed income investments should be diversified in a way which is consistent with the risk tolerance and investment objective of the Retirement Plan.
The Company expects to contribute $0.5 million to the Retirement and Excess Plan and $1.3 million to its postretirement benefit plan in 2004.
The Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the "Act") was enacted on December 8, 2003. The Act expands Medicare, primarily adding a prescription drug benefit for Medicare-eligible retirees starting in 2006. The Company elected to defer recognizing the effects of the Act and intends to review its retiree health care strategy in light of the new Medicare provisions that may reduce the Company's obligations in the plan. Therefore, the retiree medical obligations and costs reported as of December 31, 2003 do not reflect the impact, if any, of this legislation. FASB Staff Position 106-1 permits deferring the recognition of the new Medicare provisions due to pending authoritative guidance on the accounting for the Act. The final accounting guidance could require changes to previously reported information.
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Note 14—Stock Compensation
Director Stock Compensation Program
The Company has a Director Stock Compensation Program that annually grants 200 shares of restricted common stock ("Restricted Shares") and an option for 3,000 common shares to each non-employee director. The exercise price of the options is based on the closing market price of the shares on the date that the options were granted. Each option expires ten years from the date of grant and is generally not transferable. If an optionee ceases to serve as a director for any reason other than death or disability, any unexercised options terminate. Upon the exercise of options, the shares received ("Option Shares") are nontransferable during the term of the director. If an optionee ceases to serve as a director prior to the end of his or her term, for any reason other than death or disability, the Option Shares will be redeemed by the Company at a price equal to the exercise price. The Restricted Shares are also nontransferable during the term of the director. If an optionee ceases to serve as a director prior to the end of his or her term, for any reason other than death, disability, removal without cause, or change of control, the Restricted Shares are forfeited. At December 31, 2003, 168,000 options and 23,000 Restricted Shares were outstanding under this program.
Employee Stock Option Plan
The Company's Stock Option Plans (the "Plans") are administered by the Compensation Committee of the Board of Directors. Awards under the Plans can include stock options, stock appreciation rights (SAR's), restricted stock and restricted stock units. The authority to grant awards under the Plans expired on December 31, 2003. The Company expects to submit a new stock option plan to its shareholders for approval in 2004.
Stock Options
Stock option awards provide participants with the option to purchase shares of common stock at specified exercise prices during a period of time beginning not less than one year after the date the option was granted through the option's expiration, which is generally ten years from the date of grant. The exercise prices are the fair market value of the shares on the dates the options were granted.
The following information relates to options outstanding under all plans as of December 31, 2003:
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The following table presents the activity in all the plans for the years ended December 31, 2003, 2002 and 2001:
Restricted Stock
Restricted Stock awards provide participants with rights to shares of stock upon completion of a service period or achievement of Company performance measures. During the restriction period all shares are considered outstanding and dividends are paid on the Restricted Stock. The Restricted Stock vests over periods from three to ten years from date of grant, although accelerated vesting was provided in certain grants, based on attainment of target prices for the Company's stock or other Company performance measures. The Company recognizes compensation expense, measured as the quoted market price of the Restricted Stock on the grant date, on a straight-line basis over the vesting period, with recognition of the cost associated with accelerated vesting upon attainment of the performance measures. The unearned compensation is shown as a separate component of shareholders' equity. Restricted Stock is cancelled if an employee terminates prior to the vesting date. Total compensation expense recognized by the Company for Restricted Stock was $5.8 million, $3.6 million and $2.7 million in 2003, 2002 and 2001, respectively.
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The following table presents the activity for Restricted Stock for the years ended December 31, 2001, 2002 and 2003.
Restricted Stock Units
Restricted Stock Unit awards ("RSUs") entitle the participant to a cash payment based upon the fair market value of the Company's stock at the time the award vests. During the vesting period, the participant is entitled to dividend equivalent payments equal to the actual dividends declared on the Company's stock. All expense associated with RSUs is considered compensation expense and is recognized over the vesting period. In 2003, 195,000 RSUs with a two year vesting period were awarded. Total expense recognized by the Company for RSUs in 2003 was $2.6 million.
Note 15—Income Taxes
The significant components of the provision for income taxes for the years ended December 31, 2003, 2002 and 2001 were as follows:
The current income tax provision included taxes on gains and losses on the sale of securities of $0.7 million, $0.2 million and $13.2 million for 2003, 2002 and 2001, respectively. Tax benefits of
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$5.3 million and $4.3 million related to the exercise of employee stock options were recorded directly in shareholders' equity in 2003 and 2002, respectively. There were no tax benefits recorded in 2001.
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The 2002 deferred tax liabilities and assets were reclassified based on the filed tax returns. Significant components of the Company's deferred tax liabilities and assets as of December 31, 2003 and 2002 are presented below:
At December 31, 2003, the Company had available foreign tax credit carry forwards of $15.9 million that expire as follows: 2005—$2.7 million, 2006—$12 million, 2007—$0.5 million, and 2008—$0.7 million. No benefit has been recognized for the carry forwards. Management expects to generate sufficient foreign source income to utilize the foreign tax credit carry forwards.
The following is a reconciliation of the Federal statutory income tax rate to the effective consolidated income tax rate for the years ended December 31, 2003, 2002 and 2001:
For financial statement purposes, no deferred income tax liability was recorded for tax bad debt reserves that arose in tax years beginning before December 31, 1987. Such tax bad debt reserves totaled approximately $18.2 million. If these amounts are used for purposes other than to absorb bad debt losses, they will be subject to federal income taxes at the then applicable rates.
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Note 16—Derivative and Financial Instruments
The Company is a party to derivative financial instruments in the normal course of its business to meet the financing needs of its customers and to manage its own exposure to fluctuations in interest and foreign exchange rates. These financial instruments include commitments to extend credit, standby letters of credit, foreign exchange contracts and mortgage loan origination commitments.
The Company utilizes foreign exchange contracts to offset risk related to transactions executed on behalf of customers that is accounted for at fair value in the financial statements, it has not designated any foreign exchange contracts as fair value hedges under SFAS No. 133 for operational purposes.
The Company also enters into forward contracts for the future delivery of residential mortgage loans to reduce interest rate risk associated with loans held for sale and commitments to fund loans. These contracts are considered derivative instruments under SFAS No. 133 and changes in the fair value of these contracts are recorded.
At December 31, 2003 and 2002, no interest rate swaps or options were in effect.
As with any financial instrument, derivative instruments have inherent risks. Adverse changes in interest rates, foreign exchange rates, commodity prices and equity prices affect the Company's market risks. The market risks are balanced with the expected returns to enhance earnings performance and shareholder value, while limiting the volatility of each. The Company uses various processes to monitor the overall market risk exposure, including sensitivity analysis, value-at-risk calculations and other methodologies.
The Company's exposure to derivative credit risk is defined as the possibility of sustaining a loss due to the failure of the counterparty to perform in accordance with the terms of the contract. Credit risks associated with derivative financial instruments are similar to those relating to traditional on-balance sheet financial instruments. The Company manages derivative credit risk with the same standards and procedures applied to its commercial lending activity.
SFAS No. 133, as amended, requires all derivative instruments to be carried at fair value on the Consolidated Statements of Condition. As of December 31, 2003, the Company did not designate any derivative instruments as fair value, cash flow or net investment in foreign operations hedges and all free standing and embedded derivatives required to be bifurcated have been recorded at fair value in the results of operations.
The derivatives identified and recorded at fair value as of December 31, 2003 and 2002 were as follows:
Note 17—Fair Values of Financial Instruments
The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced liquidation sale. When possible, fair values are measured based on quoted market prices for the same or comparable instruments. Because many of the Company's financial instruments lack an available market price, management must use its best judgment in estimating the fair value of those instruments based on present value or other valuation techniques. Such techniques are significantly affected by estimates and assumptions, including the discount rate, future cash flows, economic conditions, risk characteristics, and other relevant factors. These estimates are subjective in nature and involve uncertain assumptions and, therefore, cannot be determined
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with precision. Many of the derived fair value estimates cannot be substantiated by comparison to independent markets and could not be realized in immediate settlement of the instrument. Certain financial instruments and all non-financial instruments are excluded from disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.
The following methods and assumptions were used by the Company in estimating fair values of financial instruments:
Cash and Cash Equivalents: The carrying amounts reported in the balance sheet for cash and short-term investments approximated the fair value of these assets.
Investment Securities Held to Maturity and Investment Securities Available for Sale: Fair values for investment securities were based on quoted market prices, where available. If quoted market prices were not available, fair values were based on quoted market prices of comparable instruments.
Loans: Fair values of loans were determined by discounting the expected future cash flows of pools of loans with similar characteristics. Loans were first segregated by type such as commercial, real estate and consumer, and were then further segmented into fixed and adjustable rate and loan quality categories. Expected future cash flows were projected based on contractual cash flows, adjusted for estimated prepayments.
Deposit Liabilities: Fair values of non-interest bearing and interest bearing demand deposits and savings deposits were equal to the amount payable on demand (e.g., their carrying amounts) because these products have no stated maturity. Fair values of time deposits were estimated using discounted cash flow analyses. The discount rates used were based on rates currently offered for deposits with similar remaining maturities.
Short-Term Borrowings: The carrying amounts of securities sold under agreements to repurchase, funds purchased, commercial paper, and other short-term borrowings approximated their fair values.
Long-Term Debt: Fair values of long-term debt were estimated using discounted cash flow analyses, based on the Company's current incremental borrowing rates for similar types of borrowings.
Derivative and Financial Instruments: Fair values of derivative instruments (e.g., commitments to extend credit, standby letters of credit, commercial letters of credit and foreign exchange contracts) were based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties' credit standing and current settlement values or quoted market prices of comparable instruments.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of the terms or conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since commitments may expire without being drawn, the total commitment amount does not necessarily represent future cash requirements.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. These guarantees are primarily issued to support borrowing agreements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds cash and deposits as collateral on those commitments for which collateral is deemed necessary.
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The following table presents the fair values of the Company's financial instruments at December 31, 2003 and 2002:
Note 18—Business Segments
Business segment results are determined based on the Company's internal financial management reporting process and organizational structure. This process uses various techniques to assign balance sheet and income statement amounts to business segments, including allocations of overhead, Provision, and capital. This process is dynamic and requires certain allocations based on judgment and subjective factors. Unlike financial accounting, there is no comprehensive, authoritative guidance for management accounting that is equivalent to accounting principles generally accepted in the United States. The management accounting 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. Results for prior periods have been reclassified to facilitate comparability.
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The Company's business segments are as follows:
The Company's Retail Banking segment offers a broad range of financial products and services to consumers and small businesses. Loan and lease products include residential mortgage loans, home equity lines of credit, automobile loans and leases, and installment loans. Deposit products include checking, savings, and time deposit accounts. The Retail Banking segment also provides merchant services to its small business customers. Products and services from the Retail Banking segment are delivered to customers through 74 Hawaii branch locations and over 500 ATMs, e-Bankoh (on-line banking service), and a 24-hour telephone banking service.
The Commercial Banking segment offers products including corporate banking and commercial real estate loans, lease financing, auto dealer financing, deposit and cash management products, and property and casualty insurance products. Lending, deposit and cash management services are offered to middle-market and large companies in Hawaii. Commercial real estate mortgages are focused on customers that include investors, developers and builders primarily domiciled in Hawaii. The Commercial Banking unit also serves customers through its 14 branches in the Pacific Islands. As part of the initiatives for improving efficiency, the representative office in Tokyo was closed in the third quarter of 2003.
The Investment Services Group includes private banking, trust services, asset management, institutional investment advice, and retail brokerage. A significant portion of this segment's income is derived from fees, which are largely based on the market values of assets under management. The private banking and personal trust group assists individuals and families in building and preserving their wealth by providing investment, credit, and trust expertise to high-net-worth individuals. The asset management group manages portfolios and creates investment products. The institutional sales and service group offers investment advice to corporations, government entities, and foundations. Also included in the segment is Bankoh Investment Services, Inc., a full service brokerage offering equities, mutual funds, life insurance products and annuities.
The primary income earning component of this segment is Treasury, which consists of corporate asset and liability management activities including interest rate risk management and foreign exchange business. This segment's assets and liabilities (and related net interest income) consist of interest bearing deposits, investment securities, federal funds sold and purchased, government deposits, and short and long-term borrowings. The primary source of foreign exchange income relates to customer driven currency requests from merchants and island visitors. The net residual effect of transfer pricing of assets and liabilities is included in Treasury, along with eliminations of intercompany transactions.
This segment also includes divisions that provide a wide-range of support (Technology and Operations, Human Resources, Finance and Legal, and Risk Management) to the other income earning segments. Expenses incurred by these support units are charged to the business segments through an internal cost allocation process. This segment also includes the system replacement project expenses that are not incurred by or allocated to the Retail, Commercial and Investment Services Group segments.
Divestitures and Corporate Restructuring Related Activities
This segment reflected the 2001 implementation of the Company's strategic plan to improve credit quality and to divest underperforming businesses. It included the impact of the sales of the divested businesses and restructuring and other related costs. It also included losses associated with the accelerated resolution of credit problems undertaken in the first quarter of 2001. The amounts reported in 2002 for this category consisted of the remaining costs associated with the 2001 divestitures and branch closures in the Pacific Islands and the merger of First Savings into the Bank.
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The financial results for each of the Company's business segments for the years ended December 31, 2003, 2002 and 2001 were as follows:
Business Segment Selected Financial Information
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Note 19—Foreign Activities
The following tables provide selected financial data for the Company's foreign activities:
As discussed in Note 3, in 2001 the Company divested its South Pacific banking operations and closed its branches in the Asia Division, except for a representative office in Japan which closed in 2003. In 2001, to measure international profitability, the Company maintained an internal transfer pricing system that makes certain income and expense allocations, including interest expense for the use of domestic funds. Interest rates used in determining charges on advances of funds were based on prevailing deposit rates. Overhead was allocated based on services rendered by administrative units to profit centers.
The Company continues to provide lending to foreign borrowers and purchase foreign investments to take advantage of its foreign tax credits.
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Note 20—Parent Company Financial Statements
Condensed financial statements of Bank of Hawaii Corporation (Parent only) follow:
Condensed Statements of Income
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Condensed Statements of Condition
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Condensed Statements of Cash Flows
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Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9a. Controls and Procedures
The Company's management, including the Chief Executive Officer and Chief Financial Officer, evaluated the Company's disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of December 31, 2003. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective. There were no significant changes in the Company's internal controls over financial reporting that occurred during the quarter ended December 31, 2003 that have materially affected or are reasonably likely to materially affect the Company's internal control over financial reporting.
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PART III
Except as otherwise indicated, the following information required by the Instructions to Form 10-K is incorporated herein by reference from various sections of the Bank of Hawaii Corporation Proxy Statement for the annual meeting of shareholders to be held on April 30, 2004, as summarized below:
Item 10. Directors and Executive Officers of the Registrant
"Board of Directors"; "Section 16 (a) Beneficial Ownership Reporting Compliance."
Information regarding the executive officers of the Company is incorporated by reference from "Executive Officers of the Registrant" at the end of Part I of this report.
The Company's Board of Directors has determined that Robert A. Huret, a member of the Company's Audit Committee, is a financial expert within the meaning of Section 3(a)(58) of the Exchange Act. This financial expert is independent within the meaning of Section 10A(m)(3) of the Exchange Act.
The Company has adopted a written code of ethics within the meaning of Item 406 of Regulation S-X that applies to its executive officers, including its Chief Executive Officer, Chief Financial Officer and Controller. A copy of the code of ethics will be available by April 30, 2004 on the Company's website, www.boh.com.
Item 11. Executive Compensation
"Executive Compensation."
Item 12. Security Ownership of Certain Beneficial Owners and Management
"Beneficial Ownership."
"Proposal 2: Approval of Bank of Hawaii Corporation 2004 Stock Option Plan and Incentive Compensation Plan"
Item 13. Certain Relationships and Related Transactions
"Certain Transactions with Management and Others."
Item 14. Principal Accounting Fees and Services
Fees paid to registered public accountants are disclosed under the caption "Proposal 3: Election of an Independent Auditor" and related pre-approval policies are disclosed under the caption "Appendix B. Audit Pre-Approval Procedures For Audit and Non-Audit Services" of the Proxy Statement, which is incorporated by reference in this Item.
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PART IV
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
The following Consolidated Financial Statements of Bank of Hawaii Corporation and Subsidiaries are included in Item 8 of this report:
Consolidated Statements of Income—Years ended December 31, 2003, 2002, and 2001
Consolidated Statements of Condition—December 31, 2003 and 2002
Consolidated Statements of Shareholders' Equity—Years ended December 31, 2003, 2002, and 2001
Consolidated Statements of Cash Flows—Years ended December 31, 2003, 2002, and 2001
Notes to Consolidated Financial Statements
All other schedules to the Consolidated Financial Statements stipulated by Article 9 of Regulation S-X and all other schedules to the financial statements of the registrant required by Article 5 of Regulation S-X are not required under the related instructions or are inapplicable and, therefore, have been omitted.
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EXHIBIT INDEX
89
90
Current Report on Form 8-K dated December 15, 2003 and filed December 16, 2003, reporting Item 5.
Current Report on Form 8-K dated October 27, 2003 and filed October 28, 2003, reporting Item 12.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
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 in the capacities and on the date indicated.
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