UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
For the fiscal year ended December 31, 2004or
For the transition period from to
Commission File # 000-50245
NARA BANCORP, INC.
3701 Wilshire Boulevard
Registrant’s telephone number, including area code: (213) 639-1700Securities registered pursuant to Section 12(b) of the Act: NoneSecurities registered pursuant to Section 12(g) of the Act:Common Stock, par value $0.001 per share(Title of Class)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes o No þ
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act) Yes þ No o
The aggregate market value of the Common Stock held by non-affiliates of the Registrant based upon the closing sale price of the Common Stock as of the last business day of the Registrant’s most recently completed second fiscal quarter, June 30, 2004, as reported on the Nasdaq National Market, was approximately $397,429,000.
Number of shares outstanding of the Registrant’s Common Stock, as of March 31, 2005: 23,366,660
Table of Contents
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PART I
Forward-Looking Information
Certain matters discussed in this Annual Report on Form 10-K may constitute forward-looking statements under Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These statements may involve risks and uncertainties. These forward-looking statements relate to, among other things, expectations regarding the business environment in which we operate, projections of future performance, perceived opportunities in the market and statements regarding our mission and vision. Forward-looking statements include, but are not limited to, statements preceded by, followed by or that include words such as “will,” “believes,” “expects,” “anticipates,” “intends,” “plans,” “estimates” or similar expressions. Our actual results, performance or achievements may differ significantly from the results, performance or achievements expressed or implied in such forward-looking statements. For a detailed discussion of the factors that might cause such a difference, see Item 1. “Business- Factors That May Impact Our Business or the Value of Our Stock.”
Factors that might affect forward-looking statements include, among other things:
• the demand for our products;
• actions taken by our competitors;
• adverse actions taken by any one of our regulatory agencies, which would limit our activities, such as a Memorandum of Understanding or consent agreement;
• changes in the FDIC insurance premium;
• tax rate changes, new tax laws and revised tax law interpretations;
• adverse changes occurring in the securities markets;
• inflation and changes in prevailing interest rates that reduce our margins or the fair market value of the financial instruments that we hold;
• economic or business conditions, either nationally or in our market areas, that are worse than we anticipated;
• legislative or regulatory changes that adversely affect our business;
• the timing, impact and other uncertainties of our asset sales or securitizations;
• technology changes that are more difficult or expensive than we expect;
• increases in delinquencies and defaults by our borrowers and other loan delinquencies;
• increases to our provision for losses on loans and leases due to loan quality/performance deterioration;
• our inability to sustain or improve the performance of our subsidiaries;
• our inability to achieve our financial goals and strategic plans, including any financial goals related both to contemplated and consummated assets sales or acquisitions;
• potential delisting of our stock by NASDAQ , and the effect on our stock price if this occurs;
• potential litigation relating to our recent accounting restatement;
• possible weaknesses in our system of internal and disclosure controls; and
• credit and other risks of lending, leasing and investment activities.
As a result, we cannot assure you that our future results of operations or financial condition or any other matters will be consistent with those expressed or implied in any forward-looking statements. Accordingly, we caution you not to rely on these forward-looking statements. We do not undertake, and specifically disclaim any obligation, to update these forward-looking statements, which speak only as of the date made except as may otherwise be required by law.
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Item 1. BUSINESS
General
Nara Bancorp, Inc. (“Nara Bancorp,” on a parent-only basis, and “we” or “our” on a consolidated basis with its subsidiaries) is a bank holding company headquartered in Los Angeles, California. We offer a full range of commercial banking and consumer financial services through our wholly owned subsidiary, Nara Bank, a California state-chartered bank (the “Bank” or “Nara Bank”). During the first quarter of 2001, Nara Bancorp became a bank holding company regulated by the Board of Governors of the Federal Reserve System (the “FRB”) as part of the reorganization of Nara Bank into a holding company structure. Nara Bancorp was incorporated under the laws of the State of Delaware in 2000. Nara Bank was organized in 1989 as a national bank and converted to a California state-chartered bank on January 3, 2005. Nara Bancorp’s principal business is to serve as a holding company for Nara Bank and other bank-related subsidiaries, which Nara Bancorp may establish or acquire. Our headquarters are located at 3701 Wilshire Boulevard, Suite 220, Los Angeles, California 90010, and our telephone number at that address is (213) 639-1700. Nara Bank’s deposits are insured by the Bank Insurance Fund (“BIF”), as administered by the Federal Deposit Insurance Corporation (“FDIC”), up to applicable limits. Nara Bank is a member of the Federal Reserve System.
Nara Bancorp currently has five special-purpose subsidiaries that were formed for capital-raising transactions: Nara Capital Trust I, Nara Statutory Trust II, Nara Capital Trust III, Nara Statutory Trust IV, and Nara Statutory Trust V. In March 2001 and 2002, Nara Bancorp established Nara Capital Trust I (“Trust I”) and Nara Statutory Trust II (Trust II”), respectively. The Trust I issued $10.0 million in trust preferred securities bearing a fixed rate of 10.18%. The interest is payable semi-annually for a 30- year term. Trust II issued $8.0 million in trust preferred securities. The interest rate is adjusted quarterly on March 26, June 26, September 26 and December 26 during its 30-year term based on the 3-month LIBOR plus 3.60 % and is paid quarterly. In June 2003, Nara Bancorp established Nara Capital Trust III (“Trust III”), and in December of 2003 Nara Bancorp established Nara Statutory Trust IV (“Trust IV”) and Nara Statutory Trust V (“Trust V”). In three separate private placement transactions, the Trusts III, IV, and V issued $5.0 million, $5.0 million and $10.0 million with quarterly adjustable rates based on the 3-month LIBOR plus 3.15%, 2.85%, and 2.95%, respectively, and interest is paid quarterly for a 30- year term. In all five issuances, we participated as part of a pooled offering with several other financial institutions. The statutory business trusts were established as part of our capital planning to complement and support future growth.
With the adoption of FIN 46, Nara Bancorp deconsolidated the five grantor trusts as of December 31, 2003. As a result, the subordinated debentures issued by Bancorp to the grantor trusts in connection with the trust preferred financing, totaling $39.3 million, are reflected in our consolidated statements of financial condition in the liabilities section at December 31, 2004 and 2003, under the caption “subordinated debentures.” We record interest expense on the corresponding subordinated debentures in the consolidated statements of income. Nara Bancorp also recorded $2.1 million in other assets in the consolidated statements of financial condition at December 31, 2004 and 2003 for the common capital securities issued by the grantor trusts held by Bancorp.
Nara Bank opened for business in June 1989 under the name “United Citizens National Bank” as a national banking association. The institution’s name was changed to “Nara Bank, National Association” in January 1994, and in January 2005, became “Nara Bank” after converting to a California state-chartered bank. Nara Bank is headquartered at 3701 Wilshire Boulevard, Suite 220, Los Angeles, California 90010. Nara Bank primarily focuses its business in Korean communities in California and in the greater New York City metropolitan area.
Nara Bank supplemented its growth over the past few years through strategic acquisitions in its primary market areas in California and New York. The following is a summary of our acquisitions since 1998:
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At December 31, 2004, the Bank had two wholly owned subsidiaries. The first subsidiary, Nara Loan Center, is a New Jersey corporation organized in 2000. Nara Loan Center is a loan production office, generating mostly SBA loans. The second subsidiary, Nara Real Estate Trust, a Maryland real estate investment trust, was formed in April of 2003. Nara Real Estate Trust holds only loans secured by real estate and as of December 31, 2004, had total assets of $128 million.
Our website address is www.narabank.com. Electronic copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports, are available free of charge by visiting our website atwww.narabank.com/i_stock.asp andwww.narabank.com/I_finan.asp. These reports are generally posted as soon as reasonably practicable after they are electronically filed with the Securities and Exchange Commission.
Restatement of Financial Statements
On March 30, 2005, we filed a Form 8-K announcing that on February 23, 2005, a letter (the “Letter”) dated October 10, 2002 addressed to the former President and Chief Executive Officer of Nara Bancorp, Inc. (the “Company”) and signed by the former Chairman of the Board of the Company was brought to the attention of the Audit Committee. The Letter addressed the relinquishment of certain profit sharing rights held by the former President and Chief Executive Officer payable in 2003 and 2004 and the Letter further provided that Nara Bank, a wholly-owned subsidiary of the Company, purportedly agreed to reimburse the former President and Chief Executive Officer for certain automobile and country club expenses and to provide him with compensation for additional work to be performed after his retirement, all in an amount not to exceed the amount of profit sharing rights to be relinquished by him.
A special sub-committee of the Audit Committee of the Board of Directors of the Company (the “Subcommittee”) engaged independent counsel to conduct an investigation of matters relating to the Letter. The Subcommittee discovered that the amount the former President and Chief Executive Office relinquished was approximately $600,000 in 2002 and $0 in 2003. The Subcommittee determined that the failure to disclose and account for the arrangement to reimburse certain expense amounts up to approximately $600,000 contemplated by the Letter had a material effect on the Company’s previously issued consolidated financial statements for the year ended December 31, 2003 and 2002. The Subcommittee evaluated the error in accordance with the quantitative and qualitative guidance set forth in Staff Accounting Bulletin No. 99. As a result thereof, on March 24, 2005, the Subcommittee concluded (and on March 25, 2005 the Board of Directors concurred) that the Company should restate its consolidated financial statements for the year ended December 31, 2002 and 2003 and, accordingly, the previously issued financial statements and the related independent auditors reports thereon for the year ended December 31, 2003 and 2002 should no longer be relied upon. The Subcommittee discussed the restatement with the Company’s independent registered public accounting firm for 2004 as well as its former independent registered public accounting firm for 2003 and 2002. Additionally, the Subcommittee engaged its current independent registered public accounting firm to re-audit the Company’s 2003 and 2002 consolidated financial statements.
On March 30, 2005, the Company announced in a current report on Form 8-K that it was restating its annual consolidated financial statements for the fiscal years ended December 31, 2003 and 2002. In the course of the re-audits of the Company’s consolidated financial statements for the fiscal years ended December 31, 2003 and 2002, certain additional errors were also identified (i.e., other than the one relating to the Letter) in the Company’s consolidated financial statements for fiscal 2003 and 2002. Specifically, errors were identified relative to accounting for bank owned life insurance, lease arrangements under which the Company occupies its premises, incentive compensation, profit sharing and bonus payments to certain employees and various other accounting matters. Accordingly, the Company’s fiscal 2003 and 2002 consolidated financial statements are also restated for these accounting errors. See Note 2 “Restatement” of the Notes to Consolidated Financial Statements for a detailed discussion of the restatements.
All financial information contained in this Annual Report on Form 10-K gives effect to this restatement. Information regarding the effect of the restatement on our financial position and results of operations is provided in Note 2 to the Notes to Consolidated Financial Statements. Financial information included in reports on Form 10-Q, Form 10-K and Form 8-K previously filed or furnished by the Company for these periods should not be relied upon and are superseded by the information in this Annual Report on Form 10-K.
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Recent Developments
On March 10, 2005, Nara Bancorp declared a dividend of $0.0275 per common share for the first quarter of 2005, which was paid on April 12, 2005 to stockholders of record on March 31, 2005. On June 23, 2005, Nara Bancorp declared a dividend of $0.0275 per common share for the second quarter of 2005, which is payable on July 17, 2005 to stockholders of record on July 5, 2005.
Business Overview
Our principal business activities are conducted through Nara Bank by earning interest on loans and investment securities that are funded by customer deposits and other borrowings. The difference between interest received and interest paid comprises the majority of our operating earnings. The FDIC insures Nara Bank’s deposits up to the maximum legal limits, and the Bank is a member of the Federal Reserve System.
Through our network of 16 branches and 8 loan production offices, we offer a full range of commercial banking and consumer financial services to our customers, who typically are individuals and small- to medium-sized businesses in our market areas. We accept deposits and originate a variety of loans including commercial loans, commercial real estate loans, trade finance, Small Business Administration (SBA) loans, automobile and various consumer loans. To better meet our customers’ needs, our mini-market branches generally offer extended hours from 9 a.m. to 6 p.m. Each of our branches, operates 24-hour automated teller machines. We provide courier services to qualifying customers and offer personal banking officers to key customers to better support their banking needs. We honor merchant drafts for both VISA and MasterCard and provide debit card services to our customers. In addition, most of our branches offer travelers’ checks, safe deposit boxes, notary public and other customary bank services. We also offer 24-hour banking by telephone. Our website at www.narabank.com features both English and Korean applications and internet banking services.
A significant amount of our operating income and net income depends on the difference between interest revenue received from interest-earning assets and interest expense paid on interest-bearing liabilities. However, interest rates are highly sensitive to many factors that are beyond our control, such as general economic conditions and the policies of various governmental and regulatory authorities, in particular those of the Federal Reserve Board. Although our business may vary with local and national economic conditions, such variations are not seasonal in nature.
Lending Activities
Commercial Loans
Commercial loans are extended to businesses for various purposes such as providing working capital, purchasing inventory, purchasing machinery and equipment, debt refinance, business acquisition and other business related financing needs. Commercial loans are typically classified as (1) short-term loans (or lines of credits), which are often used to finance current assets such as inventory and accounts receivable, which typically have terms of one year with interest paid monthly on the outstanding balance and principal balance due at maturity and (2) long-term loans (or term loans to businesses) which typically have terms of 5 to 7 years with principal and interest paid monthly. The credit-worthiness of our borrowers is determined before a loan is originated and periodically reviewed to ascertain credit quality for both short-term and long-term loans. Commercial loans are typically collateralized by the borrower’s business assets and/or real estate property. Nara Bank also extends commercial loans in the U.S. that are secured by real estate property located in South Korea. As of December 31, 2004, we had approximately $2.5 million in commercial loans secured by the real estate property located in South Korea. We do not expect the loans secured by real estate property located in South Korea to
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make up a significant portion of our loan portfolio in the near future. We also offer small business loans to smaller retail businesses of up to $150,000 with terms of 4 to 7 years at fixed interest rates using a credit scoring system.
Our commercial loan portfolio includes trade finance loans from Nara Bank’s International Banking Department, which generally serves businesses involved in international trade activities. These loans are typically collateralized by business assets and are used to meet the short-term working capital needs (accounts receivable and inventories) of our borrowers. The International Banking Department also issues and advises on letters of credit for export and import businesses.
Commercial Real Estate Loans
Real estate loans are extended for the purchase and refinance of commercial real estate and are generally secured by first deeds of trust. The maturities on such loans are generally restricted to seven years with a balloon payment due at maturity and are amortized for up to 25 years. We offer both fixed and floating rate loans. It is our policy to restrict real estate loan amounts to 70% of Nara Bank’s appraised value of the property.
Small Business Administration Loans
The Bank also extends loans partially secured by the U.S. Small Business Administration (SBA). The Bank extends SBA loans known as 7(a) loans and SBA 504 loans. SBA 7(a) loans are typically extended for the purpose of providing working capital, purchase of inventory, purchase of machinery and equipment, debt refinance, business acquisitions, start-up financing, or to purchase/construct owner-occupied commercial property. SBA 7(a) loans are typically term loans with maturities ranging from 7 to 10 years for business only related loans and 25 years for real estate related loans. SBA loans are fully amortized with monthly payment of principal and interest. SBA loans are typically floating rate loans that are secured by business assets and/or real estate. Depending on the loan amount, each loan is typically guaranteed 75% to 85% by the SBA with a maximum gross loan amount to any one small business borrower of $2.0 million and a maximum SBA guaranteed amount of $1.5 million.
The SBA 7(a) loans we generate represent an important segment of our non-interest income due to our ability to sell the guaranteed portion in the secondary market at a premium while earning from the servicing fee income on the sold portion over the remaining life of the loan. Therefore, in addition to the interest yield earned on the un-guaranteed portion of the SBA loans that are not sold, we recognize income from the gains on the sales and from loan servicing on the SBA loans sold.
SBA 504 loans are typically extended for the purpose of purchasing owner-occupied commercial real estate or long-term capital equipment. SBA 504 loans are typically extended for 20 years or the life of the asset being financed. SBA 504 loans are financed as a participation loan between the Bank and the SBA through a Certified Development Company (“CDC”). Generally, the loans are structured so as to give the Bank a 50% first deed of trust (“T/D”), the SBA a 40% second T/D (SBA 504), and the remaining 10% is funded by the borrower. Rates for the first T/D Bank loans are subject to normal bank commercial rate and the second T/D SBA loans are fixed for the life of the loans based on the U.S. Treasury rate index.
All of our SBA loans are handled through Nara Bank’s SBA Loan Department. The SBA Loan Department is staffed by loan officers who provide assistance to qualified businesses. For SBA 7(a) loans, we attained our initial SBA Preferred Lender status in the Los Angeles and Santa Ana, California districts on January 16, 1997. SBA Preferred Lender status is the highest designation awarded by the U.S. Small Business Administration and generally facilitates the marketing and approval process for SBA loans. We have since attained SBA Preferred Lender status in San Francisco, Seattle, Spokane, Illinois, Atlanta, New York, New Jersey, Virginia, Baltimore, Washington D.C., Georgia and Denver.
Consumer Loans
Consumer loans are extended for automobile and home equity loans with a majority of the consumer loan portfolio currently consisting of automobile loans. Referrals from automobile dealers comprise the majority of originations for automobile loans. We offer fixed rate loans to buyers who do not qualify for automobile dealers’ most preferential loan rates for new and used car financing. We offer home equity loans and lines up to 89% of the appraised value of the real
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estate. We also extend credit to United States legal residents secured by real estate located in South Korea. As of December 31, 2004, we had extended approximately $1.0 million in consumer loans secured by real estate in South Korea.
Concentrations
Loan concentrations are considered to exist when there are significant amounts of loans to a number of borrowers engaged in similar activities, which would cause them to be similarly impacted by economic or other conditions. The following table describes the industry concentrations in our loan portfolio over the past five years, which exceeded 10% of our total loans as of the dates indicated:
Investing Activities
The main objectives of our investment strategy are to support a sufficient level of liquidity while providing a means to manage our interest rate risk, and to generate an adequate level of interest income without taking undue risks. Subject to various restrictions, our investment policy permits investment in various types of securities, certificates of deposits and federal funds sold. Our investment portfolio consists of government sponsored agency bonds, mortgage backed securities, Collaterized Mortgage Obligations (“CMOs”), bank-qualified California municipal bonds, corporate bonds and government sponsored enterprise preferred stocks, which were sold during the first quarter of 2005. For a detailed breakdown of our investment portfolio, please refer to “Item 7. — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Financial Condition — Investment Security Portfolio.
Securities are classified as held-to-maturity or available-for-sale. We do not maintain a trading portfolio. Securities in the held-to-maturity category consist of securities purchased for long-term investment in order to enhance our ongoing stream of net interest income. Securities deemed held-to-maturity are classified as such because we have both the intent and ability to hold these securities to maturity. Securities purchased to meet investment-related objectives such as interest rate risk and liquidity management, but which may be sold as necessary to implement management strategies, are designated as available-for-sale at the time of purchase. At December 31, 2004, we had $2.0 million in securities held-to- maturity and $133.4 million in securities available-for-sale. We purchased $74.8 million and sold $26.4 million in investment securities during 2004.
Deposit Activities
We attract both short-term and long-term deposits from the general public by offering a wide range of deposit products and services. Through our branch network, we provide our banking customers with money market accounts, savings and checking accounts, certificate of deposit, individual retirement accounts, business checking accounts, 24-hour automated teller machines, and Internet banking and bill-pay services.
Our primary source of funds is FDIC-insured deposits. We try to match maturities of our interest-bearing liabilities with our interest-earning assets. We cover all volatile funds with liquid assets as a method to ensure adequate liquidity. Thus, we analyze our deposits’ maturities and interest rates to monitor and control the cost of funds and review the stability of the supply of funds. We believe our deposits are a stable and reliable funding source.
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Borrowing Activities
When we have more funds than required for our reserve requirements or short-term liquidity needs, we sell federal funds to other financial institutions. Conversely, when we have less funds than required, we may borrow funds from both our correspondent banks and the Federal Reserve Bank, also known as the FRB. The maximum amount that we currently are authorized to borrow from our correspondent banks is $46.0 million on an overnight basis. In addition to the correspondent banks, the maximum amount that we may borrow from the FRB discount window is 98% of the market value of the securities that are pledged. At December 31, 2004, the par value of the securities that we have pledged for this purpose was $1.8 million.
The Federal Home Loan Bank System functions in a reserve credit capacity for qualifying financial institutions. As a member, we are required to own capital stock in the Federal Home Loan Bank of San Francisco (“FHLBSF”) and may apply for advances from the FHLB utilizing, qualifying mortgage loans and certain securities as collateral for these advances.
The FHLBSF offers a full range of borrowing programs on its advances with terms of up to 30 years at competitive market rates. A prepayment penalty is usually imposed for early repayment of these advances. As a member of the Federal Reserve Bank, we may also borrow from the Federal Reserve Bank of San Francisco.
Market Area and Competition
We have 16 branch offices located in Los Angeles, Orange County, Oakland, Silicon Valley, and New York and 8 loan production offices located in San Jose, Seattle, Chicago, New Jersey, Atlanta, Virginia, Denver and Dallas. Most of our services are offered in Los Angeles County, Orange County, the San Francisco Bay Area, Silicon Valley (Santa Clara County), and the New York metropolitan area, each of which has high concentrations of Korean-Americans. The banking and financial services industry generally, and in our market areas specifically, are highly competitive. The increasingly competitive environment is a result primarily of changes in regulation, changes in technology and product delivery systems, and the accelerating pace of consolidation among financial services providers as well as strong competition amongst the banks serving the Korean-American community. In addition, recent federal legislation may have the effect of further increasing the pace of consolidation within the financial services industry. See “Item 1. Business — Supervision and Regulation - Financial Services Modernization Legislation.”
We compete for loans, deposits, and customers with other commercial banks, savings and loan associations, securities and brokerage companies, mortgage companies, insurance companies, finance companies, money market funds, credit unions, and other non-bank financial service providers. Many of these competitors are much larger in total assets and capitalization, have greater access to capital markets, are more widely recognized, have broader geographic scope and offer a broader range of financial services than we do.
Economic Conditions, Government Policies and Legislation
Our profitability, like most financial institutions, depends primarily on interest rate differentials. In general, the major portion of our earnings consist of the difference between the interest rates paid on interest-bearing liabilities, such as deposits and borrowings, and the interest rates received on our interest-earning assets, such as loans we extend to our customers and securities held in our investment portfolio. These rates are highly sensitive to many factors that are beyond our control, such as inflation, recession and unemployment. The impact that future changes in domestic and foreign economic conditions might have on our performance cannot be predicted.
Our business also is influenced by the monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the FRB. The FRB implements national monetary policies (with objectives such as curbing inflation and combating recession) through its open-market operations in U.S. government securities, by adjusting the required level of reserves for depository institutions subject to its reserve requirements, and by varying the target federal funds and discount rates applicable to borrowings by depository institutions. The actions of the FRB in these areas influence the growth of bank loans, investments, and deposits and also affect interest rates earned on interest-earning assets and paid on interest-bearing liabilities. The nature and impact on Nara Bancorp and Nara Bank of future changes in monetary and fiscal policies cannot be predicted.
From time to time, legislation, as well as regulations, are enacted which have the effect of increasing the cost of doing business, limiting or expanding permissible activities, or affecting the competitive balance between banks and other
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financial services providers. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies, and other financial institutions and financial services providers are frequently made in the U.S. Congress, in the state legislatures, and before various regulatory agencies. This legislation may change banking statutes and our operating environment in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. We cannot predict whether any of this potential legislation will be enacted, and if enacted, the effect that it, or any implementing regulations, would have on our financial condition or results of operations. See “Item 1. Business — Supervision and Regulation” below.
Supervision and Regulation
Bank holding companies and banks are extensively regulated under both federal and state law. These regulations are intended primarily for the protection of depositors and the deposit insurance fund and not for the benefit of our stockholders. Set forth below is a summary description of the material laws and regulations that relate to our operations. The description is qualified in its entirety by reference to the applicable laws and regulations.
Nara Bancorp
As a registered bank holding company, we are subject to regulation under the Bank Holding Company Act of 1956, as amended, (the “BHCA”). We are required to file with the FRB periodic reports and such additional information as the FRB may require pursuant to the BHCA. The FRB and the California Commissioner of Financial Institutions may conduct examinations of our subsidiaries and us.
The FRB may require that we terminate an activity or terminate control of, or liquidate, or divest ourselves of certain subsidiaries or affiliates when the FRB believes the activity or the control of the subsidiary or affiliate constitutes a significant risk to the financial safety, soundness or stability of any of our banking subsidiaries. The FRB also has the authority to regulate provisions of certain bank holding company debt, including the authority to impose interest ceilings and reserve requirements on such debt. Under certain circumstances, we must file written notice and obtain approval from the FRB prior to purchasing or redeeming our equity securities.
Further, both Nara Bancorp and Nara Bank are subject to the capital adequacy regulations of the FRB. See “Capital Requirements.”
We are required to obtain the prior approval of the FRB for the acquisition of more than 5% of the outstanding shares of any class of voting securities or substantially all of the assets of any bank or bank holding company. Prior approval of the FRB is also required if we merge or consolidate with another bank holding company. We are prohibited by the BHCA, except in certain statutorily prescribed instances, from acquiring direct or indirect ownership or control of more than 5% of the outstanding voting shares of any company that is not a bank or bank holding company and from engaging directly or indirectly in activities other than those of banking, managing or controlling banks, or furnishing services to our subsidiaries. However, subject to the prior approval of the FRB, we may engage in any, or acquire shares of companies engaged in, activities that are deemed by the FRB to be so closely related to banking, or managing, or controlling banks as to be a proper incident thereto.
Under FRB regulations, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. In addition, it is the FRB’s policy that a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company’s failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the FRB to be an unsafe and unsound banking practice or a violation of the FRB’s regulations or both.
We are also a bank holding company within the meaning of Section 3700 of the California Financial Code. As such, our subsidiaries and we are subject to examination by, and may be required to file reports with, the California
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Department of Financial Institutions.
Our securities are registered with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”). As such, we are subject to the information, proxy solicitation, insider trading, and other requirements and restrictions of the Exchange Act.
Nara Bank
As a California state-chartered bank whose accounts are insured by the Federal Depository Insurance Corporation (“FDIC”), the Bank is subject to regulation, supervision, and regular examination by the California Commissioner of Financial Institutions (“DFI” or the “California Commissioner”), and the Bank’s primary federal regulator is the Federal Reserve Board. The regulations of these agencies govern most aspects of the Bank’s business, including the making of periodic reports, its activities relating to dividends, investments, loans, borrowings, capital requirements, certain check-clearing activities, branching, mergers and acquisitions, reserves against deposits and numerous other areas. Supervision, legal action, and examination by these agencies are generally intended to protect depositors, creditors, borrowers and the deposit insurance fund and generally are not intended for the protection of stockholders.
If, as a result of an examination of Nara Bank, the FRB or the DFI should determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity or other aspects of Nara Bank’s operations are unsatisfactory or that Nara Bank or its management is violating or has violated any law or regulation, various remedies are available to the FRB and the DFI. Such remedies include the power to enjoin “unsafe or unsound practices,” to require affirmative action to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in capital, to restrict the growth of Nara Bank, to assess civil monetary penalties, to remove officers and directors, and to terminate Nara Bank’s deposit insurance. Further, Nara Bank is also required to maintain certain minimum levels of capital. See “Capital Requirements.”
In February 2002, Nara Bank entered into a Stipulation and Consent to the Issuance of a Consent Order (the “Consent Order”) in connection with alleged deficiencies relating to the lack of sufficient internal controls, procedures and inadequate compliance with the Bank Secrecy Act. During 2002, management took steps to comply with the Consent Order and to further comply with the Bank Secrecy Act, including, but not limited to, the implementation of new IT systems and the expansion of employee training programs. On January 22, 2003, the OCC terminated the Consent Order, and since such date Nara Bank was no longer subject to the requirements of the Consent Order.
As a result of a recent regulatory examination, the Company’s regulatory agencies are expected to place additional restrictions and requirements on the Company which may limit the Company’s growth and expansion and its ability to pay cash dividends without prior regulatory approval.
Sarbanes-Oxley Act of 2002
On July 30, 2002, the President signed into law the “Sarbanes-Oxley Act of 2002” (the “SOX”). The stated goals of the SOX are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. The SOX has resulted in broad corporate and accounting reform for public companies and the accounting firms that audit them. Many provisions of the SOX became effective immediately and others became effective since passage of the law.
The SOX generally applies to all companies, both U.S. and non-U.S., that file or are required to file periodic reports with the Securities and Exchange Commission, (the “SEC”), under the Exchange Act. The SOX includes very specific additional disclosure requirements and new corporate governance rules, requires the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules, and mandates further studies of certain issues by the SEC and the Comptroller General. The SOX also represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between the board of directors and management and between the board of directors and its committees.
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To date, the SEC and the securities exchanges have implemented most of the requirements of the SOX. We have incurred, and expect to continue to incur, significant additional expenses in complying with the new requirements under SOX and applicable rules and regulations.
USA Patriot Act of 2001
On October 26, 2001, the President signed the USA Patriot Act of 2001 (the “Patriot Act”). Enacted in response to the terrorist attacks on September 11, 2001, the Patriot Act is intended to strengthen U.S law enforcement’s and the intelligence communities’ abilities to work cohesively to combat terrorism on a variety of fronts. The potential impact of the Patriot Act on financial institutions of all kinds is significant and wide ranging. The Patriot Act contains sweeping anti-money laundering and financial transparency laws and requires various regulations, including:
The Department of the Treasury in consultation with the FRB and other federal financial institution regulators has promulgated rules and regulations implementing the Patriot Act which:
On May 9, 2003, the Department of Treasury, in conjunction with other bank regulators, issued a Joint Final Rule that provides for minimum standards with respect to customer identification and verification. We were required to comply with this rule by October 1, 2003. We have implemented and will continue to implement the provisions of the Patriot Act as such provisions become effective. We currently maintain and will continue to maintain policies and procedures to comply with the Patriot Act requirements. At this time, we do not expect that the Patriot Act will have a material impact on the results of our operations.
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Bank Secrecy Act
The Financial Recordkeeping and Reporting of Currency and Foreign Transactions Act of 1970 (the “Bank Secrecy Act”) is a disclosure law that forms the basis of the U.S. federal government’s framework to prevent and detect money laundering and to deter other criminal enterprises. Following the September 11, 2001 terrorist attacks, an additional purpose was added to the Bank Secrecy Act: “To assist in the conduct of intelligence or counter-intelligence activities, including analysis, to protect against international terrorism.” Under the Bank Secrecy Act, financial institutions such as Nara Bank are required to maintain certain records and file certain reports regarding domestic currency transactions and cross-border transportations of currency. This, in turn, allows law enforcement officials to create a paper trail for tracing illicit funds that resulted from drug trafficking or other criminal activities. Among other requirements, the Bank Secrecy Act requires financial institutions to report all cash transactions in excess of $10,000. Nara Bank has established a Bank Secrecy Act compliance policy under which, among other precautions, the Bank keeps currency transaction reports to document cash transactions in excess of $10,000 or in multiples totaling more than $10,000 during one business day, monitors certain potentially suspicious transactions such as the exchange of a large number of small denomination bills for large denomination bills, and scrutinizes electronic funds transfers for Bank Secrecy Act compliance. At this time, we do not expect that the Bank Secrecy Act will have a material impact on the results of our operations.
Financial Services Modernization Legislation
General. On November 12, 1999, President Clinton signed into law the Gramm-Leach-Bliley Act of 1999, also referred to as the “FSMA.” The FSMA repeals the two affiliation provisions of the Glass-Steagall Act: Section 20, which restricted the affiliation of Federal Reserve Member Banks with firms “engaged principally” in specified securities activities; and Section 32, which restricts officer, director, or employee interlocks between a member bank and any company or person “primarily engaged” in specified securities activities. In addition, the FSMA also contains provisions that expressly preempt any state law restricting the establishment of financial affiliations, primarily related to insurance. The general effect of the law is to establish a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms, and other financial service providers by revising and expanding the BHCA framework to permit a holding company system to engage in a full range of financial activities through a new entity known as a financial holding company.
The FSMA also:
We do not believe that the FSMA will have a material adverse effect on our operations in the near-term. However, to the extent that it permits banks, securities firms and insurance companies to affiliate, the financial services industry may experience further consolidation and banks may increasingly diversify the financial products that they offer. The FSMA is intended to grant to community banks, such as Nara Bank, certain powers as a matter of right that larger institutions have accumulated on an ad hoc basis. Nevertheless, the FSMA may have the result of increasing the amount of competition that we face from larger institutions and other types of companies offering financial products, many of which may have substantially greater financial resources than we do.
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Financial Holding Companies. Bank holding companies that elect to become a financial holding company may affiliate with securities firms and insurance companies and engage in other activities that are financial in nature or are incidental or complementary to activities that are financial in nature. “Financial in nature” activities include:
Prior to filing a declaration of its election to become a financial holding company, all of the bank holding company’s depository institution subsidiaries must be well capitalized, well managed, and, except in limited circumstances, in compliance with the Community Reinvestment Act.
Failure to comply with the financial holding company requirements could lead to divestiture of subsidiary banks or require all activities of such company to conform to those permissible for a bank holding company. No FRB approval is required for a financial holding company to acquire a company (other than a bank holding company, bank or savings association) engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the FRB including:
A bank holding company that is not also a financial holding company can only engage in banking and such other activities determined by the FRB to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.
We have not elected to become a financial holding company, although our management may reevaluate this decision as business conditions require.
Expanded Bank Activities. The FSMA also permits banks to engage in expanded activities through the formation of financial subsidiaries. A bank may have a subsidiary engaged in any activity authorized for banks directly or any financial activity, except for insurance underwriting, insurance investments, real estate investment or development, or merchant banking, which may only be conducted through a subsidiary of a financial holding company. Financial activities include all activities permitted under new sections of the BHCA or permitted by regulation.
A bank seeking to have a financial subsidiary, and each of its depository institution affiliates, must be “well-capitalized,” “well-managed” and in compliance with the Community Reinvestment Act. The total assets of all financial subsidiaries may not exceed the lesser of 45% of a bank’s total assets, or $50 billion. A bank must exclude from its assets and equity all equity investments, including retained earnings, in a financial subsidiary. The assets of the subsidiary may not be consolidated with the bank’s assets. The bank must also have policies and procedures to assess financial subsidiary risk and protect the bank from such risks and potential liabilities.
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Privacy. Under the FSMA, federal banking regulators adopted rules that limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. Pursuant to these rules, financial institutions must provide:
These privacy provisions affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors. We do not believe that these privacy provisions will have a significant impact on our operations.
Dividends and Other Transfers of Funds
Dividends from Nara Bank constitute the principal source of income for Nara Bancorp. Nara Bancorp is a legal entity separate and distinct from Nara Bank. Nara Bank is subject to various statutory and regulatory restrictions on its ability to pay dividends to Nara Bancorp. During 2005, the maximum dividend that Nara Bank could declare, without prior regulatory approval, is $36.7 million plus the Bank’s 2005 net income. In addition, FRB and DFI have the authority to prohibit Nara Bank from paying dividends, depending upon Nara Bank’s financial condition, if such payment is deemed to constitute an unsafe or unsound practice. As a result of a recent regulatory examination, the Company’s regulatory agencies are expected to place additional restrictions and requirements on the Company which may limit the Company’s and the Bank’s ability to pay cash dividends without prior regulatory approval.
Transactions with Affiliates
Nara Bank is subject to certain restrictions imposed by federal law on any extensions of credit to, or the issuance of a guarantee or letter of credit on behalf of, Nara Bancorp or other affiliates, the purchase of, or investments in, stock or other securities thereof, the taking of such securities as collateral for loans, and the purchase of assets of Nara Bancorp or other affiliates. Such restrictions prevent Nara Bancorp and such other affiliates from borrowing from Nara Bank unless the loans are secured by marketable obligations of designated amounts. Further, such secured loans and investments by Nara Bank to or in Nara Bancorp or to or in any other affiliate are limited in the amounts indicated below for “covered transactions” under Regulation W. California law also imposes certain restrictions with respect to transactions involving Nara Bancorp and other controlling persons of Nara Bank. Additional restrictions on transactions with affiliates may be imposed on Nara Bank under the prompt corrective action provisions of federal law. See “— Prompt Corrective Action and Other Enforcement Mechanisms.”
Regulation W. During 2003 the Federal Reserve Board’s newly issued Regulation W became effective, which codifies prior regulations under an interpretative guidance with respect to transactions with affiliates. Affiliates of a bank include, among other entities, the bank’s holding company and companies that are under common control with the bank. In general, subject to certain specified exemptions, a bank or its subsidiaries are limited in their ability to engage in “covered transactions” (as defined below) with affiliates:
In addition, a bank and its subsidiaries may engage in covered transactions and other specified transactions only on terms and under circumstances that are substantially the same, or at least as favorable to the bank or its subsidiary, as those prevailing at the time for comparable transactions with nonaffiliated companies.
A “covered transaction” includes:
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In addition, under Regulation W:
Regulation W generally excludes all non-bank and non-savings association subsidiaries of banks from treatment as affiliates, except to the extent that the FRB decides to treat these subsidiaries as affiliates. Concurrently with the adoption of Regulation W, the FRB has proposed a regulation, which would further limit the amount of loans that could be purchased by a bank from an affiliate to not more than 100% of the bank’s capital and surplus.
Check 21
The Check Clearing for the 21st Century Act, or “Check 21” as it is commonly known, became effective October 28, 2004. Check 21 facilitates check collection by creating a new negotiable instrument called a “substitute check,” which permits, but does not require, banks to replace original checks with substitute checks or information from the original check and process check information electronically. Banks that do use substitute checks must comply with certain notice and recredit rights. Check 21 is expected to cut the time and cost involved in physically transporting paper items and reduce float, i.e., the time between the deposit of a check in a bank and payment, especially in cases in which items were not already being delivered same-day or overnight. The Bank does not intend to utilize the Check 21 authority and processing in the near future.
Capital Requirements
The federal banking agencies have adopted risk-based minimum capital guidelines intended to provide a measure of capital that reflects the degree of risk associated with a banking organization’s operations for both transactions reported on the balance sheet as assets and transactions which are recorded as off-balance-sheet items. Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off-balance-sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as federal banking agencies, to 100% for assets with relatively high credit risk. The higher the category, the more risk a bank is subject to and thus the more capital that is required. As of December 31, 2004, Nara Bank’s total risk-based capital ratio was 11.1%.
The guidelines divide a bank’s capital into two tiers. Tier I includes common equity, retained earnings, certain non-cumulative perpetual preferred stock, subordinated debentures (limited to 25% of Tier 1 Capital), and minority interest in equity accounts of consolidated subsidiaries. Goodwill and other intangible assets (except for mortgage servicing rights and purchased credit card relationships, subject to certain limitations) are subtracted from Tier I capital. As of December 31, 2004, Nara Bank’s Tier I risk-based capital ratio was 9.9%.
Tier II capital includes, among other items, cumulative perpetual and long-term, limited-life preferred stock, mandatory convertible securities, certain hybrid capital instruments, term subordinated debt and the allowance for loan
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losses (subject to certain limitations). Certain items are required to be deducted from Tier II capital. Banks must maintain a total risk-based ratio of 8%, of which at least 4% must be Tier I capital.
In addition to the risk-based guidelines, federal banking regulators require banking organizations to maintain a minimum amount of Tier I capital to total assets, referred to as the leverage ratio. For a banking organization rated in the highest of the five categories used by regulators to rate banking organizations, the minimum leverage ratio of Tier I capital to total assets must be 4%. As of December 31, 2004, Nara Bank’s leverage capital ratio was 9.1%. In addition to these uniform risk-based capital guidelines and leverage ratios that apply across the industry, the regulators have the discretion to set individual minimum capital requirements for specific institutions at rates significantly above the minimum guidelines and ratios. For further discussion of our capital, see “Capital Resources” under “Management Discussion and Analysis of Financial Condition and Results of Operations.”
On July 2, 2003, the Federal Reserve Board issued Supervisory Letter SR 03-13 clarifying that bank holding companies should continue to report trust preferred securities in accordance with current Federal Reserve Board instructions which allows trust preferred securities to be counted in Tier I capital subject to certain limitations. The Federal Reserve Board indicated they were reviewing the implications of any accounting treatment changes and, if necessary or warranted, they would provide appropriate guidance. On March 1, 2005, the Federal Reserve Board adopted a final rule that allows the continued limited inclusion of trust preferred securities in Tier I capital of bank holding companies. However, under the final rule, trust preferred securities will be subject to stricter quantitative limits. The Board’s final rule limits restricted core capital elements to 25 percent of all core capital elements, net of goodwill less any associated deferred tax liability. Amounts of restricted core capital elements in excess of these limits generally may be included in Tier II capital. The final rule provides a five-year transition period ending March 31, 2009, for application of the new quantitative limits.
The following table presents the amounts of regulatory capital and the capital ratios for Nara Bancorp and Nara Bank, compared to their minimum regulatory capital requirements as of December 31, 2004.
Prompt Corrective Action and Other Enforcement Mechanisms
Federal banking agencies possess broad powers to take corrective and other supervisory action to resolve the problems of insured depository institutions, including but not limited to those institutions that fall below one or more prescribed minimum capital ratios. Each federal banking agency has promulgated regulations defining the following five categories in which an insured depository institution will be placed, based on its capital ratios: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. At December 31, 2004, Nara Bank exceeded the required ratios for classification as “well capitalized.”
An institution that, based upon its capital levels, is classified as well capitalized, adequately capitalized, or undercapitalized may be treated as though it were in the next lower capital category if the appropriate federal banking agency, after notice and opportunity for hearing, determines that an unsafe or unsound condition or an unsafe or unsound practice warrants such treatment. At each successive lower capital category, an insured depository institution is subject to
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more restrictions. The federal banking agencies, however, may not treat a significantly undercapitalized institution as critically undercapitalized unless its capital ratio actually warrants such treatment.
In addition to measures taken under the prompt corrective action provisions, commercial banking organizations may be subject to potential enforcement actions by the federal regulators for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation, or any condition imposed in writing by the agency or any written agreement with the agency. Finally, pursuant to an interagency agreement, the FDIC can examine any institution that has a substandard regulatory examination score or is considered undercapitalized — without the express permission of the institution’s primary regulator.
Safety and Soundness Standards
The federal banking agencies have adopted guidelines designed to assist the federal banking agencies in identifying and addressing potential safety and soundness concerns before capital becomes impaired. The guidelines set forth operational and managerial standards relating to: (i) internal controls, information systems and internal audit systems, (ii) loan documentation, (iii) credit underwriting, (iv) asset growth, (v) earnings, and (vi) compensation, fees and benefits. In addition, the federal banking agencies have also adopted safety and soundness guidelines with respect to asset quality and earnings standards. These guidelines provide six standards for establishing and maintaining a system to identify problem assets and prevent those assets from deteriorating. Under these standards, an insured depository institution should: (i) conduct periodic asset quality reviews to identify problem assets, (ii) estimate the inherent losses in problem assets and establish reserves that are sufficient to absorb estimated losses, (iii) compare problem asset totals to capital, (iv) take appropriate corrective action to resolve problem assets, (v) consider the size and potential risks of material asset concentrations, and (vi) provide periodic asset quality reports with adequate information for management and the board of directors to assess the level of asset risk. These guidelines also set forth standards for evaluating and monitoring earnings and for ensuring that earnings are sufficient for the maintenance of adequate capital and reserves.
Premiums for Deposit Insurance
Through the Bank Insurance Fund (“BIF”), the FDIC insures the deposits of Nara Bank up to prescribed limits for each depositor. The amount of FDIC assessments paid by each BIF member institution is based on its relative risk of default as measured by regulatory capital ratios and other factors. Specifically, the assessment rate is based on the institution’s capitalization risk category and supervisory subgroup category. An institution’s capitalization risk category is based on the FDIC’s determination of whether the institution is well capitalized, adequately capitalized or less than adequately capitalized. An institution’s supervisory subgroup category is based on the FDIC’s assessment of the financial condition of the institution and the probability that FDIC intervention or other corrective action will be required.
The assessment rate currently ranges from zero to 27 cents per $100 of domestic deposits. The FDIC may increase or decrease the assessment rate schedule on a semi-annual basis. An increase in the assessment rate could have a material adverse effect on our earnings, depending on the amount of the increase. The FDIC is authorized to terminate a depository institution’s deposit insurance upon a finding by the FDIC that the institution’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the institution’s regulatory agency. The termination of deposit insurance for Nara Bank could have a material adverse effect on our earnings.
All FDIC-insured depository institutions must pay an annual assessment to provide funds for the payment of interest on bonds issued by the Financing Corporation, a federal corporation chartered under the authority of the Federal Housing Finance Board. The bonds, commonly referred to as FICO bonds, were issued to capitalize the Federal Savings and Loan Insurance Corporation. The current FICO assessment rate for BIF-insured deposits is $0.0144 per $100 of assessable deposits. The FICO assessments are adjusted quarterly to reflect changes in the assessment bases of the FDIC’s insurance funds and do not vary depending on a depository institution’s capitalization or supervisory evaluations.
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Interstate Banking and Branching
The BHCA permits bank holding companies from any state to acquire banks and bank holding companies located in any other state, subject to certain conditions, including certain nationwide and state imposed concentration limits. The establishment of new interstate branches is also possible in those states with laws that expressly permit it. Interstate branches are subject to certain laws of the states in which they are located. Competition may increase further as banks branch across state lines and enter new markets.
Community Reinvestment Act and Fair Lending Developments
We are subject to certain fair lending requirements and reporting obligations involving home mortgage lending operations and Community Reinvestment Act activities, (“CRA”). The CRA generally requires the federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of its local communities, including low- and moderate-income neighborhoods. A bank may be subject to substantial penalties and corrective measures for a violation of certain fair lending laws. The federal banking agencies may take compliance with such laws and CRA obligations into account when regulating and supervising other activities. Furthermore, financial institutions are subject to annual reporting and public disclosure requirements for certain written agreements that are entered into between insured depository institutions or their affiliates and nongovernmental entities or persons that are made pursuant to, or in connection with, the fulfillment of the CRA.
A bank’s compliance with its CRA obligations is based on a performance-based evaluation system, which bases CRA ratings on an institution’s lending service and investment performance. When a bank holding company applies for approval to acquire a bank or other bank holding company, the FRB will review the assessment of each subsidiary bank of the applicant bank holding company, and such records may be the basis for denying the application.
Federal Reserve System
The Federal Reserve Board requires all depository institutions to maintain non-interest bearing reserves at specified levels against their transaction accounts (primarily checking, NOW, and Super NOW checking accounts) and non-personal time deposits. At December 31, 2004, we believe that Nara Bank was in compliance with these requirements.
Employees
As of December 31, 2004, we had 342 full-time equivalent employees. None of our employees are represented by a union or covered by a collective bargaining agreement. Management believes that its relations with its employees are good. See Item 10 below for a list of our executive officers.
Factors That May Impact Our Business or the Value of Our Stock
Set forth below are certain factors that may affect our financial results and operations, which you should consider when evaluating our business and prospects.
We face risks related to our recent accounting restatements, including potential litigation and regulatory actions. On March 30, 2005 we announced that we had discovered accounting inaccuracies in previously reported financial statements and concluded that we would restate our consolidated financial statements for the year ended December 31, 2002. See Item 1 Business, “Restatement of Financial Statements” for further discussion. In the course of the re-audits of our consolidated financial statements for the fiscal years ended December 31, 2003 and 2002, certain additional accounting errors were also identified.
The restatement of our financial statements and the occurrence of the events caused us to incur substantial unanticipated legal and accounting expenses. In addition, restatement may lead to litigation claims and/or regulatory proceedings against us. These claims and proceedings may include, without limitation, private securities lawsuits brought against us and regulatory investigations or proceedings initiated by the Securities and Exchange Commission, the Federal Reserve Board and the California Department of Financial Institutions. We may also be asked to enter into a regulatory agreement or order with one or more of these regulatory agencies which could limit our activities, such as a Memorandum of Understanding or consent agreement. The defense and outcome of any such claims or proceedings against us and any agreement with regulators may divert management’s attention and resources, and we may be required to pay damages if such claims or proceedings are not resolved in our favor.
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Any litigation or regulatory proceeding, even if resolved in our favor, could cause us to incur significant legal and other expenses. We also may have difficulty raising equity capital or obtaining other financing. We may not be able to effectuate our current business strategy and our future business activities may be limited. Moreover, we may be the subject of negative publicity focusing on the financial statements inaccuracies and resulting restatement and negative reactions from our stockholders, creditors or others with which we do business. The occurrence of any of the foregoing could harm our business and reputation, require us to incur significant expenses to resolve any claims and cause the price of our securities to decline or remain at current levels.
If we fail to maintain an effective system of internal and disclosure controls, we may not be able to accurately report our financial results or prevent fraud. Effective internal and disclosure controls are necessary for us to provide reliable financial reports, and these controls also help us to detect and deter fraud and to operate successfully as a public company. If we cannot provide reliable financial reports or prevent fraud, our reputation and operating results would be adversely affected. We have in the past discovered, and may in the future discover, areas of our disclosure and internal controls that need improvement in material respects. In connection with a review of our internal control over financial reporting, we identified certain deficiencies in some of our disclosure and internal controls and procedures. We have taken steps to remediate the material weaknesses in internal control over financial reporting and the ineffectiveness of our disclosure controls and procedure and have specifically addressed them in the section labeled, “Report on Management’s Assessment of Internal Control Over Financial Reporting” Under Item 9A Controls and Procedures. However we cannot be certain that our efforts to improve our internal and disclosure controls will be successful or that we will be able to maintain adequate controls over our financial processes and reporting in the future. Any failure to develop or maintain effective controls or difficulties encountered in their implementation or other ineffective improvement of our internal and disclosure controls could harm our operating results or cause us to fail to meet our reporting obligations. If we are unable to adequately establish or improve our internal control over financial reporting, our independent auditors may not be able to issue an unqualified opinion on the effectiveness of our internal control over financial reporting. Ineffective internal and disclosure controls could also cause investors to lose confidence in our reported financial information, which would likely have a negative effect on the trading price of our securities.
If we cannot maintain compliance with Nasdaq listing requirements and Nasdaq rules, Nasdaq may delist our common stock, which would negatively affect the trading price of our common stock and your ability to sell our common stock, and generally could harm our business. On April 5, 2005, we were notified by the Nasdaq Listing Qualifications Department that we were not in compliance with the requirements of certain NASDAQ rules as a result of the Company’s failure to timely file its annual report on Form 10-K for the year ended December 31, 2004 and therefore, that we were subject to delisting proceedings. On May 12, 2005 the Company attended a hearing before the Nasdaq Listing Qualifications Panel (“Panel”) and requested a conditional listing on the Nasdaq National Market until June 30, 2005 to provide the Company an opportunity to file its periodic reports with the Securities and Exchange Commission and become compliant with the NASDAQ listing requirements. As of the date of this filing, the Panel is still considering our request. If we are delisted from the Nasdaq Stock Market, trading of our common stock would thereafter be conducted in the over-the-counter market or on the National Association of Securities Dealers, Inc. “electronic bulletin board.” If this occurs, the value of our common stock would likely be adversely affected, which could negatively affect our operations and ability to raise capital. Market liquidity for our common stock could be severely and adversely affected as a stockholder would likely find it more difficult to sell shares of our common stock or to obtain accurate quotations as to the prices of our common stock. Delisting from NASDAQ could also result in the loss of confidence by prospective and existing customers and employees, which would further harm our business.
Deterioration of economic conditions in California, New York or South Korea could adversely affect our loan portfolio and reduce the demand for our services. We focus our business primarily in Korean communities in California and in the greater New York City metropolitan area. Deterioration in economic conditions in our market areas could have a material adverse impact on the quality of our business. An economic slowdown in California, New York, or South Korea could have the following consequences, any of which could reduce our net income:
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Our allowance for loan losses may not cover actual loan losses. If our actual loan losses exceed the amount we have allocated for probable losses, it will hurt our business. We try to limit the risk that borrowers will fail to repay loans by carefully underwriting the loans. Losses nevertheless occur. We create allowance allocations for estimated loan losses in our accounting records. We base these allowances on estimates of the following:
If these allocations were inadequate, our results of financial condition could be materially and adversely affected.
A downturn in the real estate market could seriously impair our loan portfolio. As of December 31, 2004, approximately 58% of our loan portfolio consisted of loans secured by various types of real estate. If real estate values decline significantly, especially in California or New York, higher vacancies and other factors could harm the financial condition of our borrowers, the collateral for our loans will provide less security, and we would be more likely to suffer losses on defaulted loans.
Changes in interest rates affect our profitability. Changes in prevailing interest rates may hurt our business. We derive our income mainly from the difference or “spread” between the interest earned on loans, securities and other interest-earning assets, and interest paid on deposits, borrowings and other interest-bearing liabilities. In general, the wider the spread, the more we earn. When market rates of interest change, the interest we receive on our assets and the interest we pay on our liabilities will fluctuate. This can cause decreases in our spread and can greatly affect our income. In addition, interest rate fluctuations can affect how much money we may be able to lend. For example, when interest rates rise, loan originations tend to decrease.
If we lose key employees, our business may suffer. If we lose key employees temporarily or permanently, it could hurt our business. We could be particularly hurt if our key employees went to work for competitors. Our future success depends on the continued contributions of existing senior management personnel.
Environmental laws could force us to pay for environmental problems. The cost of cleaning up or paying damages and penalties associated with environmental problems could increase our operating expenses. When a borrower defaults on a loan secured by real property, we often purchase the property in foreclosure or accept a deed to the property surrendered by the borrower. We may also take over the management of commercial properties whose owners have defaulted on loans. We also lease premises where our branches and other facilities are located and where environmental problems may exist. Although we have lending, foreclosure and facilities guidelines intended to exclude properties with an unreasonable risk of contamination, hazardous substances may exist on some of the properties that we own, lease, manage or occupy. We may face the risk that environmental laws could force us to clean up the properties at our expense. It may cost much more to clean up a property than the property is worth. We could also be liable for pollution generated by a borrower’s operations if we take a role in managing those operations after a default. We may find it difficult or impossible to sell contaminated properties.
We are exposed to the risks of natural disasters. A significant portion of our operations is concentrated in California. California is in an earthquake-prone region. A major earthquake could result in material loss to us. A significant percentage of our loans are and will be secured by real estate. Many of our borrowers could suffer uninsured property damage, experience interruption of their businesses or lose their jobs after an earthquake. Those borrowers might not be able to repay their loans, and the collateral for such loans could decline significantly in value. Unlike a bank with
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operations that are more geographically diversified, we are vulnerable to greater losses if an earthquake, fire, flood or other natural catastrophe occurs in Southern California.
An increase in non-performing assets would reduce our income and increase our expenses. If the level of non-performing assets rises in the future, it could adversely affect our operating results. Non-performing assets are mainly loans on which the borrowers are not making their required payments. Non-performing assets also include loans that have been restructured to permit the borrower to have smaller payments and real estate that has been acquired through foreclosure of unpaid loans. To the extent that assets are non-performing, we have less cash available for lending and other activities.
Changes in governmental regulation may impair our operations or restrict our growth. We are subject to significant governmental supervision and regulation. These regulations are intended primarily for the protection of depositors. Statutes and regulations affecting our business may be changed at any time, and the interpretation of these statutes and regulations by examining authorities may also change. Within the last several years Congress and the President have passed and enacted significant changes to these statutes and regulations. There can be no assurance that such changes to the statutes and regulations or in their interpretation will not adversely affect our business. Nara Bank is subject to regulation and examination by the DFI and the Federal Reserve Board. In addition to governmental supervision and regulation, Nara Bank is subject to changes in other federal and state laws, including changes in tax laws, which could materially affect the banking industry. Nara Bancorp is subject to the rules and regulations of the Federal Reserve Board. If we fail to comply with federal and state bank regulations, the regulators may limit our activities or growth, fine us or ultimately put us out of business. Banking laws and regulations change from time to time. Bank regulations can hinder our ability to compete with financial services companies that are not regulated or are less regulated.
Federal and state bank regulatory agencies regulate many aspects of our operations. These areas include:
Our stock price may be volatile, which could result in substantial losses for our stockholders.The market price of our common stock could be subject to wide fluctuations in response to a number of factors, including:
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Future offerings of debt securities, which would be senior to our common stock upon liquidation, or equity securities, which would dilute our existing stockholders and may be senior to our common stock for the purposes of dividend distributions, may adversely affect the market price of our common stock. In the future, we may attempt to increase our capital resources by making additional offerings of debt or equity securities, including commercial paper, medium-term notes, senior or subordinated notes and classes of preferred stock or common stock. Upon liquidation, holders of our debt securities and shares of preferred stock and lenders with respect to other borrowings will receive a distribution of our available assets prior to the holders of our common stock. Additional equity offerings by us may dilute the holdings of our existing stockholders or reduce the market price of our common stock, or both. If we issue preferred stock, we would have a preference on dividend payments that could limit our ability to make a dividend distribution to the holders of our common stock. Because a decision to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings. Thus, our stockholders bear the risk of our future offerings reducing the market price of our common stock or diluting their stock holdings in us.
Accounting Matters — Recent Accounting Pronouncements
EITF Issue 03-1 entitled, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”, contains accounting guidance regarding other-than-temporary impairment on securities that was to take effect for the quarter ended September 30, 2004. However, the effective date of portions of this guidance has been delayed, and more interpretive guidance is to be issued in the near future. The effect of this new and pending guidance on our financial statements is not known, but it is possible this guidance could change management’s assessment of other-than-temporary impairment in future periods. (See discussion in Note 3 to the Notes to Consolidated Financial Statements related to fair value of securities available for sale.)
FAS 123, Revised, requires all public companies to record compensation cost for stock options provided to employees in return for employee service. The cost is measured at the fair value of the options when granted, and this cost is expensed over the employee service period, which is normally the vesting period of the options. This will apply to awards granted or modified on or after January 1, 2006. Compensation cost will also be recorded for prior option grants that vest after the date of adoption. The effect on results of operations will depend on the level of future option grants and the calculation of the fair value of the options granted at such future dates, as well as the vesting periods provided, and so the effect cannot currently be predicted.
SOP 03-3 requires that a valuation allowance for loans acquired in a transfer, including in a business combination, reflect only losses incurred after acquisition and should not be recorded at acquisition. This standard applies to any loan acquired in a transfer that showed evidence of credit quality deterioration since it was made. The effect of this new standard on our financial position and results of operations is not expected to be material upon adoption.
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Item 2. PROPERTIES
Our principal executive offices are located at 3701 Wilshire Blvd., Suite 220, Los Angeles, California 90010. We conduct our operations through ten full branch offices, six mini branch offices and eight loan production offices located throughout California, in the greater New York City metropolitan area and in Chicago, Seattle, New Jersey, Atlanta, Virginia, Denver, and Dallas. We lease all of our offices. We believe our present facilities are adequate for our present needs. We also believe that, if necessary, we could secure suitable alternative facilities on similar terms, without adversely impacting operations. The locations of our full branch offices, including our corporate headquarters, are as follows:
Our six mini branches are located inside supermarkets and the Aroma office is located inside the Sports Center Building in Los Angeles. The locations are as follows:
We currently have eight loan production offices to promote SBA loans. We have SBA Preferred Lender status in those areas. The locations are as follows:
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Item 3. LEGAL PROCEEDINGS
We are a party to routine litigation incidental to our business, none of which is considered likely to have a material adverse effect on us. As of December 31, 2004 and 2003, we have recorded an accrued liability of $120,000 and $-0- for litigation settlements. For a discussion of litigation risks relating to our recent accounting restatement, please see “Business-Factors That May Impact Our Business or the Value of Our Stock — We face risks related to our recent accounting restatements including potential litigation and regulatory actions”.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of our security holders, through the solicitation of proxies or otherwise, during the fourth quarter of the fiscal year ended December 31, 2004.
Part II
Our common stock, par value $0.001 per share, began trading on the Nasdaq National Market on February 5, 2001 under the symbol “NARA.” The common stock of Nara Bank, par value $3.00 per share, was also traded on the Nasdaq National Market under the symbol “NARA” through February 2, 2001, which was Nara Bank’s last trading day.
There were 23,366,660 shares of common stock held by approximately 1,885 beneficial owners and 554 registered owners as of March 31, 2005. The following table sets forth, for the calendar quarters indicated, the range of high and low sales prices for the common stock of Nara Bancorp for each quarter within the last two fiscal years as reported on the Nasdaq National Market. Sales prices represent actual sales of which our management has knowledge. The prices have been adjusted to reflect the effect of two-for-one stock splits announced on February 14, 2003 and May 17, 2004.
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Dividends
The following table shows cash dividends declared during 2004.
Future dividends are subject to the discretion of our Board of Directors and will depend upon a number of factors, including future earnings, financial condition, cash needs and general business conditions. All dividends must comply with applicable bank regulations.
Nara Bancorp’s ability to pay dividends is subject to restrictions set forth in the Delaware General Corporation Law. The Delaware General Corporation Law provides that a Delaware corporation may pay dividends either (i) out of the corporation’s surplus (as defined by Delaware law), or (ii) if there is no surplus, out of the corporation’s net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year.
Nara Bancorp’s ability to pay cash dividends in the future will depend in large part on the ability of Nara Bank to pay dividends on its capital stock to Nara Bancorp. The ability of Nara Bank to declare a cash dividend to Nara Bancorp is subject to minimum capital requirements and California law, which restricts the amount available for cash dividends to the lesser of the retained earnings or the Bank’s net income for its last two fiscal years plus current year income. Where the above test is not met, cash dividends may still be paid, with the prior approval of the DFI in an amount not exceeding the greatest of (1) retained earnings of the Bank; (2) the net income of the Bank for its last fiscal year; or (3) the net income of the Bank for its current fiscal year. During 2005, the maximum dividend that the Bank could declare, without prior regulatory approval, is $36.7 million plus the Bank’s 2005 net income. However, as a result of a recent regulatory examination, the Company’s regulatory agencies are expected to place additional restrictions and requirements on the Company which may limit the Company’s and the Bank’s ability to pay cash dividends without prior regulatory approval.
Item 6. SELECTED FINANCIAL DATA
The following table presents selected financial and other data of Nara Bancorp and prior to the February 2001 reorganization, financial and other data of Nara Bank, as of and for each of the years in the five-year period ended December 31, 2004. The information below should be read in conjunction with, and is qualified in its entirety by, the more detailed information included elsewhere herein including our Audited Consolidated Financial Statements and Notes thereto.
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You should read the following discussion and analysis of our financial condition and results of operations together with our Consolidated Financial Statements and accompanying notes presented elsewhere in this Report. This discussion and analysis may contain forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those set forth under “Business—Factors That May Impact Our Business or the Value of Our Stock” and elsewhere in this Report.
Overview
Nara Bancorp, Inc. is a bank holding company headquartered in Los Angeles, California. We offer a full range of commercial banking and consumer financial services through our wholly owned subsidiary, Nara Bank, a California state-chartered bank. Nara Bank primarily focuses its business in Korean communities in California and in the greater New York City metropolitan area. Through our network of 16 branches and 8 loan production offices, we offer commercial banking and consumer financial services to our customers, who typically are individuals and small- to medium-sized businesses in our market areas. We accept deposits and originate a variety of loans including commercial loans, commercial real estate loans, trade finance, Small Business Administration (SBA) loans, automobile and various consumer loans.
Our principal business involves earning interest on loans and investment securities that are funded by customer deposits and other borrowings. Our operating income and net income derives primarily from the difference between interest income received from interest-earning assets and interest expense paid on interest-bearing liabilities and, to a lesser extent, from fees received in connection with servicing loan and deposit accounts and fees from the sale of SBA loans. Our major expenses are the interest we pay on deposits and borrowings and general operating expenses which primarily consist of salaries and employee benefits, occupancy, and provision for loan losses. Interest rates are highly sensitive to many factors that are beyond our control, such as inflation, recession and unemployment. We cannot predict the impact that future changes in domestic and foreign economic conditions might have on our performance.
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Our business is also influenced by the monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the Federal Reserve Board (FRB). The FRB implements national monetary policies (with objectives such as curbing inflation and combating recession) through its open-market operations in U.S. government securities, by adjusting the required level of reserves for depository institutions subject to its reserve requirements, and by varying the target federal funds and discount rates applicable to borrowings by depository institutions. The actions of the FRB in these areas influence the growth of bank loans, investments, and deposits and also affect interest rates earned on interest-earning assets and paid on interest-bearing liabilities. The nature and impact on Nara Bancorp and Nara Bank of future changes in monetary and fiscal policies cannot be predicted.
From time to time, legislation and regulations are enacted which have the effect of increasing the cost of doing business, limiting or expanding permissible activities, or affecting the competitive balance between banks and other financial services providers. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies, and other financial institutions and financial services providers are frequently made in the U.S. Congress, in the state legislatures, and before various regulatory agencies. This legislation may change banking statutes and our operating environment in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. We cannot predict whether any of this potential legislation will be enacted, and if enacted, the effect that it, or any implementing regulations, would have on our financial condition or results of operations.
We have a significant geographic concentration in the Korean communities in California and in the greater New York City metropolitan area, and our results are affected by economic conditions in these areas. A decline in economic and business conditions in our market areas could have a material impact on the quality of our loan portfolio or the demand for our products and services, which in turn may have a material adverse effect on our results of operations.
During fiscal 2004, we experienced a significant growth in our assets due to growth in our existing branches and opening of one new branch.
Our total assets grew by 20% for 2004 to $1,507.7 million at December 31, 2004. The increase in total assets in 2004 was primarily due to growth in our loans funded by comparable increases in deposits and borrowings. The loan growth during 2004 was predominantly in real estate and commercial loans and deposit growth was in money market and time deposits that are $100,000 or more.
Our net income was $19.8 million for the year ended December 31, 2004 and represents a 45% increase from $13.7 million for the year ended December 31, 2003. The major contributor to the increase in net income for the year ended December 31, 2004 was a 28% increase in net interest income for 2004 compared to 2003 as a result of loan growth and an increase in our net interest margin. More detailed discussions are in the various sections below.
A special sub-committee of the Audit Committee of the Board of Directors of the Company (the “Subcommittee”) engaged independent counsel to conduct an investigation of matters relating to the Letter. The Subcommittee discovered that the amount the former President and Chief Executive Officer relinquished was approximately $600,000 in 2003 and $0 in 2004. The Subcommittee determined that the failure to disclose and account for the arrangement to reimburse certain expense amounts up to approximately $600,000 contemplated by the Letter had an effect on the Company’s previously issued consolidated financial statements for the years ended December 31, 2003 and 2002. The Subcommittee evaluated the error in accordance with the quantitative and qualitative guidance set forth in SEC Staff Accounting Bulletin No. 99. As a result thereof, on March 24, 2005, the Subcommittee concluded (and on March 25, 2005 the Board of Directors concurred) that the Company should restate its consolidated financial statements for the years ended December 31, 2003 and 2002 and, accordingly, the previously issued financial statements and the related independent auditors reports thereon for the years ended December 31, 2003 and 2002 should no longer be relied upon. The Subcommittee discussed this conclusion with the Company’s independent registered public accounting firm for 2004 as well as its former independent registered public accounting firm for 2003 and 2002. Additionally, the Subcommittee engaged its current independent registered public accounting firm to re-audit the Company’s 2003 and 2002 consolidated financial statements.
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On March 30, 2005, the Company announced in a current report on Form 8-K that it was restating its consolidated financial statements for the fiscal years ended December 31, 2003 and 2002. In the course of the re-audits of the Company’s consolidated financial statements for the fiscal years ended December 31, 2003 and 2002, certain additional errors were also identified (i.e., other than the one relating to the Letter) in the Company’s consolidated financial statements for 2003 and 2002. Specifically, errors were identified in accounting for bank owned life insurance, lease arrangements under which the Company occupies its premises, incentive compensation, profit sharing and bonus payments to certain employees and various other accounting matters. Accordingly, the Company’s 2003 and 2002 consolidated financial statements and previously released information for 2004 are also restated for these accounting errors.
All financial information contained in this Annual Report on Form 10-K gives effect to the restatement discussed above (the “Restatement”). Information regarding the effect of the restatement on our financial position and results of operations is provided in Note 2 of the Notes to Consolidated Financial Statements. Financial information included in reports on Form 10-Q, Form 10-K and Form 8-K previously filed or furnished by the Company for these periods should not be relied upon and are superseded by the information in this Annual Report on Form 10-K.
Critical Accounting Policies
The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. GAAP requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities at the date of our financial statements. Actual results may differ from these estimates under different assumptions or conditions.
Declines in the fair value of held to maturity and available for sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses in current earnings rather than in other comprehensive income (loss). During 2004, we recognized an impairment charge of $2.6 million on government sponsored enterprise preferred stocks issued by the Federal Home Loan Mortgage Corporation (“FHLMC”) and the Federal National Mortgage Association (“FNMA”). Management determined that the unrealized losses on these securities should be considered other than temporary and therefore recorded the decline in market value as impairment charges as these investments have had significant unrealized loss positions for more than one year and it is difficult to forecast significant market value recovery in a reasonable time frame. Except for unrealized losses on these securities, we believe the balance of unrealized losses as of December 31, 2004 is a temporary condition, mainly due to fluctuations in interest rates, and do not reflect a deterioration of credit quality of the issuers.
We assess the carrying value of intangible assets including goodwill at least annually in order to determine if such intangible assets are impaired. In reviewing the carrying value of intangible assets, we assess the recoverability of such assets by evaluating the fair value of the related business unit. Any impairment would be required to be recorded during the period identified. If our intangible assets were determined to be impaired, our financial results could be materially impacted.
Accounting for the allowance for loan losses involves significant judgments and assumptions by management, which has a material impact on the carrying value of net loans. The judgments and assumptions used by management are based on historical data and management’s analysis of the current economic environment as described in “Allowance for Loan Losses.”
Certain Small Business Administration (“SBA”) loans that we have the intent to sell prior to maturity are designated as held for sale at origination and are recorded at the lower of cost or market value, on an aggregate basis. A valuation allowance is established if the market value of such loans is lower than their cost, and operations are charged or credited for valuation adjustments. A portion of the premium on sale of SBA loans is recognized as other operating income at the time of the sale. The remaining portion of the premium (relating to the portion of the loan retained) is deferred and amortized over the remaining life of the loan as an adjustment to yield. Servicing assets are recognized when loans are sold with servicing retained. Servicing assets are recorded based on the present value of the contractually specified servicing fee, net of servicing costs, over the estimated life of the loan, using a discount rate based on the related note rate plus 1% to 2%. The market rate is used to determine servicing costs. Servicing assets are amortized in proportion to and over the period of estimated future servicing income. Management periodically evaluates the servicing asset for impairment, which is the carrying amount of the servicing asset in excess of the related fair value. Impairment, if it occurs, is recognized as a write down or charge-off in the period of impairment.
As part of our asset and liability management strategy, we have entered into interest rate swaps, which are derivative financial instruments, with the overall goal of minimizing the impact of interest rate fluctuations on our net interest margin. The objective of the interest rate swaps is to manage asset and liability positions in connection with our strategy of minimizing the impact of the interest rate fluctuations on our interest rate margin. The interest rate swaps qualify as cash flow hedges under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended and interpreted, and are designated as hedges of the variability of cash flows we receive from certain of our variable rate loans indexed to Prime. In accordance with SFAS No. 133, these interest rate swap agreements are measured at fair value and reported as assets or liabilities on the consolidated statement of financial condition. The portion of the change in the fair value of the interest rate swaps that is deemed effective in hedging the cash flows of the designated assets is recorded in stockholders’ equity as a component of accumulated other comprehensive income (loss) (“OCI”), net of tax, and reclassified into interest income as such cash flows occur in the future. Any ineffectiveness resulting from the hedges is recorded as a gain or loss in the consolidated statements of income as a part of noninterest income. Currently, fair value of the interest rate swaps is estimated by discounting the future cash flows using the discount rate that was adjusted by the yield curve.
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Results of Operations
Our most significant source of income is net interest income, which is the difference between our interest income and our interest expense. Generally, interest income is generated from our loans we extended to our customers and investments and interest expense is generated from interest-bearing deposits our customers have with us and other borrowings that we may have, such as Federal Home Loan Bank borrowings, and subordinated debentures. Our ability to generate profitable levels of net interest income is largely dependent on our ability to maintain sound asset quality and appropriate levels of capital and liquidity. Interest income and interest expense can fluctuate based on changes in the level of interest rates in the economy.
We attempt to minimize the effect of interest rate fluctuations on net interest margin by matching a portion of our interest-sensitive assets against our interest-sensitive liabilities. Net interest income can also be affected by a change in the composition of assets and liabilities, for example, if higher yielding loans were to replace a like amount of lower yielding investment securities. Changes in volume and changes in rates can also affect net interest income. Volume changes are caused by differences in the level of interest-earning assets and interest-bearing liabilities. Rate changes result from differences in yields earned on assets and rates paid on liabilities.
We also have non-interest income from sources other than interest income. Those sources include service charges and fees on deposit accounts, fees from trade finance activities and the issuance of letters of credit, and net gains on sale of loans and investment securities available for sale. In addition to interest expense, our income is impacted by non-interest expenses, such as salaries and benefits, occupancy, furniture and equipment expenses, and provision for loan losses.
Net Income
Our income before the cumulative effect of a change in accounting principle was $19.8 million for 2004 as compared to $13.7 million for 2003 and $9.7 million for 2002, representing an increase of 45% for 2004 and 41% for 2003. Our earnings per share on income before cumulative effect of a change in accounting principle, based on diluted shares, were $0.80, $0.59, and $0.42, for 2004, 2003 and 2002, respectively. The return on average assets before cumulative effect of a change in accounting principle was 1.45% for 2004, as compared to 1.26% for 2003 and 1.23% for 2002. The return on average stockholders’ equity before the cumulative effect of a change in accounting principle was 21.44% for 2004, compared with 18.77% for 2003 and 15.79% for 2002.
Our results for 2002 include the cumulative effect of a change in accounting principle, related to the one-time recognition of negative goodwill in the consolidated statement of income at January 1, 2002 in accordance with SFAS No. 142, resulted in an increase of $4.2 million of income, for a total net income of $13.9 million or $0.60 per diluted share.
During 2004, the increase in net income was primarily attributable to higher net interest income resulting from growth in the loan portfolio and a lower provision for loan losses. Net income in 2003 over 2002 also increased primarily due to higher interest income resulting from growth in the loan portfolio and lower interest rates paid on interest-bearing liabilities, and an increase in non-interest income offset by higher non-interest expenses and provision for loan losses.
As a result of the Restatements, our net income decreased $585 thousand and $1.6 million for the years ended 2003 and 2002, respectively, compared to amounts previously reported for such periods. The adjustments relate primarily to non-interest expense and are addressed further below and in Note 2 to the Notes to Consolidated Financial Statements. The following table summarizes increases and decreases, as applicable, in income and expense, as restated, for the years indicated.
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Net Interest Income and Net Interest Margin
Net interest income was $58.4 million for the year ended December 31, 2004 compared to $45.5 million for 2003 and $35.1 million for 2002. Net interest margin was 4.58% for the year ended December 31, 2004 compared to 4.46% for 2003 and 4.82 % for 2002. Average interest-earning assets were $1,275.2 million for 2004 compared to $1,019.6 million for 2003 and $728.9 million for 2002.
As part of our asset liability management, and in anticipation of higher short-term interest rates, we have positioned ourselves to be asset sensitive. The positive trend on our net interest margin could be affected, positively or negatively, due to highly competitive pricing of interest-bearing deposits in an increasing interest rate environment.
The increase of $12.9 million or 28% in net interest income for 2004 over 2003 was primarily due to an increase of $255.6 million or 25% in average interest-earning assets, which consisted mostly of loans. The increase in net interest margin for 2004 over 2003 was primarily related to a reduction in the average rate on interest bearing liabilities that have fully repriced during 2004. The combined effect of an increase in our loan portfolio with a reduction in the average rate on interest bearing liabilities accounts for the majority of our increase in net interest income.
The increase of $10.4 million or 30% in net interest income for 2003 over 2002 was primarily due to a $290.7 million or 40% increase in average interest-earning assets, which consisted mostly of loans. The increase of 40% in average interest-earning assets for 2003 over 2002 would have been 31% without the $61.9 million in loans purchased through two acquisitions. The decrease in net interest margin for 2003 from 2002 was primarily due to a decline in market interest rates, particularly a 25 basis point cut in interest rates in June 2003 as well as carryover effects of a 50 basis point rate cut in November 2002. Despite a 75 basis points decline in our prime rate for 2003 over 2002, our net interest margin only decreased by 36 basis points due to the income from interest rate swaps and repricing of our interest-bearing liabilities.
Interest income
Interest income was $77.1 million for the year ended December 31, 2004 compared to $61.4 million for 2003 and $48.6 million for 2002. The average yield on average interest-earning assets was 6.04% for the year ended December 31, 2004 compared to 6.02% for 2003 and 6.66% for 2002.
The increase of $15.6 million or 25% in interest income in 2004 compared to 2003 was primarily due to an increase in average interest-earnings assets, which consisted mostly of loans. Interest and fee income on loans increased $16.5 million or 30% to $71.3 million for 2004 from $54.9 million for 2003. This increase is due to a 33% increase in average loans to $1,113.8 million for 2004 from $839.1 million for 2003. Also included in interest income on loans for 2004 was $3.1 million in net interest income settlement received on interest rate swap transactions. During 2004, we had an increase of $17.6 million in interest income attributable to growth in loan volume, partially offset by a reduction of $1.1 million attributable to changes in interest rates. The average yield on loans decreased to 6.40% for 2004 from 6.54% for 2003. Interest income on securities decreased $729 thousand or 13% to $5.0 million for 2004 from $5.8 million for 2003, due to a decline in the securities’ average volume and yields.
The increase of $12.9 million or 26% in interest income in 2003 compared to 2002 was primarily due to an increase in average earning assets, which consisted mostly of loans. Average interest-earning assets increased $290.7 million or 40% to $1,019.6 million for 2003 from $728.9 million for 2002. Interest and fee income on loans increased $12.0 million or 28% to $54.9 million for 2003 from $42.9 million for 2002. This increase is primarily due to a 39% increase in average loans to $839.1 million for 2003 from $605.5 million for 2002. Included in interest income on loans for 2003 was $3.4 million in net interest income settlement received on interest rate swap transactions. During 2003, we had an increase of $15.5 million in interest income attributable to growth in loan volume, partially offset by a reduction of $3.5 million attributable to changes in interest rate. The average yield on net loans decreased to 6.54% in 2003 from 7.08% in 2002. Interest income on securities increased $750 thousand or 15% to $5.8 million for 2003 from $5.0 million for 2002, primarily due to an increase in our investment portfolio.
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Interest Expense
Deposits
Interest expense on our deposits was $15.5 million for the year ended December 31, 2004 compared to $12.8 million for 2003 and $10.6 million for 2002. The average cost of interest-bearing deposits was 1.84% for the year ended December 31, 2004 compared to 2.02% for 2003 and 2.41% for 2002. The average cost of deposits was 1.32% for 2004 compared to 1.43% for 2003 and 1.63% for 2002.
The increase of $2.7 million or 21% in interest expense on deposits for 2004, compared to 2003 was primarily due to an increase in the volume of average interest-bearing deposits. Average interest-bearing deposits increased $210.7 million or 33% to $843.7 million for 2004 from $633.0 million for 2003. The decrease in average cost of the deposits was primarily due to the repricing of higher cost deposits as a result of lower interest rates during the first half of 2004. However, the cost of interest bearing deposits increased during the second half of 2004 as market rates started to rise and as the competition for deposits increased. Overall, the average cost of interest-bearing deposits was 1.84% during 2004.
The increase of $2.2 million or 20% in interest expense on deposits for 2003 compared to 2002 was primarily due to an increase in the volume of average interest-bearing deposits. Average interest-bearing deposits increased $192.8 million or 44% to $633.0 million for 2003 from $440.2 million for 2002. The increase of 44% in interest-bearing deposits was due to deposits purchased of $75.5 million through two acquisitions during 2003 and internal growth through existing branches. The decrease in average cost of the deposits was primarily due to the repricing of higher cost deposits to lower interest rates as a result of a decline in market interest rates during the year. The cost of average interest-bearing deposits decreased 39 basis points during 2003 primarily due to decreases in market rates.
Borrowings
Borrowings include the borrowings from the FHLB, subordinated notes and subordinated debentures. As part of our asset liability management, we utilize FHLB borrowings to supplement our deposit source of funds. Therefore, there could be fluctuations in these balances depending on the short-term liquidity needs of the Bank. Interest expense on FHLB borrowings and subordinated notes was $833 thousand for the year ended December 31, 2004 compared to $1.6 million for 2003 and $1.5 million for 2002. The average cost of FHLB borrowings was 2.17% for the year ended December 31, 2004 compared to 2.03% for 2003 and 2.96% for 2002. Interest expense on subordinated debentures was $2.3 million for the year ended December 31, 2004 compared to $1.6 million for 2003 and $1.4 million for 2002. The average cost of the subordinated debentures was 6.31% for the year ended December 31, 2004 compared to 7.51% for 2003 and 8.71% for 2002.
The decrease of $776 thousand or 48% in interest expense on FHLB and other borrowings for 2004 compared to 2003 was due to a decrease in FHLB borrowings. Average FHLB borrowings decreased $40.7 million or 51% to $38.4 million for 2004 compared to $79.1 million for 2003. The increase of $791 thousand or 51% in interest expense on subordinated debentures was primarily due to additional subordinated debentures issued at the end of 2003. Average subordinated debentures increased $16.4 million or 79% to $37.1 million for 2004 compared to $20.7 million for 2003. With the exception of one subordinated debenture, which has a fixed interest rate, all other subordinated debentures have variable interest rates that are tied to LIBOR with quarterly adjustments. We expect our interest rate payments on these subordinated debentures to continue to rise, as overall interest rates appear to be on the rise.
The increase of $112 thousand or 7% in interest expense on FHLB and other borrowings for 2003 compared to 2002 was primarily due to an increase in FHLB borrowings during the year. Average FHLB borrowings increased $38.2 million or 93% to $79.1 million for 2003 compared to $40.9 million for 2002. The increase of $190 thousand or 14% in interest expense on subordinated debentures for 2003 compared to 2002 was due to the issuance of an additional $20 million in subordinated debentures in 2003; $5 million in June and $15 million in December of 2003. Average subordinated debentures increased $5.1 million or 33% to $20.7 million for 2003 from $15.6 million for 2002.
Net Interest Margin and Net Interest Rate Spread
We analyze our earnings performance using, among other measures, the net interest spread and net interest margin. The net interest spread represents the difference between the average yield on interest-earning assets and average rate paid on interest-bearing liabilities. Net interest income, when expressed as a percentage of average total interest-earning assets, is referred to as the net interest margin. Our net interest margin is affected by changes in the yields earned on assets and rates paid on liabilities, referred to as rate changes.
Interest rates charged on our loans are affected principally by the demand for such loans, the supply of money available for lending purposes, and other competitive factors. These factors are in turn affected by general economic conditions and other factors beyond our control, such as federal economic policies, the general supply of money in the economy, legislative tax policies, governmental budgetary matters, and the actions of the Federal Reserve Board. The table below presents the average yield on each category of interest-earning asset, average rate paid on each category of interest-bearing liability, and the resulting net interest spread and net interest margin for each year in the three-year period ended December 31, 2004.
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Average Balance Sheet and Analysis of Net Interest Income
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The following table illustrates changes in interest income (including loan fees) and interest expense and the amount attributable to variations in interest rates and volumes for the period indicated. The variances attributable to simultaneous volume and rate changes have been allocated to the change due to volume and the change due to rate categories in proportion to the relationship of the absolute dollar amounts attributable solely to the change in volume and to the change in rate.
Provision for loan losses
The provision for loan losses was $3.9 million for the year ended December 31, 2004 compared to $5.3 million for 2003 and $2.8 million for 2002. The decrease of $1.4 million or 26% in the provision for loan losses for 2004 compared to 2003 was primarily due to decreases in non-accrual and classified loans despite the continuing growth of our loan portfolio. The increase of $2.5 million or 88% in the provision for loan losses for 2003 compared to 2002 was primarily due to the continuing growth in our loan portfolio and increases in classified loans. Our gross loans (net of deferred fees) increased $273.9 million or 38% during 2003. We use a systematic methodology to calculate an adequate balance of allowance for loan losses. Through applying this methodology, which takes into account our loan portfolio mix, credit quality, loan growth, the amount and trends relating to our delinquent and non-performing loans, regulatory policies, general economic conditions and other factors relating to the collectibility of loans in our portfolio, we determine the appropriateness of our allowance for loan losses, which is further adjusted by quarterly provisions charged against earnings.
Please refer to the section “Financial Condition- Allowance for Loan Losses” for a description of our systematic methodology employed in determining an adequate balance of allowance for loan losses.
Noninterest Income
Noninterest income was $20.7 million for the year ended December 31, 2004 compared to $20.1 million for 2003 and $17.2 million for 2002. The increase was $0.6 million or 3% in 2004 and $2.9 million or 17% in 2003. Included in our noninterest income for 2004 were impairment charges due to other than temporary declines in market values of securities totaling $2.6 million related to government sponsored enterprise preferred stocks. Excluding such impairment charges, the increase would have been $3.2 million or 16% for the year ended December 31, 2004.
The increase in noninterest income in 2004 compared to 2003 was primarily due to increases in net gains on sales of SBA loans, SBA loan servicing fees, and loan referral income offset by the recognition of $2.6 million of impairment
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charge on government sponsored enterprise preferred stocks. Net gains on sales of SBA loans increased $1.8 million or 48% to $5.5 million for 2004 from $3.7 million for 2003. During 2004 we sold a total of $81.8 million in SBA loans, which represents an increase of $25.6 million or 46% from $56.2 million in 2003. Net service fee income on SBA loans also increased $349 thousand or 41% to $1.2 million for 2004 from $854 thousand for 2003 due to the ongoing increases in the balance of SBA loans that we service. During 2004, we entered into a loan referral program with GE Capital and Zion Bancorp and recognized $1.0 million in loan referral income.
The increase in noninterest income in 2003 compared to 2002 was primarily due to an increase in service charges on deposit accounts and net gains on sales of SBA loans. Service charges on deposit accounts increased $1.3 million or 21% to $7.7 million from $6.3 million for 2002. This increase was due to an increase in non-sufficient fund (“NSF”) fee income. The NSF fee income increased $1.4 million or 42% to $4.7 million for 2003 from $3.3 million for 2002. Net gains on sales of SBA loans increased $1.3 million or 54% to $3.7 million in 2003 from $2.4 million in 2002. We sold a total of $56.2 million in SBA loans in 2003, which was an increase of $8.6 million or 18% from $47.6 million in 2002.
The breakdown of noninterest income by category is reflected below:
Noninterest Expense
Noninterest expense was $42.0 million for the year ended December 31, 2004 compared to $38.2 million for 2003 and $34.3 million for 2002. The increase was $3.8 million or 10% in 2004 and $3.9 million or 11% in 2003.
The increase in noninterest expense in 2004 compared to 2003 was primarily due to increases in salaries and employee benefits, occupancy, professional fees, and amortization of intangible assets. Salaries and employee benefits increased $1.6 million or 8% to $22.2 million in 2004 from $20.5 million in 2003. This was primarily due to additional employees hired for our California Rowland Heights branch, established in 2004 and annual salary adjustments to reflect increases in inflation. Salaries and employee benefits for 2003 was restated to include additional bonuses of $203 thousand. Occupancy expenses increased $826 thousand or 15% to $6.2 million in 2004 from $5.4 million in 2003, primarily due to the opening of new branches. Occupancy expenses were restated to include expenses for leases with escalating rents on a straight-line basis over the lease term, rather than as paid, and to correctly account for leasehold improvement amortization. The restatement of occupancy expenses related to rent escalation clauses were increases of $636 thousand and $500 thousand in 2004 and 2003, respectively. The restatement of leasehold improvement amortization resulted in increased expense of $164 thousand and $94 thousand in 2004 and 2003, respectively. We have also received regulatory approval to open two new branches in 2005. One will be located in Gardena, California and the second in Bayside, New York.
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Professional fees increased $1.1 million or 74% to $2.5 million in 2004 from $1.4 million in 2003. This increase was primarily due to expenses related to compliance with the Sarbanes-Oxley Act (“SOX”) and the Bank Secrecy Act (“BSA”). We incurred approximately $700 thousand in expenses to comply with SOX. Amortization of intangible assets increased $369 thousand or 111% to $701 thousand in 2004 from $332 thousand in 2003. This increase was due to higher levels of core deposit intangibles resulting from acquisitions in 2003 and 2002. Amortization of intangible assets was also restated to include adjustments related to the change in useful life and method of amortization. The useful life of the intangible was changed from seven to ten years and the method was changed from the straight line basis to an accelerated basis. The restatement of amortization of intangible assets resulted in a decrease of amortization of $129 thousand, $77 thousand and $18 thousand in 2004, 2003 and 2002.
During the years ending December 31, 2003 and 2002, several of the split dollar life insurance agreements we had entered into precluded us from being able to fully realize the cash surrender value of the life insurance policies as of the balance sheet date, as the agreements required us to continue to maintain the policies or replace them with comparable life insurance policies until the death of the split dollar participants. Accordingly, we restated our financial statements to record discounts of $345 thousand and $1.4 million for 2003 and 2002 on the cash surrender value of the split dollar life insurance policies to record the cash surrender value at the amount that can be effectively realized at the balance sheet date for the estimated present value of the cash surrender value based upon the estimated mortality dates of the split dollar participants. During the fourth quarter of 2004, we amended certain of the split dollar life insurance agreements in order to eliminate the requirement for us to continue to maintain the policies or replace them with comparable life insurance policies until the death of the split dollar participants. Accordingly, in the fourth quarter of 2004, we reversed $1.4 million of the discounts on the cash surrender value of the split dollar life insurance policies established in 2003 and 2002.
The increase in noninterest expense in 2003 compared to 2002 was primarily due to increases in salaries and employee benefits, occupancy, data processing, professional fees, and amortization of intangible assets. Salaries and benefit expenses increased $2.6 million or 15% to $20.5 million in 2003, from $17.9 million in 2002. This was primarily due to additional employees hired for the opening of two new branches during 2003 and increases in our group insurance rate, which became effective at the end of 2002. Salaries and employee benefits for 2002 was restated to include $600 thousand of employee reimbursement charges, related to the inaccurate accounting of incentive payments that were relinquished by the former President and Chief Executive Officer and to include $81 thousand of nonaccrued bonuses payable as of December 31, 2002. Occupancy expenses increased $732 thousand or 16% to $5.4 million in 2003 from $4.7 million in 2002. This was also due to opening of new branches during the year, relocation of our Manhattan office and additional expenses associated with increases in the number of branches as a result of the acquisition of Asiana Bank in August of 2003. Also included in the occupancy expenses were the restated expenses related to the proper accounting for rent escalation clauses and leasehold improvement amortization as previously mentioned. Such expenses recorded for 2002 were $403 thousand and $68 thousand. Data processing related expenses increased $388 thousand or 23% to $2.1 million in 2003 from $1.7 million in 2002. This increase was primarily due to increases in number of accounts and transactions from the existing branches as well as the accounts from the acquisitions. Professional fees increased $305 thousand or 27% to $1.4 million in 2003 from $1.1 million in 2002. This increase was primarily due to fees paid to establish Nara Real Estate Trust and fees related to the assumption of loans and deposits of Korea Exchange Bank’s Broadway branch. Amortization of intangible assets increased $210 thousand or 172% to $332 thousand in 2003 from $122 thousand in 2002. This increase was due to core deposit intangibles created from the assumption of deposits from Industrial Bank of Korea New York in November of 2002, the acquisition of Asiana Bank in August of 2003, and the assumption of deposits from Korea Exchange Bank’s Broadway branch in October of 2003.
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A breakdown of noninterest expenses by category is illustrated below:
Income Tax provision
The income tax provision for the year ended December 31, 2004 was $13.5 million compared to $8.4 million in 2003 and $5.5 million in 2002. The effective tax rate was 40% for 2004 compared to 38% for 2003 and 37% for 2002 (excluding the impact of the cumulative effect of a change in accounting principle which was not tax effected). The increase in the effective tax rate in 2004 was primarily due to less nontaxable income in 2004. The increase in the effective tax rate in 2003 was primarily due to an increase in state income taxes.
Financial Condition
Our total assets were $1,507.7 million at December 31, 2004 compared to $1,259.8 million at December 31, 2003 and $981.4 million at December 31, 2002. The increase was $247.9 million or 20% for 2004 and $278.4 million or 28% for 2003. We have experienced significant growth (on a percentage basis) of our assets in the last two fiscal years. We believe that our future growth in assets will not increase at the same rate experienced in the prior two years. The increase in total assets in 2004 from 2003 was primarily due to growth in our loan portfolio. Gross loans increased $224.4 million or 22% during 2004. The increase in total assets in 2003 from 2002 was primarily due to growth in our loan portfolio and partly due to acquisitions. Gross loans increased $273.9 million or 38% during 2003. These increases were funded by growth in deposits and increases in FHLB borrowings. In August of 2003, we acquired Asiana Bank with total assets of $34.3 million. In October of 2003, we also purchased $46.2 million in deposits and $39.5 million in loans from Korea Exchange Bank of New York’s Broadway branch. In November of 2002, we purchased $49.5 million in deposit and $1.3 million in loans from Industrial Bank of Korea, New York.
Loan Portfolio
Our loans receivable, net of allowance for loan losses, were $1,207.1 million at December 31, 2004 compared to $984.9 million at December 31, 2003 and $715.0 million at December 31, 2002. The increase in net loans was $222.2 million or 23% for 2004 and $269.9 million or 38% for 2003. Average loans, as a percentage of our average total interest-earning assets, were 87%, 82% and 83% for 2004, 2003 and 2002, respectively. Our average loans were $1,113.8 million, $839.1 million and $605.5 million for the years ended December 31, 2004, 2003 and 2002, respectively. As a result of our continued focus on commercial loans and continued demand for commercial real estate loans, loan growth remained concentrated in commercial loans and commercial real estate loans.
The average loans for 2004 increased $274.7 million or 33% from 2003. From the total increases, 27% was contributed by our New York operation. The net loans in the New York region increased $73.9 million or 26% to $353.5 million at December 31, 2004 from $279.6 million at December 31, 2003.
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The average loans for 2003 increased $233.6 million or 39% from 2002. From the total increases, $33.5 million or 14% was contributed by our New York operation. The net loans in the New York region increased $92.4 million or 49% to $279.6 million at December 31, 2003 from $187.2 million at December 31, 2002. This increase included $39.5 million in loans purchased from Korea Exchange Bank’s Broadway branch (“KEB, Broadway”) in October of 2003.
The rates of interest charged on variable rate loans are set at specified increments in relation to our prime lending rate and accordingly vary as our prime lending rate varies. Approximately 93% of our total loans were variable-rate loans at December 31, 2004.
With certain exceptions, we are permitted, under applicable law, to make unsecured loans to individual borrowers in aggregate amounts of up to 15% of the sum of our total capital and the allowance for loan losses (as defined for regulatory purposes). As of December 31, 2004, our lending limit was approximately $22 million for unsecured loans per borrower. For the purpose of lending limits, a secured loan is defined as a loan secured by readily marketable collateral having a current market value of at least 100% of the amount of the loan or extension of credit at all times. In addition to unsecured loans, we are permitted to make collateral-secured loans in an additional amount up to 10% (for a total of 25%) of our total capital and the allowance for loan losses.
Commercial loans are extended for the purposes of providing working capital, financing the purchase of inventory, especially for importers and exporters, or equipment and for other business purposes. Short-term business loans (payable within one year) are generally used to finance current transactions and typically provide for periodic interest payments, with principal being payable at maturity. Term loans (usually 5 to 7 years) normally provide for monthly payments of both principal and interest. SBA guaranteed loans usually have a longer maturity (7 to 25 years). The credit-worthiness of the borrower is reviewed on a periodic basis, and most loans are collateralized by inventory, equipment and/or real estate. During 2004, commercial loans increased $81.7 million or 23% to $441.9 million at year-end 2004 from $360.2 million at year-end 2003. Commercial loans increased $47.6 million or 15% during 2003 from $312.6 million at year-end 2002.
Our real estate loans consist primarily of loans secured by deeds of trust on commercial property. It is our policy to restrict real estate loan amounts to 70% of the appraised value of the property. We offer both fixed and floating rate loans. The maturities on such loans are generally restricted to seven years (on an amortization up to 25 years with a balloon payment due at maturity). Our real estate loans, mostly consisting of commercial real estate loans, increased $141.8 million or 25% to $717.7 million at year-end 2004 from $575.9 million at year-end 2003. Real estate loans increased $220.1 million or 62% during 2003 from $355.8 million at year-end 2002.
Most of our consumer loan portfolio consists of automobile loans, home equity lines and loans, and signature lines and loans. Referrals from automobile dealers comprise the majority of our automobile loans. We also offer fixed-rate loans to buyers of new and previously owned automobiles who do not qualify for the automobile dealers’ most preferential loan rates. We carry all loans at face amount, less payments collected, net of deferred loan fees (costs) and the allowance for loan losses. Interest on all loans is accrued daily on a simple interest basis. Once a loan is placed on non-accrual status, accrual of interest is discontinued and previously accrued interest is reversed. Loans are placed on a non-accrual status when principal and interest on a loan is 90 days or more delinquent, unless it is both well-secured and in the process of collection or if we believe that the collection is highly uncertain.
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The following table shows the composition of our loan portfolio by type of loan on the dates indicated:
We extend lines of credit to business customers usually on an annual review basis. We normally do not make loan commitments in material amounts for periods in excess of one year.
The level of consumer and other loans has increased steadily over the past few years; however, the percentage of those loans to total loans has decreased due to higher demand for commercial and real estate loans.
The following table shows our loan commitments and letters of credit outstanding at the dates indicated:
The increase in standby letters of credit is a direct result of increase in commercial loans.
Non-performing Assets
Non-performing assets consisted of nonaccrual loans, accruing loans 90 days or more past due, restructured loans where the terms of repayment have been renegotiated resulting in a reduction or deferral of interest or principal, and other real estate owned (“OREO”).
Loans are placed on nonaccrual status when they become 90 days or more past due, unless the loan is both well secured and in the process of collection. Loans may be placed on non-accrual status earlier if the full and timely collection of principal or interest becomes uncertain. When a loan is placed on non-accrual status, unpaid accrued interest is charged against interest income. Loans are charged off when our management determines that collection has become unlikely. OREO consists of real estate acquired by us through foreclosure or similar means that we intend to offer for sale.
Non-performing assets were $2.9 million at December 31, 2004 compared to $5.6 million at December 31, 2003 and $2.2 million at December 31, 2002. The decrease in non-performing assets in 2004 compared to 2003 was primarily due to decreases in non-accrual loans, which is discussed in the paragraph below. The increase in non-performing assets in 2003, compared to 2002, was primarily due to an increase in non-accrual loans, which is also discussed in the paragraph below.
Non-performing loans were $2.7 million at December 31, 2004 compared to $5.1 million at December 31, 2003 and $1.1 million at December 31, 2002. The decrease of $2.4 million or 47% in 2004 was primarily due to loans that were paid off in part or in full and non-performing loans that were charged off. The gross interest income that we would have recorded in 2004, 2003 and 2002 if non-accrual loans had been current in accordance with their original terms was $449 thousand, $315 thousand and $415 thousand, respectively. The increase of $3.8 million or 345.4% in 2003 in non-accrual loans compared to 2002 was primarily due to three loans totaling $2.7 million that were fully secured, and $900 thousand in various loans we acquired in 2003 when we acquired Asiana Bank of which 50% were fully secured by real estate and other assets.
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The following table illustrates the composition of our nonperforming assets as of the dates indicated:
We did not own any OREO at December 31, 2004 and 2003. We owned OREO, taken through foreclosure, in an aggregate amount of $36,000 at December 31, 2002. We incurred $604 and $10,897 in expenses in 2003 and 2002, respectively, related to these OREO properties. No provisions for expenses were made in 2004 and 2003 for OREO. At December 31, 2002, we reserved $7,000 as a valuation allowance. The following table summarizes our OREO at the dates indicated:
Maturity of Loans and Sensitivity of Loans to Changes in Interest Rates
The following table illustrates the maturity distribution and repricing intervals of the loans outstanding as of December 31, 2004. In addition, the table shows the distribution of such loans between those with variable or floating interest rates and those with fixed or predetermined interest rates.
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Loan concentrations are considered to exist when there are significant amounts of loans to multiple borrowers engaged in similar activities, which would cause them to be similarly impacted by economic or other conditions. The following table describes the industry concentrations in our loan portfolio as of the dates indicated:
Allowance for Loan Losses
The risk of nonpayment on loans is inherent in all commercial banking operations. We employ a concept of total quality loan management in order to minimize our credit risk. For new loans, we thoroughly analyze each loan application and a majority of those loans are approved by the Management Loan Committee (“MLC”), which is comprised of the Chief Executive Officer, Chief Operating Officer, Chief Credit Officer, Senior Loan Administrator and any other credit administrators as designated by the MLC. For existing loans, we maintain a systematic loan review program, which includes a quarterly loan review by the internal loan review officer and a semi-annual loan review by external loan consultants. Based on the reviews, loans are graded for their overall quality, which is measured based on the sufficiency of credit and collateral documentation; proper lien perfection; proper approval by loan committee(s); adherence to any loan agreement covenants; compliance with internal policies and procedures and laws and regulations; sources of repayment; and liquidation value of the collateral and other sources of repayment. We closely monitor loans that management has determined require further supervision because of the loan size, loan structure, and/or specific circumstances of the borrower. These loans are periodically reviewed by the MLC.
When principal or interest on a loan is 90 days or more past due, a loan is normally placed on non-accrual status unless it is considered to be both well-secured and in the process of collection. Further, a loan is considered to be a loss in whole or in part when (1) its loss exposure beyond any collateral value is apparent, (2) servicing of the unsecured portion has been discontinued or (3) collection is not anticipated due to the borrower’s financial condition and general economic conditions in the borrower’s industry. Any loan, or portion of a loan, judged by management to be uncollectible is charged against the allowance for loan losses, while any recoveries are credited to such allowance.
Our allowance for loan losses is based on management’s estimates of probable incurred losses that are inherent in the loan portfolio. The allowance for loan losses is established through charges to operating expenses in the form of provisions for loan losses. Actual loan losses or recoveries are charged or credited, respectively, directly to the allowance for loan losses. The amount of the allowance is determined by management and reported to the Board of Directors of Nara Bank at least quarterly. The results of both internal and external loan reviews are used to help determine the allowance for loan losses. Our current loan review system takes into consideration such factors as the current financial condition of the borrower, the value of collateral, economic conditions and their impacts on various industries. Our own historical loan loss experience is factored into a detailed loss migration analysis method, which determines loss factors to be used in calculating the allowance for loan losses.
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The allowance for loan losses was $14.6 million at December 31, 2004 compared to $12.5 million at December 31, 2003 and $8.5 million at December 31, 2002. The allowance for loan losses increased $2.1 million or 17% at December 31, 2004 compared to December 31, 2003, primarily due to an increase in the size of our loan portfolio which increased 22%. We recorded a provision for loan losses of $3.9 million in 2004, compared to $5.3 million in 2003 and $2.8 million in 2002. During 2004, we charged off $2.5 million and recovered $801 thousand. The allowance for loan losses was 1.20% of gross loans at December 31, 2004, as compared to 1.25% of gross loans at December 31, 2003 and 1.17% at December 31, 2002. Total classified loans at December 31, 2004 were $6.5 million compared to $10.9 million at December 31, 2003.
Specific loss allocations for impaired loans in accordance with SFAS No. 114 were $797 thousand at December 31, 2004, compared to $1.6 million at December 31, 2003 and $1.3 million at December 31, 2002. Our management and Board of Directors of Nara Bank review the adequacy of the allowance for loan losses at least quarterly. Based upon these evaluations and internal and external reviews of the overall quality of our loan portfolio, management and the Board of Directors believe that the allowance for loan losses was adequate as of December 31, 2004, to absorb estimated probable incurred losses inherent in the loan portfolio. However, no assurances can be given as to whether we will experience further losses in excess of the allowance, which may require additional provisions for loan losses. If there are further losses, they may have a negative impact on our earnings.
The following table shows the provision made for loan losses, the amount of loans charged off, the recoveries on loans previously charged off together with the balance in the allowance for loan losses at the beginning and end of each year, the amount of average and total loans outstanding, and other pertinent ratios as of the dates and for the years indicated:
Allowance For Loan Losses Methodology
We maintain an allowance for loan losses for estimated probable incurred losses that are inherent in our loan portfolio. The allowance is based on our regular quarterly assessments. Our methodologies for measuring the appropriate level of the allowance includes the combination of: (1) Historical Loss of a Migration Analysis for pools of loans and (2) a Specific Allocation Method for individual loans.
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The following table reflects our allocation of the allowance for loan losses by loan category and the ratio of each loan category to total loans as of the dates indicated:
Allocation of Allowance for Loan Losses
The adequacy of the allowance for loan losses is determined by management based upon an evaluation and review of the credit quality of the loan portfolio, consideration of historical loan loss experience, all relevant internal and external factors that affect loan collectability, and other pertinent factors.
The Migration Analysis is a formula method based on our actual historical net charge-off experience for each loan pool and loan risk grade (Pass, Special Mention, Substandard and Doubtful).
Central to the migration analysis is our credit risk rating system. Our internal loan review, external contracted credit review examinations, and regulatory examinations are used to determine and validate loan risk grades. Our credit review system takes into consideration factors such as: borrower’s background and experience; historical and current financial condition; credit history and payment performance; economic conditions and their impact on various industries; type, market value and volatility of the market value of collateral; lien position; and the financial strength of guarantors.
To calculate our various loss allocation factors, we use a twelve-quarter rolling average of historical losses detailing charge-offs and recoveries, by loan type pool balances to determine the estimated credit losses for each type of non-classified and classified loans. Also, in order to reflect the impact of recent events more heavily, the twelve-quarter rolling average has been weighted. The most recent four quarters have been assigned a 40% weighted average while the prior four quarters have been assigned a 33% weighted average and the oldest four quarters have been assigned a 27% weighted average. We began a twelve-quarter rolling average of historical losses as of the quarter ended March 31, 2004. Prior to March 31, 2004, an eight-quarter rolling average of historical losses was used to calculate our various loss allocation factors. Beginning March 31, 2004, management determined that a twelve-quarter rolling average provided a better analysis. The changes in the time period had no material impact on the migration analysis calculation for 2004.
Additionally, in order to systematically quantify the credit risk impact of trends and changes within the loan portfolio, we make adjustments to the Migration Analysis within established parameters. Our parameters for making adjustments are established under a Credit Risk Matrix that provides seven possible scenarios for each of the factors below. The matrix allows for up to three positive/decrease (Major, Moderate, and Minor), three negative/increase (Major, Moderate, and Minor), and one neutral credit risk scenarios within each factor for each loan type pool. Generally, the factors are considered to have no significant impact (neutral) to our historical migration ratios. However, if information exists to warrant adjustment to the Migration Analysis, we make the changes in accordance with the established parameters supported by narrative and/or statistical analysis. Our Credit Risk Matrix and the seven possible scenarios enable us to adjust the Loss Migration Ratio by as much as 50 basis points in either direction (positive or negative) for each loan type pool. The following 9 factors are considered in this matrix and they are patterned after the guidelines provided under the FFIEC Interagency Policy Statement on the Allowance for Loan and Lease Losses.
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Under the Specific Allocation method, management establishes specific loss allowances for loans where management has identified significant conditions or circumstances related to a specific individual credit. The specific allowance amount is determined by a method prescribed by SFAS No. 114, Accounting by Creditors for Impairment of a Loan. The loans identified as impaired will be accounted for in accordance with one of the three acceptable valuations: 1) the present value of future cash flows discounted at the loan’s effective interest rate; 2) the loan’s observable market price; or 3) the fair value of the collateral, if the loan is collateral dependent.
We consider a loan as impaired when it is probable that not all amounts due (principal and interest) according to the contractual terms of the loan agreement will be collectable. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed.
For commercial, real estate and certain consumer loans, we base the measurement of loan impairment on the present value of the expected future cash flows, discounted at the loan’s effective interest rate or on the fair value of the loan’s collateral if the loan is collateral dependent. We evaluate installment loans for impairment on a collective basis, because these loans are smaller balance and homogeneous. Impairment losses are included in the allowance for loan losses through a charge to the provision for loan losses.
Investment Security Portfolio
The main objectives of our investment strategy are to support a sufficient level of liquidity while providing a means to manage our interest rate risk, and to generate an adequate level of interest income without taking undue risks. Our investment policy permits investment in various types of securities, certificates of deposits and federal funds sold in compliance with various restrictions in the policy. Securities are classified as held-to-maturity or available-for-sale. We do not maintain a trading portfolio. The securities that we have the ability and intent to hold to maturity are classified as held-to-maturity securities. All other securities are classified as available-for-sale.
Our held-to-maturity securities totaled $2.0 million at December 31, 2004 and 2003. Our available-for-sale securities totaled $133.4 million at December 31, 2004 compared to $126.4 million at December 31, 2003. During 2004, $23.0 million in securities were called before their maturity, $500 thousand matured, $16.6 million in mortgage related securities were paid down, and $26.4 million in securities were sold and $74.8 million in securities were purchased. All of the securities involved in the transactions were classified as available- for- sale. Securities with amortized cost of $5.1 million were pledged to the Federal Reserve Board as required or permitted by law at December 31, 2004. We also pledged $16.9 million in securities with Federal Home Loan Bank of San Francisco as borrowing collateral, $74.8 million in securities with California State Treasurer’s Office as deposit (CDs) collateral and $2.0 million with Merrill Lynch for the interest rate swap transactions. The investment portfolio consists of government sponsored agency bonds, mortgage backed securities, bank qualified California municipal bonds, CMOs, corporate debt securities and government sponsored enterprise preferred stocks.
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The following table summarizes the amortized cost, estimated market value and maturity distribution of our investment securities portfolio as of dates indicated:
Investment Portfolio
The following table summarizes the maturity of securities based on carrying value and their pertinent weighted average yield at December 31, 2004:
Investment Maturities and Weighted Average Yields
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The following table shows our investments with gross unrealized losses and their estimated fair values, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2004
We evaluate securities for other-than-temporary impairment on at least a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to the length of time and the extent to which the fair value has been less than cost; the financial condition and near-term prospects of the issuer, and our intent and ability to retain our investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. In analyzing an issuer’s financial condition, we may consider whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition.
Except for certain government sponsored enterprise preferred stocks, we believe the balance of unrealized losses is a temporary condition, mainly due to fluctuations in interest rates, and do not reflect deterioration of credit quality of the issuers. During the year ended December 31,2004, we did not have any sales of investment securities resulting in any losses. For those investments in an unrealized loss position at December 31, 2004, we have the intent and ability to hold them until maturity or full recovery of the market values. During the year ended December 31, 2004, as a result of an other than temporary decline in market value of securities, impairment charges of $2.6 million were recognized for government sponsored enterprise preferred stocks. Subsequent to December 31, 2004, all of our government sponsored enterprise preferred stocks were sold for an amount slightly above the December 31, 2004 adjusted book value.
Deposits are our primary source to fund lending and investment activities. Our deposits consist of demand deposits, savings, money market, Super-Now and time deposits with various maturities. Total deposits were $1,256.0 million at December 31, 2004 compared to $1,061.4 million at December 31, 2003 and $816.9 million at December 31, 2002. The increases were $194.6 million or 18% for 2004 and $244.5 million or 30% for 2003. On August 25, 2003, we acquired Asiana Bank with $29.3 million in deposits, which represented 12% of our total increases in deposits in 2003. On October 30, 2003, we assumed $46.2 million in deposits from Korea Exchange Bank’s Broadway Branch in New York, which represented 19% of our total increases in deposits in 2003. Excluding all deposits derived from the acquisitions, the internal growth of the deposits were $169.0 million or 21% in 2003.
The increase in deposits during 2004 was mostly attributable to an increase in money market deposits and time deposits of $100 thousand or more. Money market deposits increased $188.6 million or 155% to $310.2 million as of December 31, 2004 compared with $121.6 million at December 31, 2003. Time deposits of $100 thousand or more increased $58.5 million or 17% to $407.1 million at December 31, 2004 compared with $348.6 million at December 31, 2003. The increase in money market deposits was directly related to a limited time bank-wide promotion of our new
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money market product, which was offered during the second quarter of 2004 to fund loan growth. This particular product featured a higher interest rate, similar to some time deposits, with some of the same features as other money market deposit products. This promotion was very successful throughout all our branches, especially in our new Rowland Heights branch, which opened in March of 2004.
The increase in deposits during 2003 was comprised of increases of non-interest bearing deposits of $88.7 million or 37%, time deposits of $89.3 million or 25%, savings deposits of $16.2 million or 11%, and interest-bearing demand deposits of $50.3 million or 60%. Deposits assumed from acquisitions during 2003 was $75.5 million. The internal growth comprised of increases in non-interest bearing deposits of $69.9 million or 30%, time deposits of $51.6 million or 15%, savings deposits of $8.2 million or 6%, and interest-bearing demand deposits of $39.3 million or 47%. These increases were primarily due to new commercial banking relationships from existing branches and development of new commercial and retail banking relationships from new branches that opened in 2003.
Included in time deposits of $485.3 million at December 31, 2004 were $45.1 million in brokered deposits at December 31, 2004 compared with $57.2 million at December 31, 2003 and $65.0 million in California State Treasurers’ deposits at December 31, 2004 compared with $50.0 million at December 31, 2003. The California State Treasurer’s deposits are subject to withdrawal based on the State’s periodic evaluations. Although we strategically promote certain time deposit products, our efforts are largely concentrated in increasing the volume of low-cost transaction accounts, which generate higher fee income and are less costly than time deposits.
Details of brokered and California State Treasurers’ deposits as of December 31, 2004 are shown on the table below.
Although our deposits vary with local and national economic conditions, we do not believe that our deposits are seasonal in nature. The following table sets forth information for the periods indicated regarding the balances of our deposits by category.
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The following table shows the maturity schedules of our certificates of deposit, for the years indicated.
Other Borrowings
Advances may be obtained from the FHLB of San Francisco to supplement our supply of available funds. The FHLB of San Francisco requires all borrowers to secure all borrowings by pledging with either mortgage loans or securities with a market value greater than the outstanding advances.
The following table shows our outstanding borrowings from FHLB at December 31, 2004.
At December 31, 2004, five wholly owned subsidiary grantor trusts established by Nara Bancorp had issued $38 million of pooled Trust Preferred Securities (“trust preferred securities”). Trust preferred securities accrue and pay distributions periodically at specified annual rates as provided in the indentures. The trusts used the net proceeds from the offering to purchase a like amount of Subordinated Debentures (the “Debentures”) of Nara Bancorp. The Debentures are the sole assets of the trusts. Nara Bancorp’s obligations under the Subordinated Debentures and related documents, taken together, constitute a full and unconditional guarantee by Nara Bancorp of the obligations of the trusts. The trust preferred securities are mandatorily redeemable upon the maturity of the Debentures, or upon earlier redemption as provided in the indentures. Nara Bancorp has the right to redeem the Debentures in whole (but not in part) on or after specific dates, at a redemption price specified in the indentures plus any accrued but unpaid interest to the redemption date.
With the adoption of FIN 46, Nara Bancorp deconsolidated the five grantor trusts. As a result, the subordinated debentures issued by Bancorp to the grantor trusts, totaling $39.3 million, are reflected in our consolidated statements of financial condition in the liabilities section at December 31, 2004 and 2003, under the caption “subordinated debentures.” We record interest expense on the corresponding subordinated debentures in the consolidated statements of income. Nara Bancorp also recorded $2.1 million in other assets in the consolidated statements of financial condition at December 31, 2004 and 2003 for the common capital securities issued by the issuer trusts held by Bancorp.
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The following table shows our outstanding Trust Preferred Securities at December 31, 2004.
(Dollars in thousands)
The Subordinated Debentures are not redeemable prior to June 8, 2011 with respect to Nara Bancorp Capital Trust I, March 26, 2007 with respect to Nara Statutory Trust II, June 15, 2008 with respect to Nara Capital Trust III, January 7, 2009 with respect to Nara Statutory Trust IV, and December 17, 2008 with respect to Nara Statutory Trust V unless certain events have occurred. During March of 2004 and November of 2002, $20 million in total, $10 million each, of the total proceeds from the issuance of the Trust Securities was injected into Nara Bank, as permanent capital.
Capital Resources
Historically, our primary source of capital has been the retention of operating earnings. Our management is committed to maintaining capital at a level sufficient to assure our stockholders, our customers, and our regulators that our company and our bank subsidiary are financially sound. In order to ensure such commitment, our management performs ongoing assessments of projected sources and uses of capital in conjunction with projected increases in assets and levels of risks. We have considered, and we will continue to consider, additional sources of capital as the needs arise, whether through the issuance of additional stocks, debt or otherwise.
Our total stockholders’ equity was $101.3 million at December 31, 2004 compared to $82.6 million at December 31, 2003 and $63.5 million at December 31, 2002. This was an increase of $18.7 million or 23% for 2004 and $19.1 million or 30% for 2003. At December 31, 2004, our Tier I Capital, defined as stockholders’ equity less intangible assets, plus proceeds from the Trust Preferred Securities (subject to limitations), was $127.0 million compared to $101.0 million at December 31, 2003. This increase was primarily due to the net income of $19.8 million and proceeds of $1.1 million from stock options exercised by our employees and directors partially offset by quarterly declarations of cash dividends of $2.5 million. At December 31, 2004 Nara Bancorp’s total capital to total risk-weighted assets ratio was 11.4% and Tier I Capital to total risk weighted assets ratio was 9.7%. Bancorp’s Tier I leverage ratio was 8.9% at December 31, 2004. Nara Bank’s total capital to total risk-weighted assets ratio was 11.1%, the Tier I Capital to total risk weighted assets ratio was 9.9%, and the Tier I leverage ratio was 9.1% at December 31, 2004.
The increase of stockholders’ equity in 2003 was due to an issuance of $8.0 million in common stock to Asiana Bank stockholders in exchange for the acquisition of Asiana Bank, issuance of $1.8 million in common stock as a result of stock options and warrants exercised by our employees and directors, and net income of $13.7 million partially offset by quarterly declarations of cash dividends of $2.2 million. At December 31, 2003, Nara Bancorp’s total capital to total risk-weighted assets ratio was 11.7% and Tier I Capital to total risk weighted assets ratio was 9.3%. Bancorp’s Tier I leverage ratio was 8.3% at December 31, 2003. Nara Bank’s total capital to total risk-weighted assets ratio was 10.2%, the Tier 1 Capital to total risk weighted assets ratio was 9.0%, and the Tier I leverage ratio was 8.0% at December 31, 2003.
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The following tables compare Nara Bancorp’s and Nara Bank’s actual capital at December 31, 2004 to those required by our regulatory agencies for capital adequacy and well-capitalized classification purposes:
Liquidity Management
Liquidity risk is the risk to earnings or capital resulting from our inability to meet our obligations when they come due without incurring unacceptable losses. Liquidity risk includes the ability to manage unplanned decreases or changes in funding sources and to recognize or address changes in market conditions that affect our ability to liquidate assets quickly and with minimum loss of value. Factors considered in liquidity risk management are stability of the deposit base; marketability, maturity, and pledging of investments; and the demand for credit.
The objective of our liquidity management is to have funds available to meet cash flow requirements arising from fluctuations in deposit levels and demands of daily operations, which include funding of securities purchases, providing for customers’ credit needs and ongoing repayment of borrowings.
Our liquidity is actively managed on a daily basis and reviewed periodically by our Asset/Liability Committee and the Board of Directors. This process is intended to ensure the maintenance of sufficient funds to meet our liquidity needs, including adequate cash flow for off-balance-sheet instruments. In general, our liquidity is managed daily by controlling the level of federal funds and the funds provided by cash flow from the investment portfolio. To meet unexpected demands, lines of credit are maintained with correspondent banks, the Federal Home Loan Bank and the Federal Reserve Bank. The sale of investment securities can also serve as a contingent source of funds.
Our primary sources of liquidity are derived from financing activities, which include customer and broker deposits, federal funds facilities, and advances from the Federal Home Loan Bank of San Francisco. These funding sources are augmented by payments of principal and interest on loans and the routine liquidation of securities from our available-for-sale portfolio. Primary uses of funds include withdrawal of and interest payments on deposits, originations of loans, purchases of investment securities, and payment of operating expenses.
Net cash inflow from operating activities totaled $24.5 million, $14.9 million and $8.8 million during 2004, 2003 and 2002, respectively. Net cash inflow from operating activities for the year 2004 is primarily attributable to net income earned during the year. In addition, increases in other assets contributed to operating cash outflows in 2003.
Net cash outflows from investing activities totaled ($237.0) million, ($226.9) million and ($211.0) million during 2004, 2003 and 2002, respectively. Net cash outflows from investing activities for those periods are attributable primarily to the growth in our loan portfolio and purchases of securities. These activities were partially offset by cash received from acquisitions, payments of principal and interest on loans, maturities, payments and net sales proceeds from investment securities available-for-sale.
Net cash inflows from financing activities totaled $223.3 million, $183.7 million and $234.3 million during 2004, 2003 and 2002, respectively. Net cash inflows from financing activities for those periods were attributable primarily to growth in deposits, proceeds from exercises of stock options, and net proceeds from issuance of Subordinated Debentures in 2003 and 2002. In addition, proceeds from FHLB borrowings contributed to financing cash inflows in 2004 and 2002. Net cash inflows from financing activities were partially offset by repayments of FHLB borrowings, cash dividends, stock repurchases and retirement of subordinated notes in 2002.
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When we have more funds than we need for our reserve requirements or short-term liquidity needs, we sell federal funds to other financial institutions. When we have less funds than we need, we borrow funds from the FHLB of San Francisco, correspondent banks and the Federal Reserve Bank (“FRB”). The available borrowing amount from our correspondent banks was $46 million on an overnight basis at December 31, 2004. In addition to the correspondent banks, the available borrowing amount from the FRB discount window is 98% of the market value of the pledged security. At December 31, 2004, the par value of the pledged securities for potential FRB discount window borrowings was $2.0 million. We also have an available borrowing line with the FHLB of San Francisco for up to 25% of our total assets. At December 31, 2004 and 2003, we had $90.0 million and $60.0 million of advances outstanding from Federal Home Loan Bank, respectively.
At times we maintain a portion of our liquid assets in interest-bearing cash deposits with other banks, in overnight federal funds sold to other banks, and in investment securities available-for-sale that are not pledged. Our liquid assets were $121.8 million at December 31, 2004 compared to $100.0 million at December 31, 2003 and $138.0 million at December 31, 2002. At December 31, 2004, cash and cash equivalents, including federal funds sold, totaled $87.2 million compared to $76.4 million at December 31, 2003 and $104.7 million at December 31, 2002.
Because our primary sources and uses of funds are deposits and loans, the relationship between gross loans and total deposits provides a useful measure of our liquidity. Typically, the closer the ratio of loans to deposits is to 100%, the more we rely on borrowings and our loan portfolio to provide short-term liquidity needs. Because repayment of principal on loans tends to be less predictable than the maturity of investments and other liquid resources, the higher the loan to deposit ratio, the less liquid are our assets. For 2004, our gross loan to deposit ratio averaged 95%, compared to an average ratio of 94% for 2003 and an average ratio of 93% for 2002. As of December 31, 2004, we were not aware of any information that was likely to have a material effect on our liquidity position. However, the results of a more recent regulatory examination indicate that our liquidity will need to be carefully monitored in the future as we continue to grow our deposits, particularly as we may be unable to retain the California State Treasurer’s deposits totaling $65 million at December 31, 2004.
Off-Balance- Sheet Activities and Contractual Obligations
Nara Bank routinely engages in activities that involve, to varying degrees, elements of risk that are not reflected, in whole or in part, in the consolidated financial statements. These activities are part of our normal course of business and include traditional off-balance-sheet credit-related financial instruments, interest rate swap contracts, operating leases and long-term debt.
Traditional off-balance-sheet credit-related financial instruments are primarily commitments to extend credit and standby letters of credit. These activities could require us to make cash payments to third parties in the event certain specified future events occur. The contractual amounts represent the extent of our exposure in these off-balance-sheet activities. However, since certain off-balance-sheet commitments, particularly standby letters of credit, are expected to expire or be only partially used, the total amount of commitments do not necessarily represent future cash requirements. These activities are necessary to meet the financing needs of our customers.
Nara Bank also enters into interest rate swap contracts where we are required to either receive cash from or pay cash to counterparties depending on changes in interest rates. We utilize interest rate swap contracts to help manage the risk of changing interest rates. Our accounting for interest rate swap contracts is discussed below under Item 7A.
We do not anticipate that our current off-balance-sheet activities will have a material impact on future results of operations and financial condition. Further information regarding our financial instruments with off-balance-sheet risk can be found in Note 13 of the Notes to Consolidated Financial Statements and in Item 7A – “Quantitative and Qualitative Disclosures about Market Risks.”
We continue to lease our banking facilities and equipment under non-cancelable operating leases with terms providing monthly payments over periods up to 30 years. Our facility lease obligations are discussed under Item 2 – “Properties” And in Note 13 of the Notes to Consolidated Financial Statements.
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The following table shows our contractual obligations and commitments as of December 31, 2004.
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
The objective of our asset and liability management activities is to improve our earnings by adjusting the type and mix of assets and liabilities to effectively address changing condition and risks. Through overall management of our balance sheet and by controlling various risks, we seek to optimize our financial returns within safe and sound parameters. Our operating strategies for attaining this objective include managing net interest margin through appropriate risk/return pricing of assets and liabilities and emphasizing growth in retail deposits, as a percentage of interest-bearing liabilities, to reduce our cost of funds. We also seek to improve earnings by controlling noninterest expense, and enhancing noninterest income. We also use risk management instruments to modify interest rate characteristics of certain assets and liabilities to hedge against our exposure to interest rate fluctuations, reducing the effects these fluctuations might have on associated cash flows or values. Finally, we perform periodic internal analyses to measure, evaluate and monitor market risk.
Interest Rate Risk
Interest rate risk is the most significant market risk impacting us. Market risk is the risk of loss to future earnings, to fair values of our assets and liabilities, or to future cash flows that may result from changes in the price of a financial instrument. Interest rate risk occurs when interest rate sensitive assets and liabilities do not reprice simultaneously and in equal volume. A key objective of our asset and liability management is to manage interest rate risk associated with changing asset and liability cash flows, values of our assets and liabilities, and market interest rate movements. The management of our interest rate risk is governed by policies reviewed and approved annually by the Board of Directors of Nara Bank. The Board delegates responsibility for interest rate risk management to the Asset and Liability Management Committee (“ALCO”), which is composed of Nara Bank’s senior executives and other designated officers.
The fundamental objective of our ALCO is to manage our exposure to interest rate fluctuations while maintaining adequate levels of liquidity and capital. ALCO meets regularly to monitor the interest rate risk, the sensitivity of our assets and liabilities to interest rate changes, the book and market values of assets and liabilities, investment activities and directs changes in the composition of the statement of financial condition. Our strategy has been to reduce the sensitivity of our earnings to interest rate fluctuations by more closely matching the effective maturities or repricing characteristics of our assets and liabilities. Certain assets and liabilities, however, may react in different degrees to changes in market interest rates. Further, interest rates on certain types of assets and liabilities may fluctuate prior to changes in market interest rates, while interest rates on other types may lag behind. We consider the anticipated effects of these factors when implementing our interest rate risk management objectives.
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Swaps
As part of our asset and liability management strategy, we may enter into derivative financial instruments, such as interest rate swaps, with the overall goal of minimizing the impact of interest rate fluctuations on our net interest margin. Interest rate swaps involve the exchange of fixed-rate and variable-rate interest payment obligations without the exchange of the underlying notional amounts. During 2002, we entered into eight different interest rate swap agreements as summarized in the table below.
Under the interest rate swap agreements, we receive a fixed rate and pay a variable rate based on H.15 Prime. The swaps qualify as cash flow hedges under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended, and are designated as hedges of the variability of cash flows we receive from certain of our Prime-indexed loans. In accordance with SFAS No. 133, these swap agreements are measured at fair value and reported as assets or liabilities on the consolidated statements of financial condition. The portion of the change in the fair value of the swaps that is deemed effective in hedging the cash flows of the designated assets are recorded in accumulated other comprehensive income (loss), net of tax effects (“OCI”) and reclassified into interest income when such cash flows occur in the future. Any ineffectiveness resulting from the hedges is recorded as a gain or loss in the consolidated statements of income as a part of non-interest income.
Interest rate swap information at December 31, 2004 and 2003 is summarized as follows:
The realized gain or (loss) on interest rate swaps due to hedge ineffectiveness was $(382) thousand, $80 thousand and $442 thousand for 2004, 2003 and 2002, respectively. Interest income recorded on swap transactions totaled $3.1 million, $3.4 million, and $990 thousand for 2004, 2003, and 2002, respectively. At December 31, 2004, we pledged to the interest rate swap counterparties as collateral agency securities with a book value of $2.0 million and real estate loans of $2.8 million.
Interest Rate Sensitivity
Our monitoring activities related to managing interest rate risk include both interest rate sensitivity “gap” analysis and the use of a simulation model. While traditional gap analysis provides a simple picture of the interest rate risk embedded in the statement of financial condition, it provides only a static view of interest rate sensitivity at a specific point in time and does not measure the potential volatility in forecasted results relating to changes in market interest rates over time. Accordingly, we combine the use of gap analysis with the use of a simulation model, which provides a dynamic assessment of interest rate sensitivity.
The interest rate sensitivity gap is defined as the difference between the amount of interest-earning assets anticipated to reprice within a specific time period and the amount of interest-bearing liabilities anticipated to reprice within that same time period. A gap is considered positive when the amount of interest rate sensitive assets repricing within a
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specific time period exceeds the amount of interest-bearing liabilities repricing within that same time period. Positive cumulative gaps suggest that earnings will increase when interest rates rise and decrease when interest rates fall. Negative cumulative gaps suggest that earnings will increase when interest rates fall and decrease when interest rates rise.
The following table illustrates our combined asset and liability repricing as of December 31, 2004:
The simulation model discussed above also provides our ALCO with the ability to simulate our net interest income. In order to measure, at December 31, 2004, the sensitivity of our forecasted net interest income to changing interest rates, both in rising and falling interest rate scenarios were projected and compared to base market interest rate forecasts. One application of our simulation model measures the impact of market interest rate changes on the net present value of estimated cash flows from our assets and liabilities, defined as our market value of equity. This analysis assesses the changes in market values of interest rate sensitive financial instruments that would occur in response to an instantaneous and sustained increase in market interest rates.
At December 31, 2004, our net interest income and market value of equity exposure related to these hypothetical changes in market interest rates are illustrated in the following table.
The estimated sensitivity does not necessarily represent our forecast and the results may not be indicative of actual changes to our net interest income. These estimates are based upon a number of assumptions including: the nature and
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timing of interest rate levels including yield curve shape, prepayment on loans and securities, pricing strategies on loans and deposits, and replacement of asset and liability cash flows. While the assumptions used are based on current economic and local market conditions, there is no assurance as to the predictive nature of these conditions including how customer preferences or competitor influences may change.
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Consolidated Financial Statements, together with the reports thereon of Crowe Chizek and Company LLP begin at page F-1 of this Report and is incorporated herein by reference and contain the following:
Report of Independent Registered Public Accounting Firm
Report of Independent Registered Public Accounting Firm on Internal Control over Financial Reporting
Consolidated Statements of Financial Condition as of December 31, 2004 and 2003
Consolidated Statements of Income for the Years Ended December 31, 2004, 2003 and 2002
Consolidated Statements of Changes in Stockholders’ Equity for the Years Ended December 31, 2004, 2003, and 2002
Consolidated Statements of Cash Flows for the Years Ended December 31, 2004, 2003 and 2002.
Notes to Consolidated Financial Statements for the Years Ended December 31, 2004, 2003 and 2002
See “Item 15. Exhibits, Financial Statements Schedule” for financial statements filed as a part of this Report.
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
On September 8, 2004, Deloitte & Touche LLP notified Nara Bancorp, Inc. (“the “Company”) of its resignation as the Company’s independent registered public accounting firm. On September 17, 2004, Nara Bancorp, Inc. engaged the firm of Crowe Chizek and Company LLP as its new independent auditors.
Item 9A. CONTROLS AND PROCEDURES
We conducted an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Acting Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) under the Exchange Act) as of December 31, 2004. Based upon that evaluation, our Chief Executive Officer and Acting Chief Financial Officer determined that, as a result of errors identified in the financial statements for the previously reported years ended December 31, 2002, and 2003 and quarters and year-to-date periods ended March 31, 2004, June 30, 2004 and September 30, 2004, our disclosure controls and procedures were not effective to ensure that material information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported as and when required. These errors resulted in the restatement of the financial statements for such periods.
In light of this determination and as part of the work undertaken in connection with this report, we have applied compensating procedures and processes as necessary to ensure the reliability of our financial reporting. Accordingly, management believes, based on its knowledge, that (i) this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading with respect to the period covered by this report and (ii) the financial statements, and other financial information included in this report, fairly present in all material respects our financial condition, results of operations and cash flows as of, and for, the periods presented in this report.
This new determination is in contrast to the previous evaluation carried out under the supervision and with the participation of management, including the former Chief Executive Officer and former Chief Financial Officers. In particular, this determination differs from that stated in our Annual Reports on Form 10-K for the fiscal years ended December 31, 2002 and 2003 and our Quarterly Reports on Form 10-Q for the quarters ended March 31, 2004, June 30, 2004 and September 30, 2004 that our disclosure controls and procedures were effective as of or for the respective periods.
Our management is responsible for the integrity and objectivity of all information presented in this report. The consolidated financial statements were prepared in conformity with accounting principles generally accepted in the United States of America and include amounts based on management’s best estimates and judgments. Management believes the consolidated financial statements fairly reflect the form and substance of transactions and that the financial statements fairly represent the Company’s financial position and results of operations for the periods and as of the dates stated therein.
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The Audit Committee of the Board of Directors, which is composed solely of independent directors, meets regularly with our independent registered public accounting firm, Crowe Chizek and Company LLP, and representatives of management to review accounting, financial reporting, internal control and audit matters, as well as the nature and extent of the audit effort. The Audit Committee is responsible for the engagement of the independent auditors. The independent auditors have free access to the Audit Committee.
The Company’s independent auditors, Crowe Chizek and Company LLP, has issued an attestation report on management’s assessment of the Company’s internal control over financial reporting.
The management of Nara Bancorp, Inc. and its subsidiaries (the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting for the Company as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act. This system is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.
The Company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and the directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, a system of internal control over financial reporting can provide only reasonable assurance and may not prevent or detect misstatements. Further, because of changes in conditions, effectiveness of internal controls over financial reporting may vary over time.
With the participation of the Company’s Chief Executive Officer and Acting Chief Financial Officer, management conducted an evaluation of the effectiveness of the system of internal control over financial reporting based on the framework in Internal Control-Integrated Framework, published by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management determined that the Company’s system of internal control over financial reporting was not effective as of December 31, 2004. As of December 31, 2004, we identified four material weaknesses in internal control over financial reporting which are described below:
1. Accounting for Deferred Compensation Arrangements. The Company’s accounting for deferred compensation arrangements (approximately $600,000 in employee compensation charges) for its former Chief Executive Officer was inadequate. The Company’s consolidated financial statements for the fiscal years ended December 31, 2002 and
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2003 did not reflect the impact of an arrangement to reimburse the former Chief Executive Officer for certain expenses and additional post-retirement compensation up to $600,000 in exchange for the former Chief Executive Officer’s relinquishment of $600,000 in profit-sharing to which he was entitled. As result of this material weakness, a restatement of the Company’s consolidated financial statements for 2003 and 2002, and the recording of audit adjustments to the Company’s 2004 consolidated financial statements were required. The effect on the Company’s net income, after taxes, for the fiscal year ended December 31, 2002 was a decrease of approximately $342,000.
2. Accounting for Various Employee Related Compensation. The Company’s method of accruing incentive compensation, profit sharing and bonus payments for senior management and employees was inadequate. As result of this material weakness, a restatement of the Company’s consolidated financial statements for 2003 and 2002, and the recording of audit adjustments to the Company’s 2004 consolidated financial statements were required. The Company recorded a reduction to salary and employee benefits expense in the amount of $234,000 for 2004, an increase to salary and employee benefits expense of $203,000 for 2003 and an increase to salary and employee benefits expense of $81,000 for 2002. The cumulative net adjustment for the applicable periods was an increase of $50,000 to salary and employee benefits expense.
3. Accounting for Lease Arrangements. The Company’s lease accounting practices and procedures were inadequate. The Company had not established procedures to analyze and document whether the Company’s leases should be classified as operating or capital leases, procedures to depreciate leasehold improvements over the shorter of the remaining terms of the leases or the estimated useful lives of the improvements, and procedures to recognize scheduled lease payment increases on a straight-line basis over the lease term. This material weakness resulted in the Company recording material adjustments in the 2004 financial statements and the restatement of its 2003 and 2002 financial statements. The Company recorded increases to occupancy expenses of $800,000, $594,000 and $471,000 for 2004, 2003 and 2002 and a decrease to beginning retained earnings as of January 1, 2002 of $382,000, net of $288,000 in tax effects, to correct the accounting errors for years prior to 2002. The cumulative net adjustment for all applicable periods was an increase of $2,535,000 in occupancy expenses.
4. Accounting for Bank Owned Life Insurance. The Company’s accounting practices and procedures for recording life insurance policies owned by Nara Bank were inadequate and resulted in the Company’s failure to consider the impact of contractual limitations on the cash surrender value of those life insurance policies at the relevant balance sheet dates. Although the Company revised certain of the agreements relating to these insurance policies in the fourth quarter of 2004 to mitigate the future impact of these contractual limitations, the effect of the revised agreements was not properly reflected and the Company was required to record material audit adjustments to the Company’s 2004 consolidated financial statements and to restate the Company’s consolidated financial statements for 2003 and 2002. This material weakness resulted in the Company recording an expense of $345,000 for 2003 and $1,411,000 for 2002 to discount the carrying value for the cash surrender value of life insurance. For 2004, the Company reversed $1,426,000 of the discounts recorded in 2003 and 2002, due to the revisions made to certain agreements during the fourth quarter 2004. The cumulative net adjustment for the applicable periods was an increase of $330,000 to cash surrender value of life insurance discount expense.
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A material weakness in internal control over financial reporting is a control deficiency (within the meaning of the Public Company Accounting Oversight Board’s (“PCAOB”) Auditing Standard 2), or combination of control deficiencies, that result in there being more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. PCAOB Auditing Standard 2 identifies a number of circumstances that, because of their likely significant negative effect on internal control over financial reporting, are to be regarded as at least significant deficiencies, as well as strong indicators of a material weakness, including the restatement of previously issued financial statements and financial information to reflect the correction of a misstatement.
1. Accounting for Deferred Compensation Arrangements. The Company is implementing enhancements to its internal control over financial reporting to provide reasonable assurance that accounting errors and control deficiencies of this type will not recur. These steps include:
All contracts, letters, memoranda of understanding or other agreements relating to employment matters for senior management must be signed on behalf of Nara Bank or Nara Bancorp only upon the approval of the Compensation Committee of Nara Bancorp or the Board of Directors of Nara Bancorp.
All material contracts and agreements must be reviewed by in-house counsel, and disclosed quarterly to the Audit Committee of Nara Bancorp or to the Company’s independent auditors.
2. Accounting for Various Employee Related Compensation. The Company is implementing enhancements to its internal control over financial reporting to provide reasonable assurance that accounting errors and control deficiencies of this type will not recur. These steps include:
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3. Accounting for Lease Arrangements. The Company is implementing enhancements to its internal control over financial reporting to provide reasonable assurance that accounting errors and control deficiencies of this type will not recur. These steps include:
4. Accounting for Bank Owned Life Insurance. The Company has implemented enhancements to its internal control over financial reporting to provide reasonable assurance that accounting errors and control deficiencies of this type will not recur. These steps include:
There were no significant changes, other than as discussed above in the Company’s internal control over financial reporting or in other factors in the fourth quarter of 2004 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Item 9B. OTHER INFORMATION
None.
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PART III
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The next table provides certain information with respect to our board of directors and our executives. Nara Bancorp knows of no arrangements, including any pledge by any person of Nara Bancorp’s securities, the operation of which may, at a subsequent date, result in a change in control of Nara Bancorp. There are no arrangements or understandings by which any of the directors or nominees for director or executive officers of Nara Bancorp were selected. There is no family relationship between any of the directors, nominees or executive officers, except for two nominees for director, Messrs. Jesun Paik and Ki Suh Park, who are brothers-in-law.
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None of the directors, nominees for director or officers of Nara Bancorp serves as a director of any company which has a class of securities registered under, or which is subject to the periodic reporting requirements of, the Securities Exchange Act of 1934 or any investment company registered under the Investment Company Act of 1940.
Section 16(a) of the Securities Exchange Act of 1934, as amended (referred to as the “Exchange Act”), requires our directors and executive officers, and persons who own more than 10% of our equity securities, to file reports of ownership and reports of changes in ownership of common stock with the Securities and Exchange Commission. Prior to the completion of our reorganization in February 2001, these reports were filed with the Office of the Comptroller of the Currency. The Exchange Act requires officers, directors and greater than 10% stockholders to furnish us with copies of all Section 16(a) forms they file.
To our knowledge, based solely on a review of the copies of such forms and certifications furnished to us, we believe that all of our directors and executive officers complied with all Section 16(a) filing requirements applicable to them during the 2004 fiscal year, except for Nara Bank and Nara Bancorp, Inc. senior officer Timothy Chang, who filed a Form 3 late in connection with shares of Nara Bancorp, Inc. common stock that he privately purchased prior to becoming an insider of the corporation.
Certain Legal Proceedings: To our knowledge, based solely on a review of certifications furnished to us, we do not believe that any of our directors or executive officers has been involved in any legal proceeding that would affect the ability or the integrity of the person to become a director or executive officer.
Audit Committee Financial Expert: The Board of Directors have determined that the Chairman of the Audit Committee, Mr. Jesun Paik, is qualified as an audit committee financial expert within the meaning of the SEC regulations and has accounting and related financial management expertise within the meaning of the listing standards of the Nasdaq National Market. Mr. Paik is independent, as such term is used in Item 7(d)(3)(iv) of Schedule 14A under the Exchange Act.
The Audit Committee. The Audit Committee of Nara Bancorp consists of Director Jesun Paik as Chairman, and Directors Ki Suh Park, Yong H. Kim and John H. Park, and operates under a written charter adopted by the board of directors.
Nomination to the Board by Securities Holder: There have been no material changes by which security holders may recommend nominees to Nara Bancorp’s board of directors since last year.
Code of Ethics: We have adopted the Nara Code of Business Conduct and Ethics that applies to all officers, directors and employees. The Nara Code of Business Conduct and Ethics is available on our website at www.narabank.com. If we make any substantive amendments to the Nara Code of Business Conduct and Ethics or grant any waiver from a material provision of the Code to any executive officer or director, we will promptly disclose the nature of the amendment or waiver on our website.
Item 11. EXECUTIVE COMPENSATION
The following table sets forth certain summary information concerning compensation awarded to, earned by, or paid by Nara Bank and Nara Bancorp for services rendered in all capacities by the chief executive officer and other executive officers (referred to as the “Named Executive Officers”) for each of the fiscal years ended December 31, 2004, 2003 and 2002.
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SUMMARY COMPENSATION TABLE
Stock Option Grants and Exercises
We grant options to our executive officers under the Nara Bancorp, Inc. 2001 Nara Bank 2000 Continuation Long Term Incentive Plan (the “Incentive Plan”). As of March 31, 2005, options to purchase a total of 2,597,308 shares were outstanding under the Incentive Plan and options to purchase 621,667 shares remained available for grant under the Incentive Plan. Nara Bancorp did not grant any stock options or stock appreciation rights to directors or executive officers in 2004.
Aggregated Option Exercises in the Twelve Months Ended December 31, 2004 and December 31, 2004 Option Values
The following table sets forth the number of shares acquired by each Named Executive Officer upon the exercise of stock options during 2004 and the number of shares covered by both exercisable and unexercisable stock options held by each Named Executive Officer at December 31, 2004. Also reported are values of “in-the-money” options, which represent
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the positive spread between the respective exercise prices of outstanding stock options and $21.24 per share, which was the closing market price of Nara Bancorp’s common stock on the Nasdaq National Market on December 31, 2004 (after giving effect to our two-for-one stock split effected as of the close of business on June 14, 2004):
AGGREGATED OPTION EXERCISES IN 2004 AND VALUES
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Compensation of Directors
During the fiscal year 2004, the non-employee directors of Nara Bank were each paid $3,000 per month as a retainer for services as director. The only employee director on the board during 2004 (the President) received $3,000 monthly for his service as a director in addition to his regular salary and bonuses. The Chairman of the board of directors, Dr. Chong-Moon Lee, received an additional $400 per month for services rendered. Total directors’ fees paid by Nara Bank during 2004 were $170,000, of which $68,000 was deferred under Nara Bank’s deferred compensation plan. Director Brian Woo received $16,000 for his service as a director of Nara Bank during 2004, prior to his death.
During the fiscal year 2004, the non-employee directors of Nara Bancorp, except for Dr. Thomas Chung, John H. Park, and Yong H. Kim, were paid $3,000 per quarter plus $1,000 for each committee meeting attended in person or $500 for each committee meeting attended by telephone conference. Directors Dr. Thomas Chung, John H. Park, and Yong H. Kim were not paid director fees by Nara Bancorp. Total directors’ fees paid in 2004 by Nara Bancorp were $60,000. Director Steve Kim received $18,000 for his service as a director of Nara Bancorp during 2004 prior to his resignation.
During the fiscal year 2004, the following directors received payment under endorsement split-dollar policies: Chang Hee Kim received $615, Yong H. Kim received $430, John H. Park received $505, and Brian Woo received $543.
Employment Agreement
Ho Yang was appointed President and Chief Executive Officer of Nara Bank and Nara Bancorp in October 2004 and commenced employment in February 2005. Mr. Yang’s employment agreement is for an initial term of three years starting February 4, 2005. Mr. Yang’s employment agreement dated October 1, 2004 provides for a base salary of $275,000 in the initial year, plus profit sharing equal to 4% of Nara Bancorp’s consolidated pretax earnings in excess of 20% of the Nara Bancorp’s consolidated previous year-end’s stockholders equity excluding unrealized gain (loss), an automobile allowance, 4 weeks of paid vacation per year and payment of business-related expenses. Pursuant to his employment agreement, Mr. Yang was granted the option to purchase 120,000 shares of Nara Bancorp’s common stock, which will vest over a period of three years, starting one year after the date of the grant. The terms of these stock options are subject to the terms and conditions set forth in the Nara Bancorp, Inc., 2001 Nara Bank 2000 Continuation Long Term Incentive Plan.
Neither Nara Bancorp nor Nara Bank has entered into any other written employment agreements with any of their respective executive officers except as described above.
Change of Control Agreement
Pursuant to Mr. Yang’s employment agreement, if he is terminated without cause during the initial term of the agreement (3 years), he will be entitled to receive an amount equal to twelve (12) months of the base salary in the form of salary continuation, but not exceeding $275,000. In the event that Mr. Yang is terminated without cause after the initial term of the agreement, he will be entitled to receive an amount equal to three (3) months of the base salary in the form of salary continuation, but not exceeding $68,750. Such severance shall be reduced by any remuneration paid to Mr. Yang because of his employment or self-employment during the severance period.
Compensation Committee Interlocks and Insider Participation
Nara Bancorp formed a Compensation Committee on July 30, 2002. To date, our executive compensation arrangements have been approved by the full board of directors of Nara Bank and ratified by the Compensation Committee of Nara Bancorp. Director Dr. Chong-Moon Lee is the Chairman of the Compensation Committee and the other members consist of Directors Ki Suh Park, Yong H. Kim and Jesun Paik. No person who served as a member of the Compensation Committee during the 2004 fiscal year is, or ever has been, an officer or employee of Nara Bancorp or any of its subsidiaries. There is no family relationship between any of the members of the Compensation Committee or executive officers, except for two Messrs. Jesun Paik and Ki Suh Park, who are brothers-in-law. None of our executive officers serve as a member of the board of directors or Compensation Committee of any entity that has one or more executive officers who serve on our board of directors or Compensation Committee.
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The following table shows the beneficial ownership of our common stock as of May 31, 2005 held by (i) our chief executive officer; (ii) executive officers during 2004; (iii) each of our directors and (iv) all directors, nominees and executive officers as a group (after giving effect to our two-for-one stock split effected as of the close of business on June 15, 2004). Our chief executive officer and our other executive officers named below are referred to in this proxy statement as the “Named Executive Officers”.
For the purposes of the following two tables, “Beneficial ownership” is a technical term broadly defined by the Securities and Exchange Commission to mean more than ownership in the usual sense. For example, a stockholder would be deemed to own our common stock if the stockholder not only holds it directly but also indirectly, if a stockholder, through a relationship, contract or understanding, has, or shares, the power to vote the stock, to sell the stock or has the right to acquire the stock, within 60 days of May 31, 2005.
The following table shows the beneficial ownership of our common stock as of May 31, 2005, by each person who we knew owned more than 5% of our common stock. We have relied on the public filings of each of the individuals on Schedules 13D or 13G, in determining how many shares these individuals own (after giving effect to our two-for-one stock split effected as of the close of business on June 15, 2004):
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The following table summarizes certain information as of December 31, 2004 with respect to our equity compensation plans (including individual compensation arrangements) under which our equity securities are authorized for issuance (after giving effect to our two-for-one stock split effected as of the close of business on June 15, 2004):
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
There are no existing or proposed material transactions between Nara Bancorp or Nara Bank and any of our officers, directors, nominees or principal stockholders or the immediate family or associates of the foregoing persons, except as indicated below.
Some of the directors and officers of Nara Bancorp and/or Nara Bank and the immediate families and the business organizations with which they are associated, are customers of, and have had banking transactions with, Nara Bank in the ordinary course of our business and we expect to have banking transactions with such persons in the future. All loans made to such persons have been made on substantially the same terms, including interest rate and collateral, as those prevailing for comparable contemporaneous transactions with other persons of similar creditworthiness and do not involve more than a normal risk of collectibility or present other unfavorable features.
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Item 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The following table sets forth the aggregate fees that we incurred for audit and non-audit services provided by Deloitte & Touche LLP and Crowe Chizek and Company LLP, both entities who acted as independent auditors and performed audit services for us in the fiscal year ending December 31, 2004. The table lists audit fees, financial information systems design and implementation fees, and other fees.
Audit Fees. The audit fees include only fees that are customary under generally accepted auditing standards and are the aggregate fees that we incurred for professional services rendered for the audit of our annual financial statements for fiscal year 2003 and 2004. Crowe Chizek’s audit fees include the fees for the audit of the 2004 consolidated financial statements and internal controls and the re-audits of the 2003 and 2002 consolidated financial statements in the approximate amount of $500,000 and include estimated fees not yet billed.
Audit Related Fees. Crowe Chizek’s audit related fees for 2004 were for consultation regarding implementation of Section 404 of the Sarbanes Oxley Act.
Tax Fees. Crowe Chizek’s tax fees for 2004 include progress billings through December 31, 2004 related to the preparation of the Company’s 2004 federal and state income tax returns.
All Other Fees. All other fees include the aggregate fees billed for services rendered by Crowe Chizek, other than those services covered above and for 2004 include fees for consultation regarding implementation of Section 302 of the Sarbanes Oxley Act.
The Audit Committee of the board of directors considered whether the provision of financial information systems design and implementation services and other non-audit services is compatible with maintaining the independence of Crowe Chizek. The Audit Committee has determined that the rendering of these non-audit services by Crowe Chizek is compatible with maintaining the principal accountant’s independence.
The Audit Committee has adopted a policy and procedures for the approval in advance of audit and non-audit services rendered by our independent auditor, Crowe Chizek and Company LLP. The policy requires advanced approval of all services before the independent auditor is engaged to provide such services. The advanced approval of services may be delegated to one or more of the Audit Committee’s members, but the decision must be reported to the full Audit Committee at its next scheduled meeting.
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PART IV
Item 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) and (c) Financial Statements and Schedules.
The financial statements listed on the Index to Financial Statements included under Item 8. “Financial Statements and Supplemental Data” are filed as part of this Form 10-K. All schedules have been omitted since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the Financial Statements and related notes.
(b) List of Exhibits The exhibits marked with an asterisk (*) constitute compensation plans or arrangements:
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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 and in the capacities and on the dates indicated.
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Nara Bancorp, Inc.and Subsidiaries
Consolidated Financial Statements forDecember 31, 2004 and 2003 andEach of the Three Years in the PeriodEnded December 31, 2004 andIndependent Auditors’ Report
F-1
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and StockholdersNara Bancorp, Inc.Los Angeles, California
We have audited the accompanying consolidated statements of financial condition of Nara Bancorp, Inc. and Subsidiaries (the Company) as of December 31, 2004 and 2003 and the related consolidated statements of income, changes in stockholders’ equity and cash flows for the years ended December 31, 2004, 2003 and 2002. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (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 audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Nara Bancorp, Inc. and Subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for the years ended December 31, 2004, 2003 and 2002 in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 2, the Company has restated its consolidated financial statements as of December 31, 2003 and for each of the two years in the period ended December 31, 2003 to reflect the effect of adjustments identified in 2005.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated June 10, 2005 expressed an adverse opinion thereon.
Crowe Chizek and Company LLP
South Bend, IndianaJune 10, 2005
F-2
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON INTERNAL CONTROL OVER FINANCIAL REPORTING
We have audited management’s assessment, included in the accompanying Report on Management’s Assessment of Internal Control Over Financial Reporting, that Nara Bancorp, Inc. and Subsidiaries (the Company) did not maintain effective internal control over financial reporting as of December 31, 2004 because of the effect of material weaknesses identified in management’s assessment, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weaknesses have been identified and included in management’s assessment.
F-3
The Company lacked appropriate controls to record a deferred compensation agreement with the then Chief Executive Officer in October 2002. This resulted in the Company recording material adjustments in the 2004 financial statements and the restatement of its 2003 and 2002 financial statements.
The Company lacked appropriate controls to consistently accrue incentive compensation, profit sharing and bonus payments to senior management. This resulted in the Company recording material adjustments in the 2004 financial statements and the restatement of its 2003 and 2002 financial statements.
The Company lacked appropriate controls for accounting for lease arrangements under which the Company occupies its premises. Specifically, the Company lacked appropriate procedures to analyze and document consideration of whether such leases should be classified as operating or capital leases, the Company lacked appropriate controls to depreciate leasehold improvements over the shorter of the remaining terms of the leases or the estimated useful lives of the improvements, and the Company lacked appropriate controls to recognize scheduled lease payment increases on a straight-line basis over the lease term. This resulted in the Company recording material adjustments in the 2004 financial statements and the restatement of its 2003 and 2002 financial statements.
The Company lacked appropriate controls for the accounting for bank owned life insurance. Specifically, the Company did not consider the impact of contractual restraints on the Company’s ability to effectively realize the cash surrender value of certain life insurance policies at the balance sheet dates. Although the Company revised certain agreements during 2004 to mitigate the future impact of this matter, the effect of the contractual restraints and their revisions were not reflected which resulted in the Company recording material adjustments in the 2004 financial statements and the restatement of its 2003 and 2002 financial statements.
These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the Company’s consolidated financial statements, and this report does not affect our report dated, June 10, 2005, on those financial statements.
In our opinion, management’s assessment that the Company did not maintain effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, because of the effect of the material weaknesses described above on the achievement of the objectives of the control criteria, the Company has not maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
F-4
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statements of financial condition of Nara Bancorp, Inc. and Subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004, and our report dated June 10, 2005 expressed an unqualified opinion on those consolidated financial statements.
We do not express an opinion or any other form of assurance on management’s statements referring to corrective actions taken by the Company or the Company’s plans to implement new controls.
F-5
NARA BANCORP, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF FINANCIAL CONDITIONDECEMBER 31, 2004 AND 2003
(Continued)
F-6
NARA BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITIONDECEMBER 31, 2004 AND 2003
See accompanying notes to consolidated financial statements.
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CONSOLIDATED STATEMENTS OF INCOMEYEARS ENDED DECEMBER 31, 2004, 2003 AND 2002
F-8
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CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITYYEARS ENDED DECEMBER 31, 2004, 2003 AND 2002
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See accompanying notes to consolidated financial statements
F-11
CONSOLIDATED STATEMENTS OF CASH FLOWSYEARS ENDED DECEMBER 31, 2004, 2003 AND 2002
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTSYEARS ENDED DECEMBER 31, 2004, 2003 AND 2002
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Effect on previously reported operating results for the years ended December 31, (in thousands except per share data):
Effect on previously reported operating results for the quarters ended (in thousands except per share data):
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Securities with amortized cost of approximately $98.8 million and $102.9 million at December 31, 2004 and 2003, respectively, were pledged to secure public deposits, various borrowings and for other purposes as required or permitted by law.
The following table shows our investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2004 and 2003.
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The Company tested goodwill for impairment as of December 31, 2004, 2003 and 2002 and determined that there was no impairment.
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EPS information is as follows for the years ended December 31:
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17. OTHER COMPREHENSIVE INCOME (LOSS)
Other comprehensive income (loss) components and related tax effects were as follows:
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STATEMENTS OF FINANCIAL CONDITION
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STATEMENTS OF INCOME
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