UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
For the fiscal year ended December 31, 2002
For the transition period from to
Commission File # 333-50126
NARA BANCORP, INC.
3701 Wilshire BoulevardSuite 220Los Angeles, California 90010
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 [X] No [ ]
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. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act) [X] Yes [ ] No
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 on June 30, 2002, as reported on the Nasdaq National Market, was approximately $101,343,219.
Number of shares outstanding of the Registrant’s Common Stock, as of March 12, 2003: 10,698,730
Portions of the Definitive Proxy Statement that will be filed in connection with the registrants Annual Meeting of Shareholders to be held on May 28, 2003 are incorporated by reference into Part III of this Form 10-K.
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TABLE OF CONTENTS
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 of 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 the word “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. “ Factors That May Impact Our Business or the Value of Our Stock.”
Factors that might affect forward-looking statements include, among other things:
As a result of the above, we cannot assure you that our future results of operations or financial conditions or any other matters will be consistent with those presented 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.
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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), incorporated under the laws of the State of Delaware in 2000, is a bank holding company, headquartered in Los Angeles, California, offering a full range of commercial banking and consumer financial services through its wholly owned subsidiary, Nara Bank, N.A., a national bank (“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 “Federal Reserve Board”) as part of the reorganization of Nara Bank into a holding company formation. Nara Bancorp’s principal business is to serve as a holding company for Nara Bank and bank-related subsidiaries, which Nara Bancorp may establish or acquire. Our headquarter is located at 3701 Wilshire Boulevard, Suite 220, Los Angeles, California 90010. Our telephone number is (213) 639-1700.
Nara Bancorp has three wholly-owned subsidiaries, Nara Bank, Nara Capital Trust I, and Nara Statutory Trust II. 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.
In March 2000 and 2001, Nara Bancorp established Nara Capital Trust I (“Trust I”) and Nara Statutory Trust II (Trust II”), respectively, as wholly owned subsidiaries. The Trust I and Trust II are statutory business trusts. 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. In both issuances, we participated as part of a pooled offering with several other financial institutions. 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 percent and is paid quarterly. For the period beginning on September 26, 2002 to December 25, 2002, the interest rate on the trust preferred securities of Trust II was 5.39 percent, and was paid on December 26, 2002. For the period beginning on December 27, 2002 to March 25, 2002, the trust preferred securities of Trust II bear the interest rate of 5.0% percent per annum. However, prior to March 26, 2007, the interest rate cannot exceed 11.0 percent.
Our website address is www.narabank.com. We did not in 2002, and currently do not, at this time, make available our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC. We do post our annual report on Form 10-K and quarterly reports on Form 10-Q but do not post at any time our current reports on Form 8-K. We do not do so because our website is still under development. We will provide either an electronic or paper copy of our reports free of charge upon request, which request may be made directly to the Investor Relations department at (213) 639-1700.
Recent Developments
On February 18, 2003, Nara Bancorp announced that its Board of Directors declared a dividend of $0.05 per common share for the first quarter of 2003, which is payable on April 11, 2003 to stockholders of record on March 31, 2003.
On February 14, 2003, Nara Bancorp announced that its Board of Directors approved a two-for-one stock split of its common stock, effected in the form of a 100% stock dividend, which was payable on March 17, 2003 to stockholders of record on close of business on March 3, 2003. The effect of this dividend is that Stockholders received one additional share of Nara Bancorp common stock for each share owned. All per share amounts and number of shares outstanding in this report have been retroactively restated for this stock split.
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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 our deposits up to the maximum legal limits, and we are a member of the Federal Reserve System.
Through our network of 14 branches and 4 loan production offices, we offer a full range of commercial banking and consumer financial services for 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, except for our Wilshire and Downtown Offices, operates 24-hour automated teller machines. We provide courier services to qualifying clients and have personal banking officers for our 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 atwww.narabank.comfeatures 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 do not appear to be 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 currents assets such as inventories and accounts receivable, which 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) have terms of 5 to 7 years with principal and interest paid monthly. The credit-worthiness of our borrowers is determined before the loan is origination 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. We also offer small business loans to smaller retail businesses for up to $100,000 with terms of 3 to 5 years at a fixed interest rate.
Our commercial loan portfolio includes trade finance loans from Nara Bank’s International 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 the subject business. The department also issues and advises and letters of credit for export and import businesses. As of December 31, 2002, outstanding letters of credit, including domestic letters of credit totaled $31.8 million.
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 loans to 70% of Nara Bank’s appraised value of the subject property.
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Small Business Administration Loans
Small Business Administration (SBA) loans are typically extended for the purpose of providing working capital, purchase of inventory, purchase of machinery and equipment, debt refinance, business acquisition, start-up financing, or to purchase/construct owner-occupied commercial property. SBA loans typically are term loans with maturities ranging from 7 to 10 years for business only related loans and are 25 years for real estate related loans. SBA loans are fully amortized with payment of principal and interest monthly. SBA loans normally provide for floating interest rates and are secured by business assets and/or real estate. Each loan is typically guaranteed 75% to 85% by the U.S. Small Business Administration, depending on the loan amount , with a maximum guaranty per borrower of $1,000,000.
The SBA loans we generate represent an important segment of our non-interest income because of our ability to sell the guaranteed portion in the secondary market at a premium while earning servicing fee income on the sold portion over the remaining life of the loan. Thus, in addition to the interest yield earned on the un-guaranteed portion of the SBA loans that we retained, we recognize income from the gains on the sales and from loan servicing on the SBA loans sold in the secondary market.
All 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. We attained SBA Preferred Lender status in the Los Angeles and Santa Ana 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. On February 24, 1999, we attained Preferred Lender status in the New York, Chicago, San Francisco, Seattle, and Spokane districts. On April 20, 2001, we also received Preferred Lender status in New Jersey, Baltimore, Washington D.C. and Atlanta districts.
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 are not qualified 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 appraisal value.
Concentrations
Loan concentrations are considered to exist when there are significant amounts of loans to a multiple 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:
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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. Our investment policy permits investment in various types of securities, certificates of deposits and federal funds sold in compliance with various restrictions in our policy. Our investment portfolio consists of government sponsored agency bonds, mortgage backed securities, Collaterized Mortgage Obligations (“CMOs”), bank-qualified California municipals, and corporate bonds.
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 designed as available-for-sale at the time of purchase. At December 31, 2002, we had $2.8 million in securities held-to maturities and $101.6 million in securities available-for-sale. We sold $ 44.6 million in investment securities during 2002.
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 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.
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 corresponding 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 $13 million on an overnight basis. In addition to the correspondent banks, the maximum amount that we may borrow from the FRB discount window is 97% of the market value of the pledged security. At December 31, 2002, the par value of the pledged security was $2.0 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 FHLBSF utilizing Federal Home Loan Bank stock, qualifying mortgage loans and mortgage-backed securities as collateral.
The FHLBSF offers a full range of borrowing program on its advance with terms of up to ten years at competitive market rates. A prepayment penalty is usually imposed for early repayment of these advances. As a member of Federal Reserve Bank, we may also borrow from the Federal Reserve Bank of San Francisco.
Market Area and Competition
Most of our services are offered in the Los Angeles County, Orange County, San Francisco Bay area, Silicon Valley (Santa Clara County), and New York areas, all regions with high concentrations of Koreans-American Communities. The banking and financial services industry generally, and in our market areas specifically,
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including California and New York City, is 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. 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 and offer a broader range of financial services than we do. We have 14 branch offices located in Los Angeles, Orange County, Oakland, Silicon Valley, New York and 4 loan production offices located in Seattle, Chicago, New Jersey, and Atlanta.
Economic Conditions, Government Policies and Legislation
Our profitability, like most financial institutions, primarily depends on interest rate differentials. In general, the difference between the interest rates paid on interest-bearing liabilities, such as deposits and other borrowings, and the interest rates received on our interest-earning assets, such as loans extended to our clients and securities held in our investment portfolio, comprise the major portion of our earnings. 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 Board of Governors of the Federal Reserve System (the “FRB”). The Federal Reserve Board 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 Federal Reserve Board 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 any of our future changes in monetary and fiscal policies cannot be predicted.
From time to time, legislation, as well as regulations, is enacted which has 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 the operating environment of Nara Bancorp and its subsidiaries 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 of us or any of our subsidiaries. See “Item 1. Business - Supervision and Regulation below.”
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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, which 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 OCC and FRB 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, we are required by the FRB to maintain certain levels of capital. See “Capital Standards.”
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 there to.
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, we and our subsidiaries are subject to examination by, and may be required to file reports with, the California Department of Financial Institutions.
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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, N.A.
Nara Bank, as a national banking association, is subject to primary supervision, examination, and regulation by the Office of the Comptroller of the Currency (the “OCC”). To a lesser extent, Nara Bank is also subject to regulations of the Federal Deposit Insurance Corporation (the “FDIC”) as administrator of the Bank Insurance Fund and the FRB. If, as a result of an examination of Nara Bank, the Office of the Comptroller of the Currency 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 Office of the Comptroller of the Currency. 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, and to remove officers and directors. The FDIC has similar enforcement authority, in addition to its authority to terminate Nara Bank’s deposit insurance in the absence of action by the Office of the Comptroller of the Currency and upon a finding that Nara Bank is in an unsafe or unsound condition, is engaging in unsafe or unsound activities, or that its conduct poses a risk to the deposit insurance fund or may prejudice the interest of its depositors.
Various requirements and restrictions under the laws of the United States and the State of California affect the operations of Nara Bank. Federal and California statutes and regulations relate to many aspects of Nara Bank’s operations, including reserves against deposits, ownership of deposit accounts, interest rates payable on deposits, loans, investments, mergers and acquisitions, borrowings, dividends, locations of branch offices and new products and services. Further, Nara Bank is also required to maintain certain minimum levels of capital. See “Capital Standards.”
During 2001, Nara Bank and its board of directors negotiated and on, February 20, 2002, they signed a Stipulation and Consent to the Issuance of a Consent Order (the “Consent Order”). Nara Bank, without admitting to any allegations, entered into 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 compliance 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 as of such date Nara Bank was no longer subject to its requirements.
Sarbanes-Oxley Act of 2002
On July 30, 2002, the President signed into law the “Sarbanes-Oxley Act of 2002” (the “SOA”). The stated goals of the SOA 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 SOA has resulted in broad corporate and accounting reform for public companies and the accounting firms that audit them. Many provisions of the SOA became effective immediately and others became effective since passage of the law or will become effective during 2003.
The SOA 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 Securities Exchange Act of 1934, or the “Exchange Act”. The SOA 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 SOA 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 a board of directors and management and between a board of directors and its committees.
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Various aspects of the new legislations have been or will be implemented by subsequent rulemaking by the SEC. We are currently evaluating what impact this new legislation and such regulations will have upon our operations, including a likely increase in certain outside professional fees.
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:
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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:
In addition, an implementing regulation under the Patriot Act regarding verification of customer identification by financial institutions has been proposed, although such regulation has not yet been finalized. 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 significant impact on 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 law also:
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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.
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:
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 national banks to engage in expanded activities through the formation of financial subsidiaries. A national bank may have a subsidiary engaged in any activity authorized for national 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.
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A national 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 national 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.
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, effective July 1, 2001, 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 to 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. Under such restrictions, the amount available for payment of dividends to Nara Bancorp by Nara Bank totaled $41.3 million at December 31, 2002. In addition, the OCC and the FRB 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.
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. The Federal Reserve Board has recently issued Regulation W, which codifies prior regulations under and 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:
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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:
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.
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 31,2002, 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, 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.
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
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for loan 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 1 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 1 capital to total assets must be 4%. 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”.
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, 2002.
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In addition, federal banking regulators may set capital requirements higher than the minimums described above for financial institutions whose circumstances warrant it. For example, a financial institution experiencing or anticipating significant growth may be expected to maintain capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets.
Basel Committee. In January 2001, the Basel Committee on Banking Supervision issued a proposal for a “New Capital Accord.” The New Capital Accord incorporates a three-part framework of minimum capital requirements, supervisory review of an institution’s capital adequacy and internal assessment process, and market discipline through effective disclosure to encourage safe and sound banking practices. The New Capital Accord is scheduled for implementation by the end of 2006. The new capital framework would consist of minimum capital requirements, a supervisory review process and the effective use of market discipline. In its proposal for minimum capital requirements, the Committee set out options from which banks could choose depending on the complexity of their business and the quality of their risk management. A standardized approach would refine the current measurement framework and introduce the use of external credit assessments to determine a bank’s capital charge. Banks with more advanced risk management capabilities could make use of an internal risk-rating based approach. Under this approach, some of the key elements of credit risk, such as the probability of default of the borrower, would be estimated internally by a bank. The Committee is also proposing an explicit capital charge for operational risk to provide for problems like internal systems failure. The supervisory review aspect of the new framework would seek to ensure that a bank’s capital position is consistent with its overall risk profile and strategy. The supervisory review process would also encourage early supervisory intervention when a bank’s capital position deteriorates. The third aspect of the new framework, market discipline, would call for detailed disclosure of a bank’s capital adequacy in order to encourage high disclosure standards and to enhance the role of market participants in encouraging banks to hold adequate capital. Banks must also disclose how they evaluate their own capital adequacy.
In July 2002, the Committee revised some aspects of the new proposed capital framework and confirmed a timetable for finalizing the new Capital Accord. The Committee intends to finalize the new Capital Accord in the fourth quarter of 2003, with planned implementation in each country by year-end 2006. Between 2003 and 2006, banks are expected to adapt and develop necessary systems and processes in conformance with the standards of the new Capital Accord.
At this time, we cannot predict whether the new Capital Accord will be adopted in the U.S. or in what form, or the effect it would have on the operations, financial condition or results of operations of Nara Bank.
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, 2002, 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 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
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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.
FDIC-insured depository institutions pay an assessment rate equal to the rate assessed on deposits insured by the Savings Association Insurance Fund (“SAIF”).
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, depending on the collective size of the particular institutions involved.
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 $0.0182 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.
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
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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. 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 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, 2002, we believe that Nara Bank was in compliance with these requirements.
Employees
As of December 31, 2002, we had 291 full-time equivalent employees. Our employees are not represented by a union or covered by a collective bargaining agreement. We have entered into a written employment agreement with Benjamin B. Hong, President and Chief Executive Officer. Management believes that its relations with its employees are good. See Item 4(a) below for a list of 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.
Deterioration of economic conditions in Southern 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 Southern California and in the greater New York City metropolitan area. A 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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Loan loss reserves may not cover actual loan losses. If our actual loan losses exceed the amount we have reserved 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 reserves for estimated loan losses in our accounting records. We base these allowances on estimates of the following:
A downturn in the real estate market could seriously impair our loan portfolio.As of December 31, 2002, approximately 48.7% of the value 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 on our spread and can greatly affect our income. In addition, interest rate fluctuation 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 lost 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 a property than the property is worth. We also could 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 Southern 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 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.
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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.
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 Comptroller of the Currency. 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. Our preferred stock, if issued, 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 our 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
SFAS No. 144, Accounting for Impairment or Disposal of Long-Lived Assets,was issued in October 2001 and requires that long-lived assets be measured at the lower of carrying amount or fair value less cost to sell, whether reported in continuing operations or in discontinued operations. It also expands the reporting of discontinued operations to include all components of an entity with operations that can be distinguished from the rest of the entity and that will be eliminated from the ongoing operations of the entity in a disposal transaction. SFAS No. 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001. The adoption of this statement is not expected to have a material impact on our financial position, results of operations, or cash flows.
Statement of Financial Accounting Standards (“SFAS”) No. 148, Accounting for Stock-based Compensation – Transition and Disclosure, an amendment of FASB Statement No. 123, amends SFAS No. 123 to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. It also amends the disclosure provisions of SFAS No. 123 to require prominent disclosure in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The provisions of SFAS No. 148 are effective for annual financial statements for fiscal years ending after December 15, 2002, and for financial reports containing condensed financial statements for interim periods beginning after December 15, 2002. We have not determined whether it will adopt the fair value based method of accounting for stock-based employee compensation.
The Financial Accounting Standards Board (“FASB”) issued Interpretation (FIN) No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees and Indebtedness of Other, an interpretation of SFAS Nos. 5, 57 and 107, and rescission of FIN No. 34, Disclosure of Indirect Guarantees of Indebtedness of Others, in November 2002. FIN No. 45 elaborates on the disclosures to be made by the guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and measurement provisions of the interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, while the provisions of the disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002. We believe the adoption of such interpretation will not have a material impact on its results of operations, financial position or cash flows.
The FASB issued FIN No. 46, Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51, in January 2003. FIN No. 46 requires that variable interest entities be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or is entitled to receive a majority of the entity’s residual returns or both. FIN No. 46 also requires disclosures about variable interest entities that companies are not required to consolidate but in which a company has a significant variable interest. The consolidation requirements of FIN No. 46 will apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements will apply to entities established prior to January 31, 2003
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in the first fiscal year or interim period beginning after June 15, 2003. We do not believe the adoption of such interpretation will have a material impact on our results of operations, financial position or cash flows.
Item 2. PROPERTIES
Our principal executive offices are located at 3701 Wilshire Blvd., Los Angeles, California 90010. We conduct our operations through nine full branch offices, five mini branch offices and four loan production offices located throughout California, in the greater New York City metropolitan area and in Chicago, Seattle, New Jersey, and Atlanta. We lease all of our offices. The leases expire under various dates, including options to renew, through January 31, 2041. We believe our present facilities are adequate for our present needs. We also believe that, if necessary, we could secure suitable alternative facilities or similar terms, without adversely impacting operations. The locations of our full branch offices, including our headquarters, are as follows:
Our four mini branches are located inside supermarkets and the Aroma office is located inside the Sports Center Building. The locations are as follows:
We currently have four loan production offices to promote SBA loans. We have SBA Preferred Lender status in those areas. The locations are as follows:
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.
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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, 2002.
Item 4(a). EXECUTIVE OFFICERS OF THE REGISTRANT
The following individuals are executive officers of Nara Bancorp. Pertinent information relating to these individuals is set forth below. There are no family relationships between any of the officers.
Benjamin B. Hong- Chief Executive Officer and President - Age 70
Mr. Hong has served as President and Chief Executive Officer of Nara Bank since 1994 and as President and Chief Executive Officer of Nara Bancorp since February 2001. Mr. Hong previously served as President and Chief Executive Officer of Hanmi Bank from 1988 to 1994.
Bon T. Goo- Executive Vice President and Chief Financial Officer - Age 53
Mr. Goo has served as Executive Vice President and Chief Financial Officer of Nara Bank since 1990 and as Executive Vice President and Chief Financial Officer of Nara Bancorp since February 2001. Mr. Goo previously served as Vice President and Manager of the Accounting, Investment and Control Division of Hanmi Bank from 1988 to 1990.
Min Jung Kim- Executive Vice President and Chief Credit Officer - Age 43
Ms. Kim has served as Executive Vice President and Chief Credit Officer of Nara Bank since 1995 and as Executive Vice President and Chief Credit Officer of Nara Bancorp since February 2001. Ms. Kim served as Vice President and Manager of the Western Branch of Hanmi Bank from 1992 to 1995.
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Part II
Item 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock, par value $0.001 per share, began trading on the Nasdaq National Market on February 5, 2001 under the symbol “NARA.” Prior to the formation of our holding company, the common stock of Nara Bank, par value $3.00 per share, also was traded on the Nasdaq National Market under the symbol “NARA” through February 2, 2001, which was Nara Bank’s last trading day.
There were 10,698,730 shares of common stock held by approximately 1,487 beneficial owners and 578 registered owners as of March 12, 2003. 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 and Nara Bank, as applicable, for each quarter within the last two fiscal years. Sales prices represent actual sales of which our management has knowledge.
Dividends
The following table shows cash dividends declared during 2002.
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. Any dividend must comply with applicable bank regulations.
Our 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.
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Our 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 us. The ability of Nara Bank to pay dividends to us is subject to restrictions set forth in the National Bank Act and the rules of the Office of Comptroller of the Currency. Pursuant to such regulations, among other restrictions, Nara Bank cannot pay dividends out of its capital; all dividends must be paid out of net profits then on hand, after deducting for expenses such as losses and bad debts. In addition, the payment of dividends out of net profits of a national bank is further limited by a statute which prohibits a bank from declaring a dividend on its shares of common stock until the surplus fund equals the amount of capital stock, or if the surplus fund does not equal the amount of capital stock, until not less than one-tenth of its net profits for the preceding half-year (in the case of quarterly dividends) or at least one-tenth of its net profits for the preceding year (in case of annual dividends) are transferred to the surplus fund.
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, for each of the years in the five-year period ended December 31, 2002. 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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Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion provides information about our results of operations, financial condition, liquidity, and capital resources. This information is intended to facilitate the understanding and assessment of significant changes and trends related to our financial condition and the results of our operations. This discussion and analysis should be read in conjunction with our Consolidated Financial Statements and the accompanying notes presented elsewhere herein.
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. The preparation of these financial statements 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.
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. Management considers this accounting policy to be a critical accounting policy. The judgments and assumptions used by management are based on historical data and management’s view of the current economic environment as described in “Allowance for Loan and Lease Losses and Methodology”.
We generally cease to accrue interest on any loan with respect to which the loan’s contractual payments are more than 90 days delinquent, as well as loans classified substandard for which interest payment reserves were established from loan funds rather than borrower funds. In addition, interest is not recognized on any loan for which management has determined that collection of our investment in the loan is not reasonably assured. A nonaccrual loan may be restored to accrual status when delinquent principal and interest payments are brought current, the loan is paying in accordance with its payment terms for a period, minimum six months, and future monthly principal and interest payments are expected to be allocated.
Properties acquired through foreclosure, or deed in lieu of foreclosure, are transferred to the other real estate owned portfolio and carried at the lower of cost or estimated fair value less the estimated costs to sell the property. The fair value of the property is based upon a current appraisal. The difference between the fair value of the real estate collateral and the loan balance at the time of transfer is recorded as a loan charge-off if fair value is lower. Subsequent to foreclosure, management periodically performs valuations and the property is carried at the lower of carrying value or fair value, less costs to sell. The determination of a property’s estimated fair value includes revenues projected to be realized from disposal of the property, construction and renovation costs.
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
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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 %. 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 in a write down or charge-off in the period of impairment.
As part of our asset and liability management strategy, we have entered 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. The objective for the interest rate swaps is to manage asset and liability positions in connection with our strategy of minimizing the interest rate fluctuations on interest rate margin and equity. The interest rate swaps qualify as cash flow hedges under Statement of Financial Accounting Standards (“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 Prime-indexed loans. 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 swaps that is deemed effective in hedging the cash flows of the designated assets is recorded as a component of accumulated other comprehensive income (“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 directly to the consolidated statement of earnings as a part of non-interest 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.
In accordance with SFAS No. 115, 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 (and are recorded at amortized cost). Accreted discounts and amortized premiums on securities are included in interest income using the interest method, and unrealized and realized gains or losses related to the holding or selling of securities are calculated using the specific identification method. All other securities are classified as available for sale with unrealized gains and losses excluded from earnings and reported in other comprehensive income. 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.
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 and investments and interest expense is generated from interest-bearing deposits and other borrowings that we may have, such as Federal Home Loan Bank borrowings, and trust preferred securities. 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 widely 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 also can 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 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.
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Net Earnings
Our net earnings before the cumulative effect of a change in accounting principle were $11.3 million for 2002 as compared to $10.8 million for 2001 and $10.5 million for 2000, representing an increase of 4.6% for 2002 and 2.9% for 2001. On a per diluted share basis, net earnings were $0.98, $0.93, and $0.99, respectively. The annualized return on average assets was 1.44% for 2002, as compared to 1.70% for 2001 and 2.18% for 2000. The annualized return on average equity was 18.17% for 2002, compared with 21.38% for 2001 and 30.31% for 2000.
The cumulative effect of the change in accounting principle, related to the one-time recognition of negative goodwill in the consolidated statement of earnings at January 1, 2002 in accordance with SFAS No. 142, resulted in an increase of $4.2 million of earnings, resulting in total net earnings for the year ended December 31, 2002 of $15.5 million or $1.35 per diluted share.
During 2002, the increase in net earnings was primarily attributable to higher net interest income resulting from growth in the loan portfolio and lower interest paid on interest-bearing liabilities. Net earnings in 2001 over 2000 also increased primarily due to growth in the loan portfolio despite a decline in net interest margin from a series of rate cuts by the Federal Reserve, and an increase in non-interest income offset by higher non-interest expenses
The following table summarizes increases and decreases, as applicable, in income and expense for the years indicated.
Operations Summary
Net Interest Income and Net Interest Margin
Net interest income was $35.1 million for the year ended December 31, 2002 as compared to $30.9 million for 2001 and $27.5 million for 2000. Net interest margin was 4.9% for the year ended December 31, 2002 as compared to 5.4% for 2001 and 6.6% for 2000. The Average interest-earning assets were $722.0 million for 2002 as compared to $572.2 million for 2001 and $416.8 million for 2000.
The increase of $4.2 million or 13.6% in net interest income for 2002 over 2001 was primarily due to an increase in loan portfolio. Despite the increase of $149.8 million or 26.2% in the average interest-earning assets, the net interest income only increased 13.6% due to a decrease in interest margin. Net interest margin decreased 50 basis points or 9.3% to 4.9% for 2002 from 5.4% for 2001. The decrease was due to 175 basis cut in prime rate during the 4th quarter of 2002, which fully repriced our quarterly adjusted loans as of January 1, 2002, and an additional 50 basis rate cut in November of 2002. However, we were able maintain the net interest spread at 4.0%.
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The increase of $3.4 million or 12.5% in net interest income for 2001 over 2000 also was due to an increase in average interest-earning assets. Despite the increase of $155.4 million or 37.3% in average interest-earning assets, net interest income only increased 12.5% due to a decrease in interest margin. Net interest margin decreased 120-basis points or 18.2% to 5.4% for 2001 from 6.6% for 2000. This was due to a 475 basis point drop in market interest rates during the year 2001.
Interest income
Interest income was $48.6 million for the year ended December 31, 2002 as compared to $47.9 million for 2001 and $41.6 million for 2000. The average yield on interest-earning assets was 6.7% for the year ended December 31, 2002 as compared to 8.4% for 2001 and 10.0% for 2000.
The increase of $711,000 or 1.5% in interest income in 2002, as compared to 2001 was primarily due to an increase in loan portfolio. Average interest-earning assets increased $149.8 million or 26.2% to $722.0 million for 2002 from $572.2 million for 2001. Interest and fee income on loans (including the effect of interest rate swaps) increased $2.4 million or 5.9% to $42.9 million for 2002 from $40.5 million for 2001. This increase is primarily due to 34.2% increase in average net loan portfolio to $600.1 million for 2002, from $447.2 million for 2001. Approximately $12.0 million is attributable to growth in loan volume, and negative $9.6 million is attributable to rate decrease. The average yield on net loans decreased to 7.2% in 2002, from $9.0% in 2001. Interest income on securities and other investments slightly increased $300,000 or 6.1% to $5.2 million for 2002 from $4.9 million for 2001, primarily due to an increase in investment securities portfolio.
The increase of $6.3 million or 15.0% in interest income in 2001, as compared to 2000 was primarily due to growth in interest-earning assets, mostly in loan portfolio. Average interest-earning assets increased $155.4 million or 37.3% to $572.2 million for 2001, from $416.8 million for 2000. Interest and fee income on loans increased $6.3 million or 18.4% to $40.5 million for 2001, from $34.2 million for 2000. This increase is primarily due to growth in loan portfolio offset by lower yields. Average net loans increased $139.8 million or 45.5% to $447.2 million for 2001, from $307.4 million for 2000. The average yield earned on net loans decreased to 9.0% in 2001, from 11.1% in 2000. Approximately $13.5 million is attributable to growth in loan volume, and negative $7.3 million is attributable to rate decrease. The decrease is primarily due to series of rate cuts made by the Federal Reserve during the year. Interest income on securities and other investments increased $1.3 million or 36.1% to $4.9 million in 2001 from $3.6 million in 2000, mainly due to an increase in the investment portfolio.
Interest Expense
Deposits
Interest expense on our deposits was $10.6 million for the year ended December 31, 2002 as compared to $15.5 million for 2001 and $13.7 million for 2000. The average cost of interest-bearing deposits was 2.4% for the year ended December 31, 2002 as compared to 4.2% for 2001 and 5.0% for 2000.
The decrease of $4.9 million or 31.6% in interest expense on deposits for 2002, as compared to 2001, was primarily due to a decrease in the cost of deposits despite the increase in average interest-bearing deposits. Average interest-bearing deposits increased $70.0 million or 18.9% to $440.2 million for 2002, from $370.2 million. The decrease in the cost of our deposits was primarily due to the lower interest rate environment and repricing of higher-cost certificates of deposits. The cost of our average interest-bearing deposits decreased 177 basis points during the year.
The decrease of $1.8 million or 11.6% in interest expense on deposits for 2001, as compared to 2000, was also due to decrease in the cost of deposits. The cost of deposits decreased 85 basis points or 20.3% while the average interest-bearing deposits increased $98.1 million or 36.1% to $370.2 million for 2001 from $272.1 million for 2000. The decrease in the cost of our deposits was also due to the decrease in rates paid on all interest-bearing deposits, predominantly on certificate of deposits.
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Borrowings
Interest expense on our borrowings, including trust preferred securities, was $2.9 million for the year ended December 31, 2002 as compared to $1.5 million for 2001 and $460,000 for 2000. The average cost of borrowings was 4.8% for the year ended December 31, 2002 as compared to 9.0% for 2001 and 8.6% for 2000.
The increase of $1.4 million or 93.3% in interest expense on borrowings for 2002, as compared to 2001, was primarily due to increase in average balance partially offset by lower funding costs. The increase in average balance was due to additional issuance of trust preferred securities of $8.0 million and an increase in Federal Home Loan Bank advances offset by payoff of subordinated notes with a 9% interest rate. The borrowings from Federal Home Loan Bank increased to $65.0 million at December 31, 2002, from $5.0 million at December 31, 2001. The decrease in the average cost of borrowings was due to a lower interest rate environment.
The increase of $1.0 million or 226% in interest expense on borrowings for 2001, as compared to 2000, was due to an increase in borrowings during the year. The average balance on borrowings increased $11.3 million or 209.3% to $16.7 million for 2001 from $5.4 million for 2000. The increase in balance was due to issuance of $10.0 million in trust preferred securities and FHLB advances.
Net Yield and Interest Rate Spread
We analyze our earnings performance using, among other measures, the interest rate spread and net yield on interest-earning assets. The interest rate spread represents the difference between the interest yield received on interest-earning assets and the interest 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 yield on interest-earning assets or net interest margin. Our net yield on interest-earning assets is affected by changes in the yields earned on assets and rates paid on liabilities, referred to as rate changes.
Interest rates charged on the 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 action 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 interest rate spread and net yield on interest-earning assets for each year in the three-year period ended December 31, 2002.
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Average Balance Sheet and Analysis of Net Interest Income
[Additional columns below]
[Continued from above table, first column(s) repeated]
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The following table shows 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 dollars amounts attributable solely to the change in volume and to the change in rate.
Provision for loan losses
The provision for loan losses on loans and leases was $2.7 million for the year ended December 31, 2002 as compared to $750,000 for 2001 and recapture of $1.1 million for 2000. The increase of $1.94 million or 258.7% in the provision for loan losses for 2002, as compared to 2001, was primarily due to growth in the loan portfolio. The gross loan portfolio (net of unearned) increased $220.9 million or 43.4% during 2002. The increase of $1.85 million or 168.2% in the provision for loan losses for 2001, as compared to 2000, was also due to growth in the loan portfolio. The gross loan portfolio increased $146.5 million or 40.4% during 2001. We use a systematic methodology to calculate the 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.
Refer to the section “Financial Condition- Allowance for Loan Losses” for a description of our systematic methodology employed in determining an adequate allowance for loan losses.
Noninterest Income
Noninterest income was $18.0 million for the year ended December 31, 2002 as compared to $15.3 million for 2001 and $13.5 million for 2000. The increase was $2.7 million or 17.5% in 2002 and $1.8 million or 13.4% in 2001.
The increase in noninterest income in 2002, as compared to 2001, was primarily due to increases in gains on SBA loan sales and SBA servicing income, service charges on deposits, and gains on interest rate swaps that we entered into during 2002. Gain on sale of SBA loans increased $1.4 million or 87.5% to $3.0 million in 2002, from $1.6 million in 2001. We sold a total of $50.0 million in 2002, which was an increase of $19.2 million or 62.3%
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from $30.8 million in 2001. Service charges on deposits increased an approximately $400,000 or 6.8% to $6.3 million for 2002, from $5.9 million for 2001. This was due to an increase in demand deposits and an increase in fees on certain items, which became effective July of 2002. In 2002, we also recognized a gain of $442,000 from interest rate swap transactions, which qualified for cash flow hedge accounting.
The increase in noninterest income for 2001, as compared to 2000, was primarily due to increases in gains on sale of SBA loans and investment securities. The gains on sales of SBA loans increased approximately $900,000 or 131.8% to $1.6 million in 2001. Total sale of SBA loans increased $16.6 million or 116.9% to $30.8 million in 2002, from $14.9 million in 2002. During 2001, we also recognized $917,000 of gains from the sale of investment securities, which totaled $16.5 million in book value. The earnings on cash surrender value increased $197,000 or 73.8% to $464,000 in 2001, compared to $267,000 in 2000. This increase was due to additional purchases of Bank- Owned Life Insurance of $1.8 million for Benjamin Hong and $3.2 million for s group of key employees during 2001.
The breakdown of noninterest income by category is reflected below:
Noninterest Expense
Noninterest expense was $32.3 million for the year ended December 31, 2002 as compared to $28.4 million for 2001 and $24.8 million for 2000. The increase was $3.9 million or 13.7% in 2002 and $3.6 million or 14.5% in 2001.
The increase in noninterest expense in 2002, as compared to 2001, was primarily due to increases in salaries and benefits, and advertising expenses. Salaries and benefit expense increased approximately $1.2 million or 7.5% to $17.3 million in 2002, from $16.0 million in 2001. This was due to new employees being hired during the 2nd half of 2001 for new branches as well as addition of personnel for specialized areas, such as compliance, internal audit, and legal to accommodate our growth and to assist us in complying with the Stipulation and Consent to the Issuance of a Consent Order signed with the Office of the Comptroller of the Currency. Advertising and marketing-related expense increased approximately $665,000 or 77.5% to $1.5 million in 2002, from $858,000 in 2001. This was due to television advertisements we launched in 2002 in California as well as New York.
The increase in noninterest expense in 2001, as compared to 2000, was primarily due to increase in salaries and benefit expenses, occupancy expense. Salaries and benefits increased $2.4 million or 17.6% to $16.0 million in 2001, from $13.6 million in 2000. This increase was primarily due increased bonus expense to compensate employees and the additional staffing for the newly opened branches during 2001. Occupancy expenses associated with new branches increased approximately $471,000 or 14.3% to $3.8 million in 2001, from $3.3 million in 2000. Furniture and equipment expenses also increased $237,000 or 21.5% to $1.3 million in 2001, from $1.1 million in
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2000.These increases also were primarily due to the opening of additional branches opened during 2001 and partly due to leasehold improvements made in our New York branches.
Our regulatory fees increased $87,000 or 21.5% to $491,000 in 2001, compared to $404,000 in 2000. The increase primarily came as the result of an increase in the OCC’s assessment fees, which are calculated based on our asset size. Communication expenses also increased $154,000 or 32.2% to $632,000 in 2001, compared to $478,000 in 2000. This increase was mainly due to upgrading and installing data lines to accommodate faster network services. Directors’ fees increased $73,000 or 24.2% to $375,000 in 2001, compared to $302,000 in 2000, as a result of electing new Directors for Nara Bancorp, in 2001. Other income decreased by 48.0%, mainly due to a discontinuation of lease income received from the Manhattan building, which was sold at the end of year 2000. The lease income totaled approximately $439,000 in year 2000.
A breakdown of noninterest expenses by category is reflected below:
Provision for Income Taxes
The provision for income taxes on income before taxes and cumulative effect of a change in accounting principle for the year ended December 31, 2002 was $6.8 million as compared to $6.3 million in 2001 and $6.8 million in 2000. The effective tax rate was 37% for 2002 (excluding the impact of the cumulative effect of a change in accounting principle which was not tax effected) as compared to 37% for 2001 and 39% for 2000. The reduction in 2002, as compared to 2001, was primarily due to a $210,000 tax benefit resulting from a California State tax law change in which one-half of the cumulative loan losses through December 31, 2001 taken for income tax purposes were forgiven, and an increase in tax-exempt investment securities. The reduction in 2001, as compared to 2000, was primarily due to the state income tax benefits related to the acquisition of KFBNY.
Financial Condition
Our total assets were $979.2 million at December 31, 2002 as compared to $679.4 million at December 31, 2001 and $602.6 million at December 31, 2000. The increase was $299.8 million or 44.1% for 2002 and $76.8 million or 12.7% for 2001. The increase in total assets from 2001 to 2002 was primarily due to growth in our loan and investment portfolio. Net loans, including loans held for sale, increased $219.3 million or 43.7% for 2002 and the investment securities increased $34.9 million or 50.2% in the year. These increases were funded by deposits and FHLB borrowings. The increase in total assets from 2000 to 2001 was also due to growth in our loan portfolio. Net loans increased $146.4 million or 41.2% during the 2001. The details are discussed below.
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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.
As of December 31, 2002, held-to-maturity securities totaled $2.8 million, compared to $4.3 million at December 31, 2001, and available-for-sale securities totaled $101.6 million at December 31, 2002, compared to $65.1 million at December 31, 2001. The decrease in held-to-maturity securities is primarily due to agency bonds that were called during 2002 as a result of decreases in interest rates. During 2002, a total of $25.2 million in agency securities were called, matured or paid down, $45.6 million were sold and $105.6 million were purchased, all classified as available- for- sale. From the investment portfolio, securities with amortized cost of approximately $3.5 million and $2.5 million were pledged to Federal Reserve Board as required or permitted by law at December 31, 2002 and 2001, respectively. We also pledged $21.8 million with Federal Home Loan Bank of San Francisco and $40.0 million with California State Treasurer’s Office. The investment portfolio consists of government sponsored agency bonds, mortgage backed securities, bank qualified California municipals, CMOs and corporate bonds. This investment portfolio composition reflects our investment strategy.
The following table summarizes the maturity of securities based on carrying value and their pertinent weighted average yield ratios for year 2002:
Loan Portfolio
Our net loans (net of allowance for loan losses), including loans held for sale, were $721.4 million at December 31, 2002 as compared to $502.1 million at December 31, 2001 and $355.7 million at December 31, 2000. The increase in net loans was $219.3 million or 43.7% for 2002 and $146.4 million or 41.2% for 2001. Net loans, as a percentage of our total interest-earnings assets, were 79.8% at December 31, 2002 as compared to 81.6% at December 31, 2001 and 66.7% at December 31, 2000. The average net loans were $600.1 million, $447.2 million, and $307.4 million at December 31, 2002, 2001, and 2000, respectively. As a result of continued focus on commercial lending activities, loan growth remained concentrated in commercial loans, including commercial real estate loans. The table below sets for the composition of our loan portfolio by type.
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The average net loans for 2002 increased $152.9 million or 34.2% from 2001. From the total increase, approximately $49.3 million or 32.2% was contributed by the New York opeartions. The net loans in the New York region increased $46.2 million or 32.8% to $187.2 million at December 31, 2002, from $141.0 million at December 31, 2001. The average net loans for 2001 increased $139.8 million or 45.5% from 2000. From the total increase, approximately 42.8% was contributed by the branches in the New York operations. The net loans in the New York region increased $62.7 or 80.1% to $141.0 million at December 31, 2001, compared to $78.3 million at December 31, 2000.
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 (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. The commercial loan portfolio also includes SBA loans held for sale. During 2002, our commercial loans increased $107.7 million or 51.0% to $318.9 million at December 31, 2002, from $211.2 million at December 31, 2001. Commercial loans also increased $71.7 million or 51.4% to $211.2 million at December 31, 2001, from $139.5 million at December 31, 2000.
Commercial Real estate Loans
Our real estate loans consist primarily of loans secured by deeds of trust on commercial property. It is our policy to restrict real estate loans 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 $104.1 million or 41.4% to $355.8 million at December 31, 2002, from $251.7 million at December 31, 2001. Real estate loans also increased $73.9 million or 41.6% to $251.7 million at December 31, 2001, from $177.8 million at December 31, 2000.
Most of our consumer loan portfolio consists of automobile loans, home equity lines and loans, and savings-secured loans. Nara Bank began originating automobile loans in early 1995. Referrals from automobile dealers comprise the majority of our origination of such loans. We also offer fixed-rate loans to buyers of new and previously owned automobiles who are not qualified for automobile dealers’ most preferential loan rates. We carry all loans at face amount, less payments collected, net of deferred loan origination fees 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 basis when principal and interest on a loan is past due 90 days or more, unless a loan is both well-secured and in process of collection.
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 86.0% of our net loans were variable-rate loans at December 31, 2002.
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, 2002, our lending limit was approximately $13.4 million for unsecured loans. 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% of our total capital and the allowance for loan losses.
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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 do not normally make loan commitments in material amounts for periods in excess of one year. Our undisbursed commercial loan commitments at December 31, 2002, 2001, and 2000 were $114.7 million, $146.2 million, and $87.9 million, respectively.
The following table shows our loan commitments and letters of credit outstanding at the dates indicated:
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Non-performing Assets
Non-performing assets consisted of non-accrual loans, loans 90 days or more past due and still accruing interest, loans restructured 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 past due, unless the loan is both well- secured and in the process of collection. Loans may be placed on nonaccrual status earlier if, in management’s opinion, the full and timely collection of principal or interest becomes uncertain. When a loan is placed on nonaccrual 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 $2.2 million at December 31, 2002 as compared to $1.8 million at December 31, 2001 and $2.3 million at December 31, 2000. The increase in total non-performing assets in 2002, as compared to 2001, was primarily due to $1.1 million of restructured loans. During 2002, five loans totaling $ 1.2 million were restructured, which are all current at December 31, 2002.
Non-performing loans were $1.1 million at December 31, 2002 as compared to $1.8 million at December 31, 2001 and $2.0 million at December 31, 2000. The decrease of $700,000 or 35.3% in 2002 as compared to 2001 was primarily due to restructured and charged-off loans. The decrease of $282,000 or 13.8% in 2001, as compared to 2000, was also due to a $1.2 million loan that was subsequently charged off in February of 2001.
The following table illustrates the composition of our nonperforming assets as of the dates indicated
We own other real estate, taken through foreclosure, in aggregate amount of $36,000 and $263,000 at December 31, 2002 and 2000, respectively. We did not own any other real estate at December 31, 2001. We incurred $11,000 and $16,000 in expenses in 2002 and 2000, respectively. There was no expense incurred through OREO transactions in 2001. We reserved $8,000 and $37,000 at December 31, 2002 and 2000, respectively, 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 shows the maturity distribution and repricing interval of the loans outstanding as of December 31, 2002. In additional, the table show 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 a multiple 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 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, which is comprised of six officers including the Chief Executive Officer, Chief Credit Officer and Chief Financial Officer. 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 type of the loan being made, the credit-worthiness or history of the borrower over the term of the loan, security for the loan and cash flow of the borrower. We closely monitor loans that management has determined require further supervision because of the loan size, loan structure, and/or complexity of the borrower. These loans are periodically reviewed by the Management Loan Committee.
When principal or interest on a loan is past due 90 days or more, 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 established to provide for loan losses that can be reasonably anticipated. 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 quarterly. The results of both internal and external loan reviews are used to determine the loan loss reserve. Our current loan review system takes into consideration such factors as the current financial condition of the borrower, the value of security, future 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 $8.5 million at December 31, 2002 as compared to $6.7 million at December 31, 2001 and $7.0 million at December 31, 2000. The allowance for loan losses increased $1.8 million or 26.9% at December 31, 2002, as compared to December 31, 2001, primarily due to the continued growth of the commercial loans and real estate portfolios. We recorded a provision of $2.7 million during 2002, compared to $750,000 in 2001. During 2002, we charged off $2.4 million and recovered $1.4 million. The allowance loan losses was 1.16% of gross loans at December 31, 2002 as compared to 1.32% at December 31, 2001 and 1.92% at December 31, 2000. This decrease in the ratio was primarily due to an increase in real estate loans, which requires less reserve due to low historical loss, under our methodology and a decrease in our classified loans. Total classified loans at December 31, 2002 were $2.5 million, compared to $4.1 million at December 31, 2001.
Specific reserves for impaired loans in accordance with SFAS No. 114, were $1.3 million at December 31, 2002 as compared to $1.4 million at December 31, 2001 and $1.9 million at December 31, 2000. Our management and Board of Directors 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, 2002, to absorb estimated losses associated with 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 loss reserves. If there are further losses, they may have a negative impact on our earnings.
We believe that the allowance for loan losses is adequate to cover all reasonably anticipated losses in our loan portfolio. However, no assurance can be given that future economic conditions will not adversely affect our service areas or that other circumstances, including circumstances beyond our control, will not result in increased losses in our loan portfolio, which could possibly exceed the total allowance for loan losses.
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 possible loan losses at the beginning and end of each period, the amount of average and total loans outstanding, and other pertinent ratios as of the dates and for the periods indicated :
The reserve for losses on commitments to extend credit and letters of credit is primarily related to undisbursed funds on lines of credit. We evaluate credit risk associated with the loan portfolio at the same time we evaluate credit risk associated with the commitments to extend credit and letters of credits. However, the
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allowances necessary for the commitments is reported separately in other liabilities in the accompanying consolidated statements of financial conditions, and not as part of the allowance for loan losses, as presented above. The reserve for losses on commitments to extend credit and letters of credit was $333,000 and $437,000 and at December 31, 2002 and 2001, respectively.
Allowance For Loan Losses Methodology
We maintain an allowance for loan and lease losses (“Allowance”) in an amount believed to be adequate to absorb the estimated known and inherent losses identified in the loan portfolio for the next twelve months. Our methodology for determining the adequacy of the Allowance is based on a consistent and comprehensive analysis that is performed quarterly by management. By assessing the probable estimated losses inherent in the loan portfolio on a quarterly basis, we are able to adjust specific and inherent loss estimates based upon the most recent information that has become available.
We use three different methodologies to determine the adequacy of the Allowance: (1) the Migration Analysis; (2) the Reasonableness Test; and (3) the Specific Allocation method.
The Migration Analysis is a formula method based on our actual historical net charge-off experience for each loan type pool and undisbursed commitments graded Pass (less cash secured loans), Special Mention, Substandard, and Doubtful.
We use an eight-quarter rolling average of historical losses detailing charge-offs, recoveries, and loan type pool balances to determine the estimated credit losses for non-classified and classified loans. Also, in order to reflect the impact of recent events, the eight-quarter rolling average has been weighted. The most recent four quarters have been assigned a 60% weighted average and the older four quarters have been assigned a 40% weighted average.
The resultant migration risk factors, or our established minimum risk factor for loan type pools that have no historical loss, whichever is greater, for each loan type pool is used to calculate our General Reserve. For loan type pools that have no historical loss, we have established a minimum risk factor for each loan grade dependent on loan types Pass (0.40% - 2.26%), Special Mention (3.0% - 6.77%), Substandard (7.0% - 84.14%), Doubtful (50.0%-100.0%), and Loss (100.0%).
For unfunded/undisbursed commitments and contingent liabilities, we use 50.0% of the migration/minimum risk factor for loans graded Pass, due to the fact that in many cases the Bank has the option of freezing or withholding unfunded loan proceeds if the Bank becomes aware of a problem or potential problem with the borrower. For graded loans (Special Mention, Substandard, Doubtful, and Loss), 100% of the migration/minimum risk factor is assigned to the unfunded/undisbursed commitments and contingent liabilities.
For identified impaired loans, if the calculated impairment is less than the migration risk factor, the migration risk factor is used. If the calculated impairment is greater than the migration risk factor, the General Reserve is increased by the amount of the difference.
Additionally, in order to systematically quantify the credit risk impact of trends and changes within the loan portfolio, we subjectively, within established parameters, make adjustments to the Migration Analysis for:
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Our parameters for making adjustments are established under a Credit Risk Matrix that provides seven possible scenarios for each of the above factors. The matrix allows for 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 impact (neutral) to our 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 Migration Analysis as much as 50 basis points in either direction (positive or negative) for each loan type pool.
The Reasonableness Test is based on a national historical loss experience for each loan graded Special Mention, Substandard, Doubtful, and Loss; and an established minimum for loans graded Pass. The reserve factors applied under this method are: 1.0% for loans graded Pass; 5.0% for loans graded Special Mention; 15.0% for loans graded Substandard; 50.0% for loans graded Doubtful; and 100.0% for loans graded Loss. This method in not intended to substitute or override the Bank’s other methodologies, but rather is used for comparative purposes.
Under the Specific Allocation method, management establishes specific allowances for loans where management has identified significant conditions or circumstances related to a credit that is believed to indicate the probability that a loss may be incurred. The specific allowance amount is determined by a method prescribed by the Statement of Financial Accounting Standards (SFAS) No. 114, “Accounting by Creditors for Impairment of a Loan.” Our actual historical repayment experience and the borrower’s cash flow, together with an individual analysis of the collateral held on a loan, is taken into account in determining the allocated portion of the required allowance under this method. As estimations and assumptions change, based on the most recent information available for a credit, the amount of the required specific allowance for a credit will increase or decrease. The Migration Analysis risk factor is used to determine the unallocated portion of the required Allowance under this method. By analyzing the identified credits on a quarterly basis, we are able to adjust a specific allowance based upon the most recent information that has become available.
Deposits are our primary source of funds to use in lending and investment activities. Our deposits consist of demand deposits, savings deposits, money market, super-NOW, and time deposits with various maturities. Total deposits were $816.9 million at December 31, 2002 as compared to $589.8 million at December 31, 2001 and $527.7 million at December 31, 2000. The increases were $227.1 million or 38.5% for 2002 and $62.1 million or 11.8% for 2001. On November 29, 2002, we assumed $49.6 million in deposits and $1.3 million in loans from The Industrial Bank of Korea, New York (“IBKNY”), which accounted for 21.8% of the total increase in deposits. Excluding this transaction, the internal deposit growth amounted to $177.5 million or 30.1% in 2002.
The increase in deposits during 2002 comprised increases in non-interest bearing deposits of $37.8 million or 19.0%, time deposits of $127.1 million or 55.8%, and savings of $62.4 million or 79.1%, offset by a slight decrease in interest-bearing demand accounts of $ 0.2 million or 0.2%. The increases are attributed to continued momentum from various promotions intended to attract deposits. Total deposits in the New York region increased $93.2 million or 56.3% to $ 258.8 million at December 31, 2002, compared to $165.6 million at December 31, 2001.
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Total deposits in Northern California increased $13.9 million or 21.3% to $79.3 million at December 31, 2002, compared to $65.4 million at December 31, 2001.
Included in time deposits of $354.8 million at December 31, 2002 are $45.3 million of brokered deposits and $35 million of State deposits, compared with $ 5.0 million of brokered deposits and $10.0 million of State deposits at December 31, 2001. Although we occasionally 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 a less costly source of funds in comparison to time deposits. Detail of those deposits is shown on the table below.
The increase in deposits during 2001 comprised of increases in non-interest bearing deposits of $6.2 million or 3.2%, time deposits of $24.7 million or 12.5%, savings of $29.1 million or 58.4%, and interest-bearing demand accounts of $ 2.1 million or 2.5%. All of these increases were primarily due to new deposits accounts and changes in balances of existing accounts. Average deposits increased $121.4 million or 28.3% to $550.3 million at December 31, 2001, compared to $428.9 million at December 31, 2000. From the total increase of $62.1 million, approximately $21.2 million or 34.1% was attributable to the branches in the New York region Total deposits in the New York region increased $21.2 million or 14.7% to $165.6 million at December 31, 2001, compared to $144.4 million at December 31, 2000. Total deposits in Northern California increased $9.3 million or 16.6% to $65.4 million at December 31, 2001, compared to $56.1 million at December 31, 2000. This increase was attributable to the Oakland branch, which opened during 2000.
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 $100,000 or more, for the years indicated.
Other Borrowings
On September 30, 1999, we issued five-year subordinated capital notes in the aggregate amount of $4.3 million with a stated interest rate of 9.0%, maturing on September 30, 2004. Interest on the notes is payable quarterly and no scheduled payments of principal were due prior to maturity. The notes were redeemable prior to their maturity as of or after September 30, 2002. The notes qualified as Tier 2 risk-based capital under Comptroller of the Currency guidelines for assessing regulatory capital. For the total risk-based capital ratio, the amount of notes that qualify as capital is reduced as those notes approach maturity. On September 30, 2002, we repaid the entire principal and the accrued interest to the note holders according to the note agreement.
During 2000, we established a borrowing line with the FHLB of San Francisco. Advances may be obtained from the FHLB of San Francisco to supplement our supply of lendable funds. Advances from the FHLB of San Francisco typically are secured by pledges of mortgage loans and/or securities, with a market value at least equal to outstanding advances. The following table shows our outstanding borrowings from FHLB at December 31, 2002.
Nara Bancorp established special purpose trusts in 2001 and 2002 for the purpose of issuing Preferred Trust Securities (the “Trust Securities”). The trusts exist for the sole purpose of issuing Trust Securities and investing the proceeds thereof in Junior Subordinated Debentures issued by Nara Bancorp. Payment of distributions out of the monies held by the trusts and payments on liquidation of the trusts or the redemption of the Junior Subordinated Debentures are guaranteed by Nara Bancorp to the extent the trusts have funds available thereof. The obligation of Nara Bancorp under the guarantees and the Junior Subordinated Debentures are subordinate and junior in right of payment to all indebtedness of Nara Bancorp and are structurally subordinated to all liabilities and obligations of Nara Bancorp’s subsidiaries. The table below summarizes the outstanding Junior Subordinated Debentures issued by each special purpose trust and the debentures issued by Nara Bancorp to each trust as of December 31, 2002.
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(Dollars in thousands)
The Junior Subordinated Debentures are not redeemable prior to June 8, 2011 with respect to Nara Bancorp Capital Trust I and March 26, 2007 with respect to Nara Statutory Trust II unless certain events have occurred. During November of 2002, $10 million of the total proceeds from the issuance of the Trust Securities were injected into Nara Bank, as permanent capital.
Capital Resources
Historically, our primary source of capital has been the retention of operating earnings. In order to ensure adequate levels of capital, we conduct ongoing assessments of projected sources and uses of capital in conjunction with projected increases in assets and level of risk. We have considered, and we will continue to consider, additional sources of capital as the need arises, whether through the issuance of additional securities, debt or otherwise.
Our total stockholders’ equity was $65.4 million at December 31, 2002 as compared to $55.4 million at December 31, 2001 and $44.5 million at December 31, 2000. This was an increase of $10.0 million or 18.1% for 2002 and $10.9 million or 24.5% for 2001. At December 31, 2002, Tier 1 Capital, stockholders’ equity less intangible assets, plus proceeds from the trust preferred securities, was $77.9 million. This increase was due to an additional $8.0 million Trust Preferred and net income of $15.5 million offset by stock repurchases of $6.4 million and cash dividend of $2.2 million during the year. At December 31, 2002, Nara Bancorp had a ratio of total capital to total risk-weighted assets of 10.7% and a ratio of Tier 1 Capital to total risk weighted assets of 9.6%. The Tier 1 leverage ratio was 8.7% at December 31, 2002. Nara Bank had a ratio of total capital to total risk-weighted assets of 11.1%, a ratio of Tier 1 Capital to total risk weighted assets of 10.0%, and Tier 1 leverage ratio was 9.3% at December 31, 2002.
At December 31, 2001, Tier 1 Capital, stockholders’ equity less intangible assets, plus proceeds from the trust preferred securities, was $63.4 million. This represents an increase of $20.7 million or 48.5% over Tier 1 Capital of $42.7 million at December 31, 2000. At December 31, 2001, Nara Bancorp had a ratio of total capital to total risk-weighted assets of 12.4% and a ratio of Tier 1 Capital to total risk weighted assets of 10.9%. The Tier 1 leverage ratio was 9.7% at December 31, 2001. Nara Bank had a ratio of total capital to total risk-weighted assets of 10.9%, a ratio of Tier 1 Capital to total risk weighted assets of 9.6%, and Tier 1 leverage ratio was 8.5% at December 31, 2001.
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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 pay anticipated deposit withdrawals and any other maturing financial obligations promptly and fully in accordance with their terms. Liquidity management involves our ability to convert assets into cash or cash equivalents without incurring significant loss, and to raise cash or maintain funds without incurring excessive cost.
In general, liquidity risk is managed daily by controlling the level of federal funds and the use of funds provided by the 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 bonds maturing in the near future can also serve as a contingent source of funds. Increases in deposit rates are considered a last resort as a means of raising funds to increase liquidity.
For deposits, our primary source of funds, we maintain a deposit policy under which we endeavor to match our interest-bearing liabilities to fund interest-earning assets as closely as possible. We also endeavor to cover all volatile funds with liquid assets, as a method to ensure adequate liquidity. Thus, we analyze our deposits’ maturities and interest rates in order to monitor and control the cost of funds and review the stability of our supply of funds.
At times when we have more funds than the amount we need for our reserve requirements or short-term liquidity needs, we sell federal funds to other financial institutions. On the other hand, when we have less funds than we need, we are allowed to borrow funds from both correspondent banks and the Federal Reserve Bank (“FRB”). The maximum borrowing amount from our correspondent banks is $13 million on an overnight basis. In addition to the correspondent banks, the maximum borrowing amount from the FRB discount window is 97% of the market value of the pledged security. At December 31, 2002, the par value of the pledged security was $2.0 million . We also have an available borrowing line with the Federal Home Loan Bank of San Francisco of up to 25% of our total assets. At December 31, 2002 and 2001, we had $65.0 million and $5.0 million of advances outstanding from Federal Home Loan Bank, respectively.
We maintain a portion of our funds in interest-bearing cash deposits with other banks, sell funds to other banks overnight (federal funds sold), and investment securities available-for-sale. The liquid assets were $33.0 million at December 31, 2002 as compared to $124.1 million at December 31, 2001 and $187.4 million at December 31, 2000. At December 31, 2001, our liquidity level was 18.3% totaling $124.1 million, reflecting a $63.3 million decrease compared to a liquidity level of $187.4 million at 2000 year-end. The decrease was mainly due to $57.5
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million decrease in federal funds sold from $99.7 million at 2000 year-end to $42.2 million at 2001 year-end. At December 31, 2002, our liquid assets included cash and cash equivalents, federal funds sold, interest-bearing deposits in other banks with maturities of one year or less, and available-for-sale investment securities not pledged. At December 31, 2002, cash and cash equivalents, including federal funds sold, totaled $ 104.7 million as compared to $72.6 million at December 31, 2001 and $132.7 million at December 31, 2000.
Because our primary sources and uses of funds are loans and deposits, 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 our loan portfolio to provide for short-term liquidity needs. Because repayment of 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 2002, our gross loan to deposit ratio averaged 93.4%, compared to an average ratio of 82.6% for 2001 and a ratio of 73.6% for 2000.
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES OF 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 asset 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 characteristic 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 internal analyses to measure, evaluate and monitor 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, or to future cash flow 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 asset and liability management is to manage interest rate risk associated with changing asset and liability cash flows and values and market interest rate movements. The management of interest risk is governed by policies reviewed and approved annually by the Board of Directors. Our Board delegates responsibility for interest 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 the ALCO is to manage our exposure to interest rate fluctuations while maintaining adequate levels of liquidity and capital. The 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 balance sheet. 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 rate on other types may lag behind. We consider the anticipated effects of these factors when implementing our interest rate risk management objectives.
Swaps
As part of our asset and liability management strategy, we may engage in 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
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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 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 statement 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 (“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 statement of earnings as a part of non-interest income. As of December 31, 2002, the amounts in accumulated OCI associated with these cash flows totaled $1,801,683 (net of tax of $1,201,121), of which $815,998 is expected to be reclassified into interest income within the next 12 months.
Interest rate swaps information at December 31, 2002 is summarized as follows:
During 2002, interest income was increased by $990,213 received from swap counterparties. No such swap contracts were held during 2001 or 2000. At December 31, 2002, we pledged to the interest rate swap counterparty as collateral agency securities with a book value of $2.0 million and real estate loans of $2.0 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 balance sheet, 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 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. Negative cumulative gaps suggest that earnings will increase when interest rates fall.
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The following table illustrates our combined asset and liability repricing as of December 31, 2002:
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, 2002, the sensitivity of our forecasted net interest income to changing interest rates, both a rising and falling interest scenario were projected and compared to a 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, 2002, our net interest income and market value of equity expose 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 Nara Bank’s net interest income. These estimates are based upon a number of assumptions including; the nature and 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 cashflow. While the
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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 might change.
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Consolidated Financial Statements, together with the report thereon of Deloitte & Touche LLP dated February 28, 2003, begin at page F-1 of this Report and contain the following:
Independent Auditors’ Report
See “Item 14. Exhibits, Financial Statements Schedules and Reports on Form 8-K” below for financial statements filed as a part of this Report.
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None
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PART III
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Incorporated herein by reference is the information from the section entitled “Election of Directors” from Nara Bancorp’s definitive Proxy Statement, to be filed with the SEC within 120 days after December 31, 2002. Reference is also made in connection with the list of Executive Officers, which is provided under Item 4(a), “Executive Officers of the Registrant.”
Item 11. EXECUTIVE COMPENSATION
Incorporated herein by reference is the information from the sections entitled “Election of Directors - Compensation of Board of Directors,” “Executive Compensation” and “Compensation Committee Interlocks and Insider Participation” from Nara Bancorp’s definitive Proxy Statement, to be filed with the SEC within 120 days after December 31, 2002.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Incorporated herein by reference is the information from the section entitled “Beneficial Ownership of Principal Stockholders and Management” from Nara Bancorp’s definitive Proxy Statement, to be filed with the SEC within 120 days after December 31, 2002.
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Incorporated herein by reference is the information from the section entitled “Certain Transactions” from Nara Bancorp’s definitive Proxy Statement, to be filed with the SEC within 120 days after December 31, 2002.
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PART IV
Item 14. CONTROLS AND PROCEDURES
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
Item 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
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Nara Bancorp, Inc.and Subsidiaries
Consolidated Financial Statements forEach of the Three Years in the PeriodEnded December 31, 2002 andIndependent Auditors’ Report
INDEPENDENT AUDITORS’ REPORT
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, 2002 and 2001 and the related consolidated statements of earnings, changes in stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2002. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Nara Bancorp, Inc. and subsidiaries as of December 31, 2002 and 2001 and the results of their operations and their cash flows for the each of the three years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 1 to the consolidated financial statements, during the year ended December 31, 2002, the Company changed its method of accounting for goodwill and other intangible assets to conform to Statement of Financial Accounting Standards No. 142.
/s/ DELOITTE & TOUCHE LLPLos Angeles, CaliforniaFebruary 28, 2003
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NARA BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITIONDECEMBER 31, 2002 AND 2001
(Continued)
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CONSOLIDATED STATEMENTS OF EARNINGSTHREE-YEAR PERIOD ENDED DECEMBER 31, 2002
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CONSOLIDATED STATEMENTS OF CASH FLOWSTHREE-YEAR PERIOD ENDED DECEMBER 31, 2002
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTSTHREE-YEAR PERIOD ENDED DECEMBER 31, 2002
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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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CERTIFICATION
I, Benjamin Hong, certify that:
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I, Bon T. Goo, certify that:
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