UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
☑
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.
For the quarterly period ended September 30, 2015
OR
☐
Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the transition period from _____________ to _______________.
Commission file number 1-13661
STOCK YARDS BANCORP, INC.
(Exact name of registrant as specified in its charter)
Kentucky
61-1137529
1040 East Main Street, Louisville, Kentucky 40206
(Address of principal executive offices including zip code)
(502) 582-2571
(Registrant’s telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year, if changed since last report)
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 ☑ No ☐
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☑ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:
Large accelerated filer
Accelerated filer ☑
Non-accelerated filer (Do not check if a smaller reporting company)
Smaller reporting company ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.).
Yes ☐ No ☑
The number of shares of the registrant’s Common Stock, no par value, outstanding as of October 27, 2015, was 14,870,711.
Stock Yards Bancorp, inc. and subsidiary
Index
Item 1. Financial Statements
The following consolidated financial statements of Stock Yards Bancorp, Inc. and Subsidiary are submitted herewith:
Consolidated Balance Sheets September 30, 2015 (Unaudited) and December 31, 2014
Consolidated Statements of Income (Unaudited) for the three and nine months ended September 30, 2015 and 2014
Consolidated Statements of Comprehensive Income (Unaudited) for the three and nine months ended September 30, 2015 and 2014
Consolidated Statements of Changes in Stockholders’ Equity (Unaudited) for the nine months ended September 30, 2015 and 2014
Consolidated Statements of Cash Flows (Unaudited) for the nine months ended September 30, 2015 and 2014
Notes to Consolidated Financial Statements (Unaudited)
STOCK YARDS BANCORP, INC. AND SUBSIDIARY
Consolidated Balance Sheets
September 30, 2015 and December 31, 2014
(In thousands, except share data)
September 30,
December 31,
2015
2014
Cash and due from banks
Federal funds sold
Cash and cash equivalents
Mortgage loans held for sale
Securities available-for-sale (amortized cost of $498,633 and $509,276 in 2015 and 2014, respectively)
Federal Home Loan Bank stock and other securities
Loans
Less allowance for loan losses
Net loans
Premises and equipment, net
Bank owned life insurance
Accrued interest receivable
Other assets
Total assets
Liabilities and Stockholders’ Equity
Deposits:
Non-interest bearing
Interest bearing
Total deposits
Securities sold under agreements to repurchase
Federal funds purchased
Accrued interest payable
Other liabilities
Federal Home Loan Bank advances
Total liabilities
Stockholders’ equity:
Preferred stock, no par value. Authorized 1,000,000 shares; no shares issued or outstanding
Common stock, no par value. Authorized 20,000,000 shares; issued and outstanding 14,868,894 and 14,744,684 shares in 2015 and 2014, respectively
Additional paid-in capital
Retained earnings
Accumulated other comprehensive income
Total stockholders’ equity
Total liabilities and stockholders’ equity
See accompanying notes to unaudited consolidated financial statements.
Consolidated Statements of Income (Unaudited)
For the three and nine months ended September 30, 2015 and 2014
(In thousands, except per share data)
For three months ended
For nine months ended
Interest income:
Securities – taxable
Securities – tax-exempt
Total interest income
Interest expense:
Deposits
Total interest expense
Net interest income
Provision (credit) for loan losses
Net interest income after provision for loan losses
Non-interest income:
Investment management and trust services
Service charges on deposit accounts
Bankcard transaction revenue
Mortgage banking revenue
Gain (loss) on sales of securities available for sale
Brokerage commissions and fees
Bank owned life insurance income
Other
Total non-interest income
Non-interest expenses:
Salaries and employee benefits
Net occupancy expense
Data processing expense
Furniture and equipment expense
FDIC insurance expense
Loss (gain) on other real estate owned
Total non-interest expenses
Income before income taxes
Income tax expense
Net income
Net income per share:
Basic
Diluted
Average common shares:
Consolidated Statements of Comprehensive Income (Unaudited)
(In thousands)
Three months ended
Nine months ended
Other comprehensive income (loss), net of tax:
Unrealized gains (losses) on securities available for sale:
Unrealized gains (losses) arising during the period (net of tax of $1,089, ($234), $683 and $1,521, respectively)
Reclassification adjustment for securities losses realized in income (net of tax of $0, $0, $0, and $3, respectively)
Unrealized (losses) gains on hedging instruments:
Unrealized (losses) gains arising during the period (net of tax of ($124), $12, ($135) and $6, respectively)
Other comprehensive income (loss), net of tax
Comprehensive income
Consolidated Statements of Changes in Stockholders’ Equity (Unaudited)
For the nine months ended September 30, 2015 and 2014
Accumulated
Common stock
other
Number of
Additional
Retained
comprehensive
shares
Amount
paid-in capital
earnings
income (loss)
Total
Balance December 31, 2013
Other comprehensive income, net of tax
Stock compensation expense
Stock issued for exercise of stock options, net of withholdings to satisfy employee tax obligations upon vesting of stock awards
Stock issued for non-vested restricted stock
Stock issued for share-based awards, net of withholdings to satisfy employee tax obligations upon award
Cash dividends declared, $0.65 per share
Shares repurchased or cancelled
Balance September 30, 2014
Balance December 31, 2014
Cash dividends declared, $0.71 per share
Balance September 30, 2015
Consolidated Statements of Cash Flows (Unaudited)
Operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation, amortization and accretion, net
Deferred income tax expense (benefit)
Loss on sale of securities available for sale
Gain on sales of mortgage loans held for sale
Origination of mortgage loans held for sale
Proceeds from sale of mortgage loans held for sale
Loss (gain) on the disposal of premises and equipment
Loss (gain) on the sale of other real estate
Excess tax benefits from share-based compensation arrangements
(Increase) decrease in accrued interest receivable and other assets
Increase in accrued interest payable and other liabilities
Net cash provided by operating activities
Investing activities:
Purchases of securities available for sale
Proceeds from sale of securities available for sale
Proceeds from maturities of securities available for sale
Net increase in loans
Purchases of premises and equipment
Proceeds from disposal of premises and equipment
Proceeds from sale of foreclosed assets
Net cash used in investing activities
Financing activities:
Net increase in deposits
Net increase (decrease) in securities sold under agreements to repurchase and federal funds purchased
Proceeds from Federal Home Loan Bank advances
Repayments of Federal Home Loan Bank advances
Issuance of common stock for options and performance stock units
Common stock repurchases
Cash dividends paid
Net cash provided by (used in) financing activities
Net decrease in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
Supplemental cash flow information:
Income tax payments
Cash paid for interest
Supplemental non-cash activity:
Transfers from loans to other real estate owned
(1)
Summary of Significant Accounting Policies
The accompanying unaudited consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and do not include all information and footnotes required by U.S. generally accepted accounting principles (US GAAP) for complete financial statements. The consolidated unaudited financial statements of Stock Yards Bancorp, Inc. (“Bancorp”) and its subsidiary reflect all adjustments (consisting only of adjustments of a normal recurring nature) which are, in the opinion of management, necessary for a fair presentation of financial condition and results of operations for the interim periods.
The unaudited consolidated financial statements include the accounts of Stock Yards Bancorp, Inc. and its wholly-owned subsidiary, Stock Yards Bank & Trust Company (“Bank”). Significant intercompany transactions and accounts have been eliminated in consolidation. In preparing the unaudited consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of certain assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of related revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses, valuation of available-for sale securities, other real estate owned and income tax assets, and estimated liabilities and expense.
A description of other significant accounting policies is presented in the notes to Consolidated Financial Statements for the year ended December 31, 2014 included in Stock Yards Bancorp, Inc.’s Annual Report on Form 10-K. Certain reclassifications have been made in the prior year financial statements to conform to current year classifications.
Interim results for the three and nine month periods ended September 30, 2015 are not necessarily indicative of the results for the entire year.
Critical Accounting Policies
Management has identified the accounting policy related to the allowance and provision for loan losses as critical to the understanding of Bancorp’s results of operations and discussed this conclusion with the Audit Committee of the Board of Directors. Since the application of this policy requires significant management assumptions and estimates, it could result in materially different amounts to be reported if conditions or underlying circumstances were to change. Assumptions include many factors such as changes in borrowers’ financial condition which can change quickly or historical loss ratios related to certain loan portfolios which may or may not be indicative of future losses. In the second quarter of 2015, Bancorp extended the historical period used to capture Bancorp’s historical loss ratios from 12 quarters to 24 quarters. Management believes the extension of the look-back period is appropriate to capture the impact of a full economic cycle and more accurately represents the current level of risk inherent in the loan portfolio. To the extent that management’s assumptions prove incorrect, the results from operations could be materially affected by a higher or lower provision for loan losses. The accounting policy related to the allowance for loan losses is applicable to the commercial banking segment of Bancorp.
The allowance for loan losses is management’s estimate of probable losses inherent in the loan portfolio as of the balance sheet date. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.
Bancorp’s allowance calculation includes allocations to loan portfolio segments at September 30, 2015 for qualitative factors including, among other factors, local economic and business conditions, the quality and experience of lending staff and management, changes in lending policies and procedures, levels of and trends in past due loans and loan classifications, concentrations of credit such as collateral type, trends in portfolio growth, changes in the value of underlying collateral for collateral-dependent loans considering Bancorp’s disposition bias, effect of other external factors such as the national economic and business trends, and the quality and depth of the loan review function. Bancorp may also consider other qualitative factors in future periods for additional allowance allocations, including, among other factors, changes in Bancorp’s loan review process. Bancorp utilizes the sum of all allowance amounts derived as described above as the appropriate level of allowance for loan and lease losses. Changes in the criteria used in this evaluation or the availability of new information could cause the allowance to be increased or decreased in future periods. In addition, bank regulatory agencies, as part of their examination process, may require adjustments to the allowance for loan and lease losses based on their judgments and estimates.
(2)
Securities
The amortized cost, unrealized gains and losses, and fair value of securities available-for-sale follow:
(in thousands)
Amortized
Unrealized
Fair
September 30, 2015
Gains
Losses
U.S. Treasury and other U.S. Government obligations
Government sponsored enterprise obligations
Mortgage-backed securities - government agencies
Obligations of states and political subdivisions
Corporate equity securities
Total securities available for sale
December 31, 2014
Corporate equity securities consist of common stock in a publicly-traded business development company.
There were no securities classified as held to maturity as of September 30, 2015 or December 31, 2014.
In the first quarter of 2015, Bancorp sold securities with total fair market value of $5.9 million, generating no gain or loss. These securities consisted of agency and mortgage-backed securities with small remaining balances and agency securities. In 2014, Bancorp sold securities with total fair market value of $7.7 million, generating a net loss of $9 thousand. These securities consisted of mortgage-backed securities with small remaining balances, obligations of state and political subdivisions, and agency securities. These sales were made in the ordinary course of portfolio management. Management has the intent and ability to hold all remaining investment securities available-for-sale for the foreseeable future.
A summary of the available-for-sale investment securities by contractual maturity groupings as of September 30, 2015 is shown below.
Securities available-for-sale
Due within 1 year
Due after 1 but within 5 years
Due after 5 but within 10 years
Due after 10 years
Mortgage-backed securities
Total securities available-for-sale
Actual maturities may differ from contractual maturities because some issuers have the right to call or prepay obligations. In addition to equity securities, the investment portfolio includes agency mortgage-backed securities, which are guaranteed by agencies such as the FHLMC, FNMA, and GNMA. These securities differ from traditional debt securities primarily in that they may have uncertain principal payment dates and are priced based on estimated prepayment rates on the underlying collateral.
Securities with a carrying value of approximately $278.1 million at September 30, 2015 and $263.1 million at December 31, 2014 were pledged to secure accounts of commercial depositors in cash management accounts, public deposits, and cash balances for certain investment management and trust accounts.
Securities with unrealized losses at September 30, 2015 and December 31, 2014, not recognized in the statements of income are as follows:
Less than 12 months
12 months or more
value
losses
Total temporarily impaired securities
Applicable dates for determining when securities are in an unrealized loss position are September 30, 2015 and December 31, 2014. As such, it is possible that a security had a market value lower than its amortized cost on other days during the past twelve months, but is not in the “Investments with an Unrealized Loss of less than 12 months” category above.
Unrealized losses on Bancorp’s investment securities portfolio have not been recognized as an expense because the securities are of high credit quality, and the decline in fair values is due to changes in the prevailing interest rate environment since the purchase date. Fair value is expected to recover as securities reach their maturity date and/or the interest rate environment returns to conditions similar to when these securities were purchased. These investments consist of 45 and 80 separate investment positions as of September 30, 2015 and December 31, 2014, respectively. Because management does not intend to sell the investments, and it is not likely that Bancorp will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, Bancorp does not consider these securities to be other-than-temporarily impaired at September 30, 2015.
FHLB stock and other securities are investments held by Bancorp which are not readily marketable and are carried at cost. This category includes holdings of Federal Home Loan Bank of Cincinnati (FHLB) stock which are required for access to FHLB borrowing, and are classified as restricted securities.
(3)
Composition of loans, net of deferred fees and costs, by primary loan portfolio class follows:
Commercial and industrial
Construction and development, excluding undeveloped land
Undeveloped land
Real estate mortgage:
Commercial investment
Owner occupied commercial
1-4 family residential
Home equity - first lien
Home equity - junior lien
Subtotal: Real estate mortgage
Consumer
Total loans
The following table presents the balance in the recorded investment in loans and allowance for loan losses by portfolio segment and based on impairment evaluation method as of September 30, 2015 and December 31, 2014.
Type of loan
Construction
and development
Commercial
excluding
and
undeveloped
Undeveloped
Real estate
industrial
land
mortgage
Loans collectively evaluated for impairment
Loans individually evaluated for impairment
Loans acquired with deteriorated credit quality
Unallocated
Allowance for loan losses
At December 31, 2014
Provision (credit)
Charge-offs
Recoveries
At September 30, 2015
Allowance for loans collectively evaluated for impairment
Allowance for loans individually evaluated for impairment
Allowance for loans acquired with deteriorated credit quality
At December 31, 2013
The considerations by Bancorp in computing its allowance for loan losses are determined based on the various risk characteristics of each loan segment. Relevant risk characteristics are as follows:
●
Commercial and industrial loans: Loans in this category are made to businesses. Generally these loans are secured by assets of the business and repayment is expected from the cash flows of the business. A weakened economy and resultant decreased consumer and/or business spending will have an effect on the credit quality in this loan category.
Construction and development, excluding undeveloped land: Loans in this category primarily include owner-occupied and investment construction loans and commercial development projects. In most cases, construction loans require only interest to be paid during construction. Upon completion or stabilization, the construction loan may convert to permanent financing in the real estate mortgage segment, requiring principal amortization. Repayment of development loans is derived from sale of lots or units including any pre-sold units. Credit risk is affected by construction delays, cost overruns, market conditions and availability of permanent financing, to the extent such permanent financing is not being provided by Bancorp.
Undeveloped land: Loans in this category are secured by land initially acquired for development by the borrower, but for which no development has yet taken place. Credit risk is affected by market conditions and time to sell lots at an adequate price. Credit risk is also affected by availability of permanent financing, to the extent such permanent financing is not being provided by Bancorp.
Real estate mortgage: Loans in this category are made to and secured by owner-occupied residential real estate, owner-occupied real estate used for business purposes, and income-producing investment properties. Repayment is dependent on credit quality of the individual borrower. Underlying properties are generally located in Bancorp’s primary market area. Cash flows of income producing investment properties are adversely impacted by a downturn in the economy as evidenced by increased vacancy rates, which in turn, will have an effect on credit quality. Overall health of the economy, including unemployment rates and real estate prices, has an effect on credit quality in this loan category.
Consumer: Loans in this category may be either secured or unsecured and repayment is dependent on credit quality of the individual borrower and, if applicable, sale of collateral securing the loan. Therefore, overall health of the economy, including unemployment rates and stock prices, will have a significant effect on credit quality in this loan category.
Bancorp has loans that were acquired in a 2013 acquisition, for which there was, at acquisition, evidence of deterioration of credit quality since origination and for which it was probable that all contractually required payments would not be collected. The carrying amount of those loans is included in the balance sheet amounts of loans at September 30, 2015 and December 31, 2014. Changes in the fair value adjustment for acquired impaired loans are shown in the following table:
Accretable discount
Non-accretable discount
Balance at December 31, 2013
Accretion
Reclassifications from (to) non-accretable discount
Disposals
Balance at December 31, 2014
Balance at September 30, 2015
The following table presents loans individually evaluated for impairment as of September 30, 2015 and December 31, 2014.
Unpaid
Average
Recorded
principal
Related
recorded
investment
balance
allowance
Loans with no related allowance recorded
Real estate mortgage
Subtotal
Loans with an allowance recorded
Differences between recorded investment amounts and unpaid principal balance amounts less related allowance are due to partial charge-offs which have occurred over the life of loans.
Impaired loans include non-accrual loans and accruing loans accounted for as troubled debt restructurings (TDR), which continue to accrue interest. Non-performing loans include the balance of impaired loans plus any loans over 90 days past due and still accruing interest. Loans past due more than 90 days and still accruing interest amounted to $544 thousand and $329 thousand at September 30, 2015 and December 31, 2014, respectively.
The following table presents the recorded investment in non-accrual loans as of September 30, 2015 and December 31, 2014.
At September 30, 2015 and December 31, 2014, Bancorp had accruing loans classified as TDR of $1.1 million and $6.4 million, respectively. Bancorp did not modify and classify any additional loans as TDR during the nine months ended September 30, 2015 or 2014.
Bancorp had no loans accounted for as TDR that were restructured and subsequently experienced a payment default within the previous 12 months as of September 30, 2015 or 2014.
Loans accounted for as TDR include modifications from original terms such as those due to bankruptcy proceedings, certain modifications of amortization periods or extended suspension of principal payments due to customer financial difficulties. Loans accounted for as TDR, which have not defaulted, are individually evaluated for impairment and, at September 30, 2015, had a total allowance allocation of $188 thousand, compared to $703 thousand at December 31, 2014.
At September 30, 2015, Bancorp did not have any outstanding commitments to lend additional funds to borrowers whose loans have been modified as TDR, compared to $458 thousand at December 31, 2014.
The following table presents the aging of the recorded investment in loans as of September 30, 2015 and December 31, 2014.
90 or more
days past
> 90 days
30-59 days
60-89 days
due (includes)
past due
non-accrual)
Current
loans
accruing
Consistent with regulatory guidance, Bancorp categorizes loans into credit risk categories based on relevant information about the ability of borrowers to service their debt such as current financial information, historical payment experience, credit documentation, public information and current economic trends. Pass-rated loans include all risk-rated loans other than those classified as special mention, substandard, substandard non-performing and doubtful, which are defined below:
Special Mention: Loans classified as special mention have a potential weakness that deserves management’s close attention. These potential weaknesses may result in deterioration of repayment prospects for the loan or of Bancorp’s credit position at some future date.
Substandard: Loans classified as substandard are inadequately protected by the paying capacity of the obligor or of collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize repayment of the debt. They are characterized by the distinct possibility that Bancorp will sustain some loss if the deficiencies are not corrected.
Substandard non-performing: Loans classified as substandard non-performing have all the characteristics of substandard loans and have been placed on non-accrual status or have been accounted for as troubled debt restructurings.
Doubtful: Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or repayment in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable.
As of September 30, 2015 and December 31, 2014, the internally assigned risk grades of loans by category were as follows:
Special
Substandard
Pass
mention
non-performing
Doubtful
(4)
Securities Sold Under Agreements to Repurchase
Securities sold under agreements to repurchase, which represent excess funds from commercial customers as part of a cash management service, totaled $67.6 million and $69.6 million at September 30, 2015 and December 31, 2014, respectively. Bancorp enters into sales of securities under agreement to repurchase at a specified future date. At September 30, 2015, all of these financing arrangements had overnight maturities and were secured by government sponsored enterprise obligations and government agency mortgage-backed securities which were owned and under the control of Bancorp.
(5)
Federal Home Loan Bank Advances
Bancorp had outstanding borrowings of $43.7 million and $36.8 million at September 30, 2015 and December 31, 2014, respectively, via twelve separate fixed-rate advances. For two advances totaling $30 million, both of which are non-callable, interest payments are due monthly, with principal due at maturity. For the remaining advances totaling $13.7 million, principal and interest payments are due monthly based on an amortization schedule.
The following is a summary of the contractual maturities and average effective rates of outstanding advances:
Advance
Rate
2020
2021
2024
2025
2028
Advances from the FHLB are collateralized by certain commercial and residential real estate mortgage loans totaling $568.9 million under a blanket mortgage collateral agreement and FHLB stock. Bancorp believes these borrowings to be an effective alternative to higher cost time deposits to manage interest rate risk associated with long-term fixed rate loans. At September 30, 2015, the amount of available credit from the FHLB totaled $408.1 million.
(6)
Derivative Financial Instruments
Occasionally, Bancorp enters into free-standing interest rate swaps for the benefit of its commercial customers who desire to hedge their exposure to changing interest rates. Bancorp offsets its interest rate exposure on these transactions by entering into offsetting swap agreements with substantially matching terms with approved reputable independent counterparties. These undesignated derivative instruments are recognized on the consolidated balance sheet at fair value. Because of matching terms of offsetting contracts and collateral provisions mitigating any non-performance risk, changes in fair value subsequent to initial recognition are expected to have an insignificant effect on earnings. Exchanges of cash flows related to undesignated interest rate swap agreements for the first nine months of 2015 were offsetting and therefore had no net effect on Bancorp’s earnings or cash flows.
Interest rate swap agreements derive their value from underlying interest rates. These transactions involve both credit and market risk. Notional amounts are amounts on which calculations, payments, and the value of the derivative are based. Notional amounts do not represent direct credit exposures. Direct credit exposure is limited to the net difference between the calculated amounts to be received and paid, if any. Bancorp is exposed to credit-related losses in the event of nonperformance by counterparties to these agreements. Bancorp mitigates the credit risk of its financial contracts through credit approvals, limits and monitoring procedures, and does not expect any counterparties to fail their obligations.
At September 30, 2015 and December 31, 2014, Bancorp had outstanding undesignated interest rate swap contracts as follows:
(dollar amounts in thousands)
Receiving
Paying
Notional amount
Weighted average maturity (years)
Fair value
In 2013, Bancorp entered into an interest rate swap to hedge cash flows of a $10 million rolling fixed-rate three-month FHLB borrowing. The swap began December 6, 2013 and ends December 6, 2016. In the third quarter of 2015, Bancorp entered into a forward starting interest rate swap to hedge cash flows of a $20 million rolling fixed-rate three-month FHLB borrowing. The start of this borrowing strategy coincides with the maturity and refinance of a current $20 million advance included in Note 5. The swap begins December 9, 2015 and matures December 6, 2020. For purposes of hedging, the rolling fixed rate advances are considered to be floating rate liabilities. The interest rate swaps involve exchange of Bancorp’s floating rate interest payments for fixed rate swap payments on underlying principal amounts. These swaps were designated, and qualified, for cash-flow hedge accounting. For derivative instruments that are designated and qualify as cash flow hedging instruments, the effective portion of gains or losses is reported as a component of other comprehensive income, and is subsequently reclassified into earnings as an adjustment to interest expense in periods in which the hedged forecasted transaction affects earnings. The following table details Bancorp’s derivative position designated as a cash flow hedge, and the fair values as of September 30, 2015 and December 31, 2014.
(dollars in thousands)
Notional
Maturity
Receive (variable)
Pay fixed
amount
date
index
swap rate
12/6/2016
US 3 Month LIBOR
12/6/2020
(7)
Goodwill and Intangible Assets
US GAAP requires that goodwill and intangible assets with indefinite useful lives not be amortized, but instead be tested for impairment at least annually. Annual evaluations have resulted in no indication of impairment. Bancorp currently has goodwill in the amount of $682 thousand from the 1996 acquisition of an Indiana bank. This goodwill is assigned to the commercial banking segment of Bancorp.
In 2013, Bancorp completed the acquisition of THE BANCorp, Inc., parent company of THE BANK – Oldham County, Inc. As a result, Bancorp recorded a core deposit intangible totaling $2.5 million which is being amortized over the expected life of the underlying deposits to which the intangible is attributable. For money market, savings and interest bearing checking accounts, this intangible asset is being amortized using a straight line method over 15 years. For the remainder of deposits, it is being amortized over a 10-year period using an accelerated method which anticipates the life of the underlying deposits. At September 30, 2015, the unamortized core deposit intangible was $1.7 million.
Mortgage servicing rights (MSRs) are initially recognized at fair value when mortgage loans are sold with servicing retained. The MSRs are amortized in proportion to and over the period of estimated net servicing income, considering appropriate prepayment assumptions. MSRs are evaluated quarterly for impairment by comparing carrying value to fair value. Estimated fair values of MSRs at September 30, 2015 and December 31, 2014 were $2.5 million and $3.4 million, respectively. Total outstanding principal balances of loans serviced for others were $413.5 million and $421.1 million at September 30, 2015, and December 31, 2014, respectively.
Changes in the net carrying amount of MSRs for the nine months ended September 30, 2015 and 2014 are shown in the following table:
For nine months
ended September 30,
Balance at beginning of period
Additions for mortgage loans sold
Amortization
Balance at September 30
(8)
Defined Benefit Retirement Plan
Bancorp sponsors an unfunded, non-qualified, defined benefit retirement plan for three key officers (two current and one retired), and has no plans to increase the number of or benefits to participants. Benefits vest based on 25 years of service. The retired officer and one current officer are fully vested, and one current officer will be fully vested in 2017. Actuarially determined pension costs are expensed and accrued over the service period, and benefits are paid from Bancorp’s assets. Net periodic benefits costs, which include interest cost and amortization of net losses, totaled $36 thousand and $32 thousand, for the three months ended September 30, 2015 and 2014, respectively. For the nine months ended September 30, 2015 and 2014, the net periodic benefit costs totaled $107 thousand and $95 thousand, respectively.
(9)
Commitments and Contingent Liabilities
As of September 30, 2015, Bancorp had various commitments outstanding that arose in the normal course of business, including standby letters of credit and commitments to extend credit, which are properly not reflected in the consolidated financial statements. In management’s opinion, commitments to extend credit of $574.6 million including standby letters of credit of $11.0 million represent normal banking transactions. Commitments to extend credit were $463.0 million, including letters of credit of $11.0 million, as of December 31, 2014. Commitments to extend credit are agreements to lend to a customer as long as collateral is available and there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses. Commitments to extend credit are mainly comprised of commercial lines of credit, construction and home equity credit lines and credit cards issued to commercial customers. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Bancorp uses the same credit and collateral policies in making commitments and conditional guarantees as for on-balance sheet instruments. Bancorp evaluates each customer’s creditworthiness on a case by case basis. The amount of collateral obtained is based on management’s credit evaluation of the customer. Collateral held varies but may include accounts receivable, inventory, equipment, and real estate. However, should the commitments be drawn upon and should our customers default on their resulting obligation to us, our maximum exposure to credit loss, without consideration of collateral, is represented by the contractual amount of those instruments. At September 30, 2015, Bancorp has accrued $372 thousand in other liabilities for inherent risks related to unfunded credit commitments.
Standby letters of credit and financial guarantees written are conditional commitments issued by Bancorp to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support private commercial transactions. Standby letters of credit generally have maturities of one to two years.
Also, as of September 30, 2015, in the normal course of business, there were pending legal actions and proceedings in which claims for damages are asserted. Management, after discussion with legal counsel, believes the ultimate result of these legal actions and proceedings will not have a material adverse effect on the consolidated financial position or results of operations of Bancorp.
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Preferred Stock
Bancorp has a class of preferred stock (no par value; 1,000,000 shares authorized), the relative rights, preferences and other terms of which or any series within the class will be determined by the Board of Directors prior to any issuance. None of this stock has been issued to date.
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Stock-Based Compensation
The fair value of all awards granted, net of estimated forfeitures, is recognized as compensation expense over the respective service period.
Bancorp currently has one stock-based compensation plan. At Bancorp's 2015 Annual Meeting of Shareholders, shareholders approved the 2015 Omnibus Equity Compensation Plan and authorized the shares available from the 2005 plan for future awards under the 2015 plan. No additional shares were made available. As of September 30, 2015, there were 362,985 shares available for future awards. The 2005 Stock Incentive Plan expired in April 2015; however, options and SARs granted under this plan expire as late as 2025.
Options, which have not been granted since 2007, generally had a vesting schedule of 20% per year. Stock appreciation rights (“SARs”) granted have a vesting schedule of 20% per year. Options and SARs expire ten years after the grant date unless forfeited due to employment termination.
Restricted shares granted to officers vest over five years. All restricted shares have been granted at a price equal to the market value of common stock at the time of grant. For all grants prior to 2015, grantees are entitled to dividend payments during the vesting period. For grants in 2015, forfeitable dividends are deferred until shares are vested. Fair value of restricted shares is equal to the market value of the shares on the date of grant.
Grants of performance stock units (“PSUs”) vest based upon service and a single three-year performance period which begins January 1 of the first year of the performance period. Because grantees are not entitled to dividend payments during the performance period, fair value of these PSUs is estimated based upon fair value of underlying shares on the date of grant, adjusted for non-payment of dividends.
Grants of restricted stock units (“RSUs”) to directors are time-based and vest 12 months after grant date. Because grantees are entitled to deferred dividend payments at the end of the vesting period, fair value of the RSUs is estimated based on fair value of underlying shares on the date of grant.
Bancorp has recognized stock-based compensation expense, within salaries and employee benefits for employees, and within other non-interest expense for directors, in the consolidated statements of income as follows:
Stock-based compensation expense before income taxes
Less: deferred tax benefit
Reduction of net income
Bancorp expects to record an additional $514 thousand of stock-based compensation expense in 2015 for equity grants outstanding as of September 30, 2015. As of September 30, 2015, Bancorp has $4.1 million of unrecognized stock-based compensation expense that is expected to be recorded as compensation expense over the next five years as awards vest. Bancorp received cash of $2.0 million and $1.4 million from the exercise of options during the first nine months of 2015 and 2014, respectively.
Fair values of Bancorp’s stock options and SARs are estimated at the date of grant using the Black-Scholes option pricing model, a leading formula for calculating the value of stock options and SARs. This model requires the input of assumptions, changes to which can materially affect the fair value estimate. Fair value of restricted shares is determined by Bancorp’s closing stock price on the date of grant. The following assumptions were used in SAR valuations at the grant date in each year:
Dividend yield
%
Expected volatility
Risk free interest rate
Expected life of SARs (in years)
Dividend yield and expected volatility are based on historical information for Bancorp corresponding to the expected life of options and SARs granted. Expected volatility is the volatility of the underlying shares for the expected term on a monthly basis. The risk free interest rate is the implied yield currently available on U.S. Treasury issues with a remaining term equal to the expected life of the options. The expected life of SARs is based on actual experience of past like-term SARs and options. Bancorp evaluates historical exercise and post-vesting termination behavior when determining the expected life.
A summary of stock option and SARs activity and related information for the nine months ended September 30, 2015 follows:
Weighted
Aggregate
average
Options
intrinsic
remaining
and SARs
Exercise
exercise
fair
contractual
price
life (in years)
Vested and exercisable
Unvested
Total outstanding
Granted
Exercised
Forfeited
Vested year-to-date
Intrinsic value for stock options and SARs is defined as the amount by which the current market price of the underlying stock exceeds the exercise or grant price.
For the periods ending December 31, 2014 and September 30, 2015, Bancorp granted shares of restricted common stock as outlined in the following table:
Grant date
weighted-
Number
average cost
Unvested at December 31, 2013
Shares awarded
Restrictions lapsed and shares released to employees/directors
Shares forfeited
Unvested at December 31, 2014
Unvested at September 30, 2015
Bancorp awarded performance-based restricted stock units (“PSUs”) to executive officers of Bancorp, the single three-year performance period for which began January 1 of the award year. The following table outlines the PSU grants.
Vesting
Expected
Grant
period
shares to
year
in years
be awarded
2013
In the first quarter of 2015, Bancorp awarded 6,080 RSUs to directors of Bancorp with a grant date fair value of $200 thousand. In the second quarter of 2015, 760 RSUs were cancelled, leaving 5,320 RSUs outstanding with a grant date fair value of $175 thousand.
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Net Income Per Share
The following table reflects, for the three and nine months ended September 30, 2015 and 2014, net income (numerator) and average shares outstanding (denominator) for basic and diluted net income per share computations:
September 30
Average shares outstanding
Dilutive securities
Average shares outstanding including dilutive securities including dilutive securities
Net income per share, basic
Net income per share, diluted
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Segments
Bancorp’s principal activities include commercial banking and investment management and trust. Commercial banking provides a full range of loan and deposit products to individual consumers and businesses. Commercial banking also includes Bancorp’s mortgage origination and securities brokerage activity. Investment management and trust provides wealth management services including investment management, trust and estate administration, and retirement plan services.
Financial information for each business segment reflects that which is specifically identifiable or allocated based on an internal allocation method. Income taxes are allocated based on the effective federal income tax rate adjusted for any tax exempt activity. All tax exempt activity and provision for loan losses have been allocated to the commercial banking segment. Measurement of performance of business segments is based on the management structure of Bancorp and is not necessarily comparable with similar information for any other financial institution. Information presented is also not necessarily indicative of the segments’ operations if they were independent entities.
Selected financial information by business segment for the three and nine month periods ended September 30, 2015 and 2014 follows:
Investment
management
banking
and trust
Three months ended September 30, 2015
Provision for loan losses
All other non-interest income
Non-interest expense
Tax expense
Three months ended September 30, 2014
Nine months ended September 30, 2015
Nine months ended September 30, 2014
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Income Taxes
An analysis of the difference between statutory and effective tax rates for the nine months ended September 30, 2015 and 2014 follows:
Nine months ended September 30
U.S. federal statutory tax rate
Tax exempt interest income
Tax credits
Cash surrender value of life insurance
State income taxes, net of federal benefit
Other, net
Effective tax rate
State income tax expense represents tax owed in Indiana. Kentucky and Ohio state bank taxes are based on capital levels, and are recorded as other non-interest expense.
US GAAP provides guidance on financial statement recognition and measurement of tax positions taken, or expected to be taken, in tax returns. As of September 30, 2015 and December 31, 2014, the gross amount of unrecognized tax benefits, including penalties and interest, was $51 thousand and $42 thousand, respectively. If recognized, tax benefits would reduce tax expense and accordingly, increase net income. The amount of unrecognized tax benefits may increase or decrease in the future for various reasons including adding amounts for current year tax positions, expiration of open income tax returns due to statutes of limitation, changes in management’s judgment about the level of uncertainty, status of examination, litigation and legislative activity and addition or elimination of uncertain tax positions. Federal and state income tax returns are subject to examination for the years after 2011.
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Assets and Liabilities Measured and Reported at Fair Value
Bancorp follows the provisions of authoritative guidance for fair value measurements. This guidance is definitional and disclosure oriented and addresses how companies should approach measuring fair value when required by US GAAP. The guidance also prescribes various disclosures about financial statement categories and amounts which are measured at fair value, if such disclosures are not already specified elsewhere in US GAAP.
Authoritative guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between participants at the measurement date. The guidance also establishes a hierarchy to group assets and liabilities carried at fair value in three levels based upon the markets in which the assets and liabilities trade and the reliability of assumptions used to determine fair value. These levels are:
Level 1: Valuation is based upon quoted prices for identical instruments traded in active markets.
Level 2: Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
Level 3: Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions would reflect internal estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques could include pricing models, discounted cash flows and other similar techniques.
Authoritative guidance requires maximization of use of observable inputs and minimization of use of unobservable inputs in fair value measurements. Where there exists limited or no observable market data, Bancorp derives its own estimates by generally considering characteristics of the asset/liability, the current economic and competitive environment and other factors. For this reason, results cannot be determined with precision and may not be realized on an actual sale or immediate settlement of the asset or liability.
Bancorp’s investment securities available-for-sale and interest rate swaps are recorded at fair value on a recurring basis. Other accounts including mortgage servicing rights, impaired loans and other real estate owned may be recorded at fair value on a non-recurring basis, generally in the application of lower of cost or market adjustments or write-downs of specific assets.
The portfolio of investment securities available-for-sale is comprised of U.S. Treasury and other U.S. government obligations, debt securities of U.S. government-sponsored corporations (including mortgage-backed securities), obligations of state and political subdivisions and corporate equity securities. U.S. Treasury and corporate equity securities are priced using quoted prices of identical securities in an active market. These measurements are classified as Level 1 in the hierarchy above. All other securities are priced using standard industry models or matrices with various assumptions such as yield curves, volatility, prepayment speeds, default rates, time value, credit rating and market prices for similar instruments. These assumptions are generally observable in the market place and can be derived from or supported by observable data. These measurements are classified as Level 2 in the hierarchy above.
Interest rate swaps are valued using primarily Level 2 inputs. Fair value measurements generally based on benchmark forward yield curves and other relevant observable market data. For purposes of potential valuation adjustments to derivative positions, Bancorp evaluates the credit risk of its counterparties as well as its own credit risk. To date, Bancorp has not realized any losses due to a counterparty’s inability to perform and the change in value of derivative assets and liabilities attributable to credit risk was not significant during 2015.
Below are the carrying values of assets measured at fair value on a recurring basis.
Fair value at September 30, 2015
Level 1
Level 2
Level 3
Investment securities available for sale
U.S. Treasury and other U.S. government obligations
Total investment securities available for sale
Interest rate swaps
Liabilities
Fair value at December 31, 2014
Bancorp did not have any financial instruments classified within Level 3 of the valuation hierarchy for assets and liabilities measured at fair value on a recurring basis at September 30, 2015 or December 31, 2014.
MSRs are recorded at fair value upon capitalization, are amortized to correspond with estimated servicing income, and are periodically assessed for impairment based on fair value at the reporting date. Fair value is based on a valuation model that calculates the present value of estimated net servicing income. The model incorporates assumptions that market participants would use in estimating future net servicing income. These measurements are classified as Level 3. At September 30, 2015 and December 31, 2014 there was no valuation allowance for the mortgage servicing rights, as the fair value exceeded the cost. Accordingly, the MSRs are not included in either table below for September 30, 2015 or December 31, 2014. See Note 7 for more information regarding MSRs.
For impaired loans in the table below, fair value is calculated as the carrying value of only loans with a specific valuation allowance, less the specific allowance. Fair value of impaired loans was primarily measured based on the value of the collateral securing these loans. Impaired loans are classified within Level 3 of the fair value hierarchy. Collateral may be real estate and/or business assets including equipment, inventory, and/or accounts receivable. Bancorp determines the value of collateral based on independent appraisals performed by qualified licensed appraisers. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Appraised values are discounted for costs to sell and may be discounted further based on management’s historical knowledge, changes in market conditions from the date of the most recent appraisal, and/or management’s expertise and knowledge of the customer and the customer’s business. Such discounts by management are subjective and are typically significant unobservable inputs for determining fair value. As of September 30, 2015, total impaired loans with a valuation allowance were $6.7 million, and the specific allowance totaled $1.6 million, resulting in a fair value of $5.1 million, compared to total impaired loans with a valuation allowance of $7.8 million, and the specific allowance allocation totaling $1.4 million, resulting in a fair value of $6.4 million at December 31, 2014. Losses represent the change in the specific allowances for the period indicated.
Other real estate owned (“OREO”), which is carried at the lower of cost or fair value, is periodically assessed for impairment based on fair value at the reporting date. Fair value is based on appraisals performed by external parties which use judgments and assumptions that are property-specific and sensitive to changes in the overall economic environment. Appraisals may be further discounted based on management’s historical knowledge and/or changes in market conditions from the date of the most recent appraisal. Many of these inputs are not observable and, accordingly, these measurements are classified as Level 3. For OREO in the table below, the fair value is the carrying value of only parcels of OREO which have a carrying value equal to appraised value. Losses represent write-downs which occurred during the period indicated. At September 30, 2015 and December 31, 2014, the carrying value of all other real estate owned was $4.6 million and $6.0 million, respectively.
Below are the carrying values of assets measured at fair value on a non-recurring basis.
Losses for 9 month
period ended
Impaired loans
Other real estate owned
September 30, 2014
For the securities portfolio, Bancorp monitors the valuation technique utilized by pricing agencies to ascertain when transfers between levels have occurred. The nature of other assets and liabilities measured at fair value is such that transfers in and out of any level are expected to be rare. For the three months ended September 30, 2015, there were no transfers between Levels 1, 2, or 3. For Level 3 assets measured at fair value on a non-recurring basis as of September 30, 2015, the significant unobservable inputs used in the fair value measurements are presented below.
Significant
Valuation
unobservable
average of
(Dollars in thousands)
Value
technique
input
Impaired loans - collateral dependent
Appraisal
Appraisal discounts (%)
Appraisal discounts
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Disclosure of Financial Instruments Not Reported at Fair Value
US GAAP requires disclosure of the fair value of financial assets and liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or nonrecurring basis. Carrying amounts, estimated fair values, and placement in the fair value hierarchy of Bancorp’s financial instruments are as follows:
Carrying
Financial assets
Cash and short-term investments
Loans, net
Financial liabilities
Short-term borrowings
FHLB advances
Management used the following methods and assumptions to estimate the fair value of each class of financial instrument for which it is practicable to estimate the value.
Cash, short-term investments, accrued interest receivable/payable and short-term borrowings
For these short-term instruments, carrying amount is a reasonable estimate of fair value.
For these securities without readily available market values, carrying amount is a reasonable estimate of fair value as it equals the amount due from FHLB or other issuer at upon redemption.
Mortgage loans held for sale are initially recorded at the lower of cost or market value. The portfolio is comprised of residential real estate loans and fair value is determined by market quotes for similar loans based on loan type, term, rate, size and the borrower’s credit score.
US GAAP prescribes the exit price concept for estimating fair value of loans. Because there is not an active market (exit price) for trading virtually all types of loans in Bancorp’s portfolio, fair value of loans is estimated by discounting future cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities (entrance price).
Fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. Fair value of fixed-rate certificates of deposits is estimated by discounting future cash flows using the rates currently offered for deposits of similar remaining maturities.
Fair value of FHLB advances is estimated by discounting future cash flows using estimates of current market rate for instruments with similar terms and remaining maturities.
Commitments to extend credit and standby letters of credit
Fair values of commitments to extend credit are estimated using fees currently charged to enter into similar agreements and creditworthiness of customers. Fair values of standby letters of credit are based on fees currently charged for similar agreements or estimated cost to terminate them or otherwise settle obligations with counterparties at the reporting date. Fair value of commitments to extend credit, letters of credit and lines of credit is not presented since management believes the fair value to be insignificant.
Limitations
Fair value estimates are made at a specific point in time based on relevant market information and information about financial instruments. Because no market exists for a significant portion of Bancorp’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Therefore, calculated fair value estimates in many instances cannot be substantiated by comparison to independent markets and, in many cases, may not be realizable in a current sale of the instrument. Changes in assumptions could significantly affect estimates.
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Regulatory Matters
Bancorp and the Bank are subject to various capital requirements prescribed by banking regulations and administered by state and federal banking agencies. Under these requirements, Bancorp and the Bank must meet minimum amounts and percentages of Tier 1, common equity Tier 1, and total capital, as defined, to risk weighted assets and Tier 1 capital to average assets. Risk weighted assets are determined by applying certain risk weightings prescribed by the regulations to various categories of assets and off-balance sheet commitments. Capital and risk weighted assets may be further subject to qualitative judgments by regulators as to components, risk weighting and other factors. Failure to meet the capital requirements can result in certain mandatory, and possibly discretionary, corrective actions prescribed by the regulations or determined to be necessary by the regulators, which could materially affect the unaudited consolidated financial statements.
In 2013, the Federal Reserve Board and the FDIC approved rules that substantially amended the regulatory risk-based capital rules applicable to Bancorp and Bank. The rules implemented the regulatory capital reforms of the Basel Committee on Banking Supervision reflected in "Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems" (Basel III) and changes required by the Dodd-Frank Act. The Basel III regulatory capital reforms became effective for Bancorp and Bank on January 1, 2015, and include new minimum risk-based capital and leverage ratios. Capital ratios for December 31, 2014 were calculated using the former rules and for September 30, 2015 ratios were calculated using the new Basel III rules. For Bancorp, key differences under Basel III include risk weighting for loan commitments under one year and higher risk weighting for certain commercial real estate and construction loans. These differences resulted in higher risk-weighted assets, and therefore, somewhat lower risk-based capital ratios.
Bancorp and the Bank met all capital requirements to which they were subject as of September 30, 2015.
The following table sets forth consolidated Bancorp’s and the Bank’s risk based capital amounts and ratios as of September 30, 2015 and December 31, 2014.
Actual
Minimum for adequately capitalized
Minimum for well capitalized
Ratio
Total risk-based capital (1)
Consolidated
NA
Bank
Common Equity Tier 1 risk-based capital (2)
Tier 1 risk-based capital (1)
Leverage (3)
Ratio became effective January 2015.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This item discusses the results of operations for Stock Yards Bancorp, Inc. (“Bancorp” or “Company”), and its subsidiary, Stock Yards Bank & Trust Company (“Bank”) for the three and nine months ended September 30, 2015 and compares these periods with the same periods of the previous year. Unless otherwise indicated, all references in this discussion to the Bank include Bancorp. In addition, the discussion describes the significant changes in the financial condition of Bancorp and the Bank that have occurred during the first nine months of 2015 compared to same periods in the year ended December 31, 2014. This discussion should be read in conjunction with the consolidated financial statements and accompanying notes presented in Part 1, Item 1 of this report.
This report contains forward-looking statements under the Private Securities Litigation Reform Act that involve risks and uncertainties. Although Bancorp believes assumptions underlying forward-looking statements contained herein are reasonable, any of these assumptions could be inaccurate. Factors that could cause actual results to differ from results discussed in forward-looking statements include, but are not limited to the following: economic conditions both generally and more specifically in markets in which Bancorp and the Bank operate; competition for Bancorp’s customers from other providers of financial services; government legislation and regulation which change from time to time and over which Bancorp has no control; changes in interest rates; material unforeseen changes in liquidity, results of operations, or financial condition of Bancorp’s customers; and other risks detailed in Bancorp’s filings with the Securities and Exchange Commission, all of which are difficult to predict and many of which are beyond the control of Bancorp.
Overview of 2015 through September 30
Bancorp completed the first nine months of 2015 with net income of $27.5 million or 5.5% more than the comparable period of 2014. The increase is due to higher net interest income and non-interest income. These increases were partially offset by higher non-interest expenses and higher income tax expense. Diluted earnings per share for the first nine months of 2015 were $1.84, compared to the first nine months of 2014 at $1.77.
As is the case with most banks, the primary source of Bancorp’s revenue is net interest income and fees from various financial services provided to customers. Net interest income is the difference between interest income earned on loans, investment securities and other interest earning assets less interest expense on deposit accounts and other interest bearing liabilities. Loan volume and interest rates earned on those loans are critical to overall profitability. Similarly, deposit volume is crucial to funding loans and rates paid on deposits directly impact profitability. Business volumes are influenced by competition, new business acquisition efforts and economic factors including market interest rates, business spending, consumer confidence and competitive conditions within the marketplace.
Net interest income increased $3.3 million, or 5.2%, for the first nine months of 2015, compared to the same period in 2014. The positive effects of increased volumes on earning assets and lower costs on time deposits were partially offset by the negative effect of declining interest rates earned. Net interest margin declined to 3.71% for the first nine months of 2015, compared to 3.78% for the same period of 2014.
In response to assessment of risk in the loan portfolio, Bancorp did not record a provision for loan losses in the first nine months of 2015, compared to a $400 thousand release of reserves in the first nine months of 2014. The provision for loan losses represents a charge to earnings necessary to establish an allowance for loan losses that, in management’s evaluation, is adequate to provide coverage for the inherent losses on outstanding loans.
Total non-interest income in the first nine months of 2015 increased $495 thousand, or 1.7%, compared to the same period in 2014, and remained consistent at 31% of total revenues. Increases in mortgage banking income and bankcard transaction revenue contributed to the growth, partially offset by decreases in investment management and trust revenue.
Total non-interest expense in the first nine months of 2015 increased $1.1 million, or 2.1%, compared to the same period in 2014, due to increases in salaries and benefits, write-downs on foreclosed assets and other non-interest expenses. These were partially offset by decreases in FDIC insurance and data processing expenses. Bancorp's efficiency ratio in the first nine months of 2015 was 57.3% compared with 58.4% in the same period in 2014.
Bancorp’s effective tax rate increased to 31.7% for the first nine months of 2015 from 31.4% for the same period in 2014. The increase in the effective tax rate from 2014 to 2015 is the result of proportionally lower nontaxable income from the increase in cash value of life insurance and municipal securities. This was partially offset by the effect of reclassifying amortization of tax credit investments to other non-interest expense in 2015.
Tangible common equity (TCE), a non-GAAP measure, is a measure of a company's capital which is useful in evaluating the quality and adequacy of capital. The ratio of tangible common equity to total tangible assets was 10.62% as of September 30, 2015, compared to 10.05% at December 31, 2014. See the Non-GAAP Financial Measures section for details on reconcilement to US GAAP measures.
The following sections provide more details on subjects presented in this overview.
a)
Results Of Operations
Net income of $9.3 million for the three months ended September 30, 2015 decreased $605 thousand, or 6.1%, from $9.9 million for the comparable 2014 period. Basic net income per share was $0.63 for the third quarter of 2015, a decrease of 7.4% from the $0.68 for the third quarter of 2014. Net income per share on a diluted basis was $0.62 for the third quarter of 2015, a decrease of 7.5% from the $0.67 for the same period in 2014. Bancorp did not record a provision for loan losses in the third quarter of 2015, compared to a $2.1 million release of reserves in the same period of 2014.
Reflecting lower net income, annualized return on average assets and annualized return on average stockholders’ equity were 1.44% and 13.32%, respectively, for the third quarter of 2015, compared to 1.64% and 15.79%, respectively, for the same period in 2014.
Net income of $27.5 million for the nine months ended September 30, 2015 increased $1.4 million, or 5.5%, from $26.1 million for the comparable 2014 period. Basic net income per share was $1.87 for the first nine months of 2015, an increase of 4.5% from the $1.79 for the first nine months of 2014. Net income per share on a diluted basis was $1.84 for the first nine months of 2015, an increase of 4.0% from the $1.77 for the first nine months of 2014. Bancorp did not record a provision for loan losses in the first nine months of 2015, compared to a $400 thousand release of reserves in the same period of 2014.
Annualized return on average assets and annualized return on average stockholders’ equity were 1.46% and 13.59%, respectively, for the first nine months of 2015, compared to 1.47% and 14.45%, respectively, for the same period in 2014.
Net Interest Income
The following tables present the average balance sheets for the three and nine month periods ended September 30, 2015 and 2014 along with the related calculation of tax-equivalent net interest income, net interest margin and net interest spread for the related periods. See the notes following the tables for further explanation.
Average Balances and Interest Rates – Taxable Equivalent Basis
Three months ended September 30
balances
Interest
rate
Earning assets:
Securities:
Taxable
Tax-exempt
FHLB stock and other securities
Loans, net of unearned income
Total earning assets
Non-earning assets:
Premises and equipment
Accrued interest receivable and other assets
Interest bearing liabilities:
Interest bearing demand deposits
Savings deposits
Money market deposits
Time deposits
Federal funds purchased and other short term borrowings
Total interest bearing liabilities
Non-interest bearing liabilities:
Non-interest bearing demand deposits
Accrued interest payable and other liabilities
Stockholders’ equity
Net interest spread
Net interest margin
Notes to the average balance and interest rate tables:
Net interest income, the most significant component of the Bank's earnings is total interest income less total interest expense. The level of net interest income is determined by mix and volume of interest earning assets, interest bearing deposits and borrowed funds, and changes in interest rates.
Net interest spread is the difference between the taxable equivalent rate earned on interest earning assets less the rate expensed on interest bearing liabilities.
Net interest margin represents net interest income on a taxable equivalent basis as a percentage of average interest earning assets. Net interest margin is affected by both interest rate spread and the level of non-interest bearing sources of funds, primarily consisting of demand deposits and stockholders’ equity.
Interest income on a fully tax equivalent basis includes the additional amount of interest income that would have been earned if investments in certain tax-exempt interest earning assets had been made in assets subject to federal taxes yielding the same after-tax income. Interest income on municipal securities and loans have been calculated on a fully tax equivalent basis using a federal income tax rate of 35%. Approximate tax equivalent adjustments to interest income were $231 thousand and $241 thousand, respectively, for the three month periods ended September 30, 2015 and 2014 and $700 thousand and $735 thousand, respectively, for the nine month periods ended September 30, 2015 and 2014.
Average balances for loans include the principal balance of non-accrual loans and exclude participation loans accounted for as secured borrowings. These participation loans averaged $7.3 million and $8.8 million, respectively, for the three month periods ended September 30, 2015 and 2014 and $7.8 million and $9.2 million, respectively, for the nine month periods ended September 30, 2015 and 2014.
Fully taxable equivalent net interest income of $22.3 million for the three months ended September 30, 2015 increased $708 thousand, or 3.3%, from $21.6 million when compared to the same period last year. The positive effects of increased volumes on loans and lower costs on time deposits were partially offset by the negative effect of declining interest rates earned. Net interest spread and net interest margin were 3.58% and 3.66%, respectively, for the third quarter of 2015 and 3.71% and 3.80%, respectively, for the third quarter of 2014.
Fully taxable equivalent net interest income of $66.2 million for the nine months ended September 30, 2015 increased $3.2 million, or 5.1%, from $63.0 million when compared to the same period last year. The positive effects of increased volumes on earning assets and lower costs on time deposits were partially offset by the negative effect of declining interest rates earned. Net interest spread and net interest margin were 3.62% and 3.71%, respectively, for the first nine months of 2015 and 3.69% and 3.78%, respectively, for the first nine months of 2014.
Average earning assets increased $157.2 million or 7.1%, to $2.39 billion for the first nine months of 2015 compared to 2014, reflecting growth in the loan portfolio and investment securities. Average interest bearing liabilities increased $34.2 million, or 2.1%, to $1.69 billion for the first nine months of 2015 compared to 2014 primarily due to increases in interest bearing demand, savings and money market deposits, FHLB advances and securities sold under agreements to repurchase, partially offset by decreases in time deposits and federal funds purchased.
Asset/Liability Management and Interest Rate Risk
Managing interest rate risk is fundamental for the financial services industry. The primary objective of interest rate risk management is to neutralize effects of interest rate changes on net income. By considering both on and off-balance sheet financial instruments, management evaluates interest rate sensitivity while attempting to optimize net interest income within the constraints of prudent capital adequacy, liquidity needs, market opportunities and customer requirements.
Interest Rate Simulation Sensitivity Analysis
Bancorp uses an earnings simulation model to estimate and evaluate the impact of an immediate change in interest rates on earnings in a one year forecast. The simulation model is designed to reflect the dynamics of interest earning assets, interest bearing liabilities and off-balance sheet financial instruments. By estimating the effects of interest rate increases and decreases, the model can reveal approximate interest rate risk exposure. The simulation model is used by management to gauge approximate results given a specific change in interest rates at a given point in time. The model is therefore a tool to indicate earnings trends in given interest rate scenarios and does not indicate actual expected results.
Bancorp assumes certain correlation rates, often referred to as a deposit “beta” of interest-bearing deposits, wherein the rates paid to customers change at a different pace when compared to changes in benchmark interest rates. Generally, certificates of deposit are assumed to have a high correlation rate, while interest-bearing checking accounts are assumed to have a lower correlation rate. Actual results may differ due to factors including competitive pricing and money supply; however, Bancorp uses its historical experience as well as industry data to inform its assumptions.
The September 30, 2015 simulation analysis, which shows little interest rate sensitivity, indicates that an increase in interest rates of 100 to 200 basis points would have a negative effect on net interest income, and a decrease of 100 basis points in interest rates would also have a negative impact. These estimates are summarized below.
Net interest
income change
Increase 200bp
Increase 100bp
Decrease 100bp
Decrease 200bp
Management expects that net interest margin will remain under pressure over the balance of the year, and any near-term increases in prevailing interest rates will not immediately benefit the Company. Because approximately 65% of its loan portfolio has fixed rates and 15% of its loan portfolio is priced at variable rates with floors of 4% or higher, a rise in rates would have a short-term negative impact on net interest income since rates would have to increase more than 75 bps before the rates on such loans will rise to compensate for higher interest costs. The extent of margin compression also will be affected by the need to respond to competitive pressures on funding sources. Approximately $693 million, or 35%, of Bancorp’s loans are variable rate; most of these loans are indexed to the prime rate and may reprice as that rate changes. However, approximately $297 million, or 15% of total loans have reached their contractual floor of 4% or higher. Approximately $133 million of variable rate loans have contractual floors below 4%. The remaining $263 million of variable rate loans have no contractual floor. Bancorp attempts to establish floors whenever possible upon acquisition of new customers. Bancorp’s variable rate loans are primarily comprised of commercial lines of credit and real estate loans. At inception, most of Bancorp’s fixed rate loans are priced in relation to the five year Treasury bond.
The scenario of rates decreasing 200 bp is not reasonably possible given current low rates for short-term instruments and most deposits.
Undesignated derivative instruments described in Note 6 are recognized on the consolidated balance sheet at fair value, with changes in fair value, due to changes in prevailing interest rates, recorded in other non-interest income. Because of matching terms of offsetting contracts, in addition to collateral provisions which mitigate the impact of non-performance risk, changes in fair value subsequent to initial recognition have a minimal effect on earnings, and are therefore not included in the simulation analysis results above.
Derivatives designated as cash flow hedges described in Note 6 are recognized on the consolidated balance sheet at fair value, with changes in fair value, due to changes in prevailing interest rates, recorded net of tax in other comprehensive income.
Provision for Loan Losses
The provision for loan losses represents a charge to earnings necessary to establish an allowance for loan losses that, in management’s evaluation, is adequate to provide coverage for inherent losses on outstanding loans. The allowance for loan losses is calculated after considering credit quality factors, and ultimately relies on an overall internal analysis of risk in the loan portfolio. Based on this analysis, the provision for loan losses is determined and recorded. The provision reflects an allowance methodology that is driven by risk ratings, historical losses, and qualitative factors. Levels of non-performing loans have trended downward in 2015 and many key indicators of loan quality continue to show improvement. Bancorp did not record a provision for loan losses in the first nine months of 2015, compared to a $400 thousand release of reserves for the same period of 2014.
Management utilizes loan grading procedures which result in specific allowance allocations for estimated inherent risk of loss. For all loans graded, but not individually reviewed for allowance purposes, a general allowance allocation is computed using historical data based on actual loss experience. Specific and general allocations plus consideration of qualitative factors represent management’s best estimate of probable losses contained in the loan portfolio at the evaluation date. Although the allowance for loan losses is comprised of specific and general allocations, the entire allowance is available to absorb any credit losses. Based on this detailed analysis of credit risk, management considers the allowance for loan losses adequate to cover probable losses inherent in the loan portfolio at September 30, 2015.
An analysis of the changes in the allowance for loan losses and selected ratios for the three and nine month periods ended September 30, 2015 and 2014 follows:
Balance at the beginning of the period
Loan charge-offs, net of recoveries
Balance at the end of the period
Average loans, net of unearned income
Provision for loan losses to average loans (1)
Net loan charge-offs to average loans (1)
Allowance for loan losses to average loans
Allowance for loan losses to period-end loans
(1) Amounts not annualized
Loans are charged off when deemed uncollectible and a loss is identified or after underlying collateral has been liquidated; however, collection efforts may continue and future recoveries may occur. Periodically, loans are partially charged off to net realizable value based upon collateral analysis and collection status.
An analysis of net charge-offs by loan category for the three and nine month periods ended September 30, 2015 and 2014 follows:
Three months
Nine months
Net loan charge-offs (recoveries)
Real estate mortgage - commercial investment
Real estate mortgage - owner occupied commercial
Real estate mortgage - 1-4 family residential
Home equity
Total net loan charge-offs
Non-interest Income and Expenses
The following table sets forth major components of non-interest income and expenses for the three and nine month periods ended September 30, 2015 and 2014.
% Change
Total non-interest income increased $135 thousand, or 1.4%, for the third quarter of 2015 and $495 thousand, or 1.7% for the first nine months of 2015, compared to the same periods in 2014.
The largest component of non-interest income is investment management and trust revenue. The magnitude of investment management and trust revenue distinguishes Bancorp from other banks of similar asset size. Trust assets under management totaled $2.19 billion at September 30, 2015, compared to $2.23 billion at September 30, 2014. Assets under management are stated at market value and the decline arose from a departure of some accounts near the end of 2014. Investment management and trust revenue, which constitutes an average of 45% of non-interest income at September 30, 2015, decreased $129 thousand, or 2.9%, in the third quarter of 2015, and $249 thousand, or 1.8% for the first nine months, as compared to the same periods in 2014. Recurring fees, which generally comprise over 95% of the investment management and trust revenue, increased $117 thousand, or 1%, for the first nine months of 2015, compared to the same period of 2014. However, one-time executor and other non-recurring fees decreased $366 thousand for the first nine months of 2015, compared to the same period in 2014. Most recurring fees earned for managing accounts are based on a percentage of market value on a monthly basis. While fees are based on market values, they typically do not fluctuate directly with the overall stock market, as accounts usually contain fixed income and various equity asset classes. Some revenues of the investment management and trust department, most notably executor, insurance, and some employee benefit plan-related fees, are non-recurring in nature and the timing of these revenues corresponds with the related administrative activities. The investment management and trust department revenue was slightly below year-earlier levels. However, so far this year, it has generated net new business well ahead of levels for the same period last year. Management believes the investment management and trust department will resume its growth in 2016, continue to factor significantly in Bancorp’s financial results and provide strategic diversity to revenue streams.
Service charges on deposit accounts increased $48 thousand, or 2.1%, in the third quarter of 2015, and were virtually flat for the first nine months of 2015, as compared to the same periods in 2014. Service charge income is driven by transaction volume, which can fluctuate throughout the year. A significant component of service charges is related to fees earned on overdrawn checking accounts. Management expects this source of revenue to slowly decline due to anticipated changes in customer behavior and ongoing regulatory restrictions.
Bankcard transaction revenue increased $41 thousand, or 3.5%, in the third quarter of 2015, and $125 thousand, or 3.6% for the first nine months of 2015, compared to the same periods in 2014, and primarily represents income the Bank derives from customers’ use of debit cards. The increase in 2015 reflects an increase in the volume of transactions, partially offset by a decrease in interchange rates received. Interchange income is based on rates set by service providers in a competitive market. Beginning in October 2011, this rate was set by the Federal Reserve for banks with over $10 billion in assets. While this threshold indicates Bancorp will not be directly affected, this change has impacted Bancorp and other similarly sized institutions as merchants gravitate to lower cost interchanges. Volume, which is dependent on consumer behavior, is expected to continue to increase slowly. However, management expects interchange rates to decrease, resulting in income from this source to remain consistent with levels experienced in 2014.
Mortgage banking revenue primarily includes gains on sales of mortgage loans. Bancorp’s mortgage banking department originates residential mortgage loans to be sold in the secondary market. Interest rates on the loans sold are locked with the borrower and investor prior to closing the loans, thus Bancorp bears no interest rate risk related to these loans. The department offers conventional, VA and FHA financing, for purchases and refinances, as well as programs for first-time home buyers. Interest rates on mortgage loans directly impact the volume of business transacted by the mortgage banking division. Mortgage banking revenue increased $131 thousand, or 20.4%, in the third quarter of 2015, and $562 thousand or 28.8%, for the first nine months of 2015, as compared to the same periods in 2014. Market rates for mortgage loans decreased in the first nine months of 2015, resulting in increased refinance activity compared to the same period in 2014. This was coupled with an increase in home purchase activity in the three quarters of 2015, an indicator of improving consumer confidence.
In 2015, Bancorp sold securities with total fair market value of $5.9 million, generating no gain or loss. These securities consisted of agency and mortgage-backed securities with small remaining balances. In 2014, Bancorp sold securities with total fair market value of $7.7 million, generating a net loss of $9 thousand. These securities consisted of mortgage-backed securities with small remaining balances, obligations of state and political subdivisions, and agency securities. These sales were made in the ordinary course of portfolio management.
Brokerage commissions and fees increased $46 thousand, or 8.5%, in the third quarter of 2015, and $39 thousand or 2.6% for the first nine months of 2015, as compared to the same periods in 2014, corresponding to overall brokerage volume. The increase is due to the timing of an incentive, paid from a third party to Bancorp, which was recorded in the third quarter of 2015 and the fourth quarter of 2014. Excluding the timing of the incentive, brokerage commissions and fees were virtually unchanged compared to the same periods in 2014. Brokerage commissions and fees earned consist primarily of stock, bond and mutual fund sales as well as wrap fees on accounts. Wrap fees are charges for investment programs that bundle together a suite of services, such as brokerage, advisory, research and management, and are based on a percentage of assets. Bancorp deploys its brokers primarily through its branch network via an arrangement with a third party broker-dealer, while larger managed accounts are serviced in the investment management and trust department.
Bank Owned Life Insurance (BOLI) income totaled $222 thousand and $229 thousand for the third quarter of 2015 and 2014, respectively, and totaled $670 thousand and $699 thousand for the first nine months of 2015 and 2014, respectively. BOLI represents the cash surrender value for life insurance policies on certain key employees who have provided consent for Bancorp to be the beneficiary of a portion of such policies. Any proceeds received under the policies and the related change in cash surrender value are recorded as non-interest income. This income helps offset the cost of various employee benefits.
Other non-interest income was virtually flat for the third quarter of 2015, and increased $37 thousand, or 2.8%, in the first nine months of 2015, as compared to the same periods in 2014, due to a variety of other factors, none of which are individually significant.
Total non-interest expenses decreased $279 thousand, or 1.5%, for the third quarter of 2015, and increased $1.1 million, or 2.1%, for the first nine months of 2015, as compared to the same periods in 2014.
Salaries and employee benefits decreased $522 thousand, or 4.4%, for the third quarter of 2015, and increased $119 thousand, or 0.4% for the first nine months of 2015, as compared to the same periods of 2014. For the third quarter, the decrease is largely due to higher bonus accruals and stock compensation in the third quarter of 2014. Partially offsetting this was an increase in salaries and health insurance costs in 2015. For the nine month period, the increase is due to an increase in salaries and health insurance costs, mostly offset by lower bonus accruals. Increased salary expenses arose from normal salary increases and staff additions including senior staff with higher per capita salaries in investment management and trust and lending functions. At September 30, 2015, Bancorp had 546 full-time equivalent employees compared to 527 at September 30, 2014.
Net occupancy expense increased $96 thousand, or 6.8%, in the third quarter of 2015, and was virtually flat for the first nine months of 2015, as compared to the same periods of 2014. The increase for the third quarter was largely due to increased maintenance and utilities expense and, to a lesser extent, increased rent and depreciation for locations added during 2015.
Data processing expense decreased $19 thousand, or 1.2% in the third quarter of 2015, and $87 thousand, or 1.8% for the first nine months of 2015, compared to the same periods of 2014. The decrease for the first nine months of 2015 is largely due to decreases in expenses for bank card processing/reissuance. This category includes ongoing computer software amortization and maintenance related to investments in new technology needed to maintain and improve the quality of delivery channels and internal resources.
Furniture and equipment expense increased $13 thousand, or 4.8% for the third quarter of 2015, and decreased $7 thousand, or 0.9% for the first nine months of 2015, as compared to the same periods in 2014. These fluctuations relate to a variety of factors, none of which were individually significant. Costs of capital asset additions flow through the statement of income over the lives of the assets in the form of depreciation expense.
FDIC insurance expense decreased $22 thousand, or 6.5%, for the third quarter of 2015, and $100 thousand or 9.7% for the first nine months of 2015, as compared to the same periods in 2014. The assessment is calculated by the FDIC and adjusted quarterly. The decline in expense is due primarily to a reduction in the assessment rate, which was driven by improved credit metrics.
Net gains on other real estate owned (OREO) totaled $12 thousand for the third quarter of 2015 compared to losses totaling $7 thousand for the same period in 2014. Net losses on OREO totaled $153 thousand for the first nine months of 2015 compared to gains totaling $342 thousand for the same period in 2014.
Other non-interest expenses increased $194 thousand or 6.0% in the third quarter of 2015, and $696 thousand or 7.3% for the first nine months of 2015, as compared to the same periods in 2014. The increases are largely due to tax credit amortization of $158 thousand for the third quarter and $475 thousand for the first nine months of 2015 that was formerly recorded as income tax expense in 2014. Also included in 2015 were expenses totaling $170 thousand for the third quarter and $372 thousand for the first nine months of 2015 to establish a reserve for estimated losses on unfunded credit commitments. This category also includes MSR amortization, legal and professional fees, advertising, printing, mail and telecommunications, none of which had individually significant variances.
In the third quarter of 2015, Bancorp recorded income tax expense of $4.4 million, compared to $4.7 million for the same period in 2014. The effective rate for the three month period was 31.9% in 2015 and 32.3% in 2014. Bancorp recorded income tax expense of $12.8 million for the first nine months of 2015, compared to $12.0 million for the same period in 2014. The effective rate for the nine month period was 31.7% in 2015 and 31.4% in 2014. The increase in the effective tax rate from 2014 to 2015 is the result of proportionally lower nontaxable income from the increase in cash value of life insurance and municipal securities, due to higher total pre-tax income. This was partially offset by the effect of amortization of tax credit investments which was recorded in other non-interest expense in 2015 and a component of tax expense in 2014.
Commitments
Bancorp uses a variety of financial instruments in the normal course of business to meet the financial needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. A discussion of Bancorp’s commitments is included in Note 9.
Other commitments discussed in Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2014, have not materially changed since that report was filed, relative to qualitative and quantitative disclosures of fixed and determinable contractual obligations.
b)
Financial Condition
Balance Sheet
Total assets increased $60.7 million, or 2.4%, from $2.56 billion on December 31, 2014 to $2.62 billion on September 30, 2015. The most significant contributor to the increase was loans, which rose $85.9 million in the first nine months of 2015. Loan production for the first nine months of 2015 has outpaced record production in 2014, contributing to solid net loan growth. Securities available-for-sale decreased $8.7 million largely as a result of maturing securities. Included in securities available-for-sale are short term obligations of U.S. Treasury or U.S. government sponsored entities. These securities, which totaled $100 million and $95 million at September 30, 2015 and December 31, 2014, respectively, normally have a maturity of less than one month, and are purchased at quarter-end as part of a tax minimization strategy. Cash and cash equivalents decreased $19.0 million, while mortgage loans held for sale increased $1.8 million. Other assets decreased $4.1 million, driven primarily by a $1.4 million decline in other real estate owned and a $1.8 million decrease in deferred tax assets.
Total liabilities increased $39.7 million, or 1.7%, from $2.30 billion December 31, 2014 to $2.34 billion on September 30, 2015. The most significant component of the increase was deposits, which rose $18.0 million or 0.8%, while Federal Home Loan Bank (“FHLB”) advances increased $6.9 million or 18.6%. Bancorp utilizes FHLB advances to manage the interest rate risk exposure of certain long-term fixed rate loans. Federal funds purchased increased $14.7 million, or 31.0%. Bancorp utilizes short-term lines of credit to manage its overall liquidity position. Securities sold under agreement to repurchase decreased $2.0 million or 2.9%, and other liabilities increased $2.2 million or 8.2%.
Elements of Loan Portfolio
The following table sets forth the major classifications of the loan portfolio.
Loans by Type
Undeveloped land (1)
Total Loans
Undeveloped land consists of land initially acquired for development by the borrower, but for which no development has yet taken place.
Bancorp occasionally enters into loan participation agreements with other banks to diversify credit risk. For certain sold participation loans, Bancorp has retained effective control of the loans, typically by restricting the participating institutions from pledging or selling their share of the loan without permission from Bancorp. US GAAP requires the participated portion of these loans to be recorded as secured borrowings. These participated loans are included in the commercial and industrial and real estate mortgage loan totals above, and a corresponding liability is recorded in other liabilities. At September 30, 2015 and December 31, 2014, the total participated portions of loans of this nature were $7.2 million and $8.1 million, respectively.
Non-performing Loans and Assets
Information summarizing non-performing assets, including non-accrual loans follows:
Non-accrual loans
Troubled debt restructuring
Loans past due 90 days or more and still accruing
Non-performing loans
Foreclosed real estate
Non-performing assets
Non-performing loans as a percentage of total loans
Non-performing assets as a percentage of total assets
The decrease in loans modified as troubled debt restructuring reflects the migration of one lending relationship to performing status.
The following table sets forth the major classifications of non-accrual loans:
Non-accrual loans by type
Home equity and consumer loans
The increase in non-accrual loans in the commercial and industrial classification primarily reflected the migration of two lending relationships to non-accrual status, on which Bancorp’s exposure to loss is now fully allocated within its allowance for loan losses.
c)
Liquidity
The role of liquidity management is to ensure funds are available to meet depositors’ withdrawal and borrowers’ credit demands while at the same time maximizing profitability. This is accomplished by balancing changes in demand for funds with changes in the supply of those funds. Liquidity is provided by short-term liquid assets that can be converted to cash, investment securities available-for-sale, various lines of credit available to Bancorp, and the ability to attract funds from external sources, principally deposits. Management believes it has the ability to increase deposits at any time by offering rates slightly higher than market rate.
Bancorp’s most liquid assets are comprised of cash and due from banks, available-for-sale marketable investment securities and federal funds sold. Federal funds sold totaled $17.9 million at September 30, 2015. These investments normally have overnight maturities and are used for general daily liquidity purposes. The fair value of the available-for-sale investment portfolio was $504.4 million at September 30, 2015. The portfolio includes maturities of approximately $125.3 million over the next twelve months, including $100 million of short-term securities which matured in October 2015. Combined with federal funds sold, these offer substantial resources to meet either new loan demand or reductions in Bancorp’s deposit funding base. Bancorp pledges portions of its investment securities portfolio to secure public fund deposits, cash balances of certain investment management and trust accounts, and securities sold under agreements to repurchase. At September 30, 2015, total investment securities pledged for these purposes comprised 55% of the available-for-sale investment portfolio, leaving $226.3 million of unpledged securities.
Bancorp has a large base of non-maturity customer deposits, defined as demand, savings, and money market deposit accounts. At September 30, 2015, such deposits totaled $1.87 billion and represented 87% of Bancorp’s total deposits. Because these deposits are less volatile and are often tied to other products of Bancorp through long lasting relationships they do not put heavy pressure on liquidity. However, many of Bancorp’s overall deposit balances are historically high. When market conditions improve, these balances will likely decrease, putting some strain on Bancorp’s liquidity position. As of September 30, 2015, Bancorp had only $498 thousand or 0.02% of total deposits, in brokered deposits.
Other sources of funds available to meet daily needs include the sale of securities under agreements to repurchase. Also, Bancorp is a member of the FHLB of Cincinnati. As a member of the FHLB, Bancorp has access to credit products offered by the FHLB. Bancorp views these borrowings as a low cost alternative to other time deposits. At September 30, 2015, available credit from the FHLB totaled $408.1 million. Additionally, Bancorp had available federal funds purchased lines with correspondent banks totaling $24 million at September 30, 2015.
Bancorp’s principal source of cash revenues is dividends paid to it as sole shareholder of the Bank. At September 30, 2015, the Bank may pay up to $52.5 million in dividends to Bancorp without regulatory approval subject to the ongoing capital requirements of the Bank.
d)
Capital Resources
At September 30, 2015, stockholders’ equity totaled $280.9 million, an increase of $21.1 million since December 31, 2014. See the Consolidated Statement of Changes in Stockholders’ Equity for further detail of the changes in equity since the end of 2014. One component of equity is accumulated other comprehensive income which, for Bancorp, consists of net unrealized gains or losses on securities available-for-sale and hedging instruments, as well as a minimum pension liability, each net of taxes. Accumulated other comprehensive income was $3.1 million at September 30, 2015 compared to a $2.1 million at December 31, 2014. The $1.0 million increase is primarily a reflection of the positive effect of the changing interest rate environment during the first nine months of 2015 on the valuation of Bancorp’s portfolio of securities available-for-sale.
The following table sets forth Bancorp’s and the Bank’s risk based capital ratios as of September 30, 2015 and December 31, 2014.
Common equity tier 1 risk-based capital (1) (2)
Under the banking agencies risk-based capital guidelines, assets and credit-equivalent amounts of derivatives and off-balance sheet exposures are assigned to broad risk categories. The aggregate dollar amount in each risk category is multiplied by the associated risk weight of the category. The resulting weighted values are added together, resulting in the Bancorp’s total risk-weighted assets. These ratios are computed in relation to average assets.
The rules described below established common equity tier 1 capital effective January 1, 2015. The ratio was not prescribed in prior years. For Bancorp, this is equal to tier 1 capital, and therefore, the ratio is equal to the tier 1 risk-based capital ratio.
Ratio is computed in relation to average assets
In 2013, the Federal Reserve Board and the FDIC approved rules that substantially amended the regulatory risk-based capital rules applicable to Bancorp and Bank. The rules implemented the regulatory capital reforms of the Basel Committee on Banking Supervision reflected in "Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems" (Basel III) and changes required by the Dodd-Frank Act. The Basel III regulatory capital reforms became effective for Bancorp and Bank on January 1, 2015, and included new minimum risk-based capital and leverage ratios. The new minimum capital level requirements applicable to bank holding companies and banks subject to the rules are:
•
a new common equity Tier 1 capital ratio of 4.5%,
a Tier 1 risk-based capital ratio of 6% (increased from 4%),
a total risk-based capital ratio of 8% (unchanged from current rules), and
a Tier 1 leverage ratio of 4% for all institutions.
The rules also established a "capital conservation buffer" of 2.5%, to be phased in over three years, above the new regulatory minimum risk-based capital ratios, and will result in the following minimum ratios once the capital conservation buffer is fully phased in:
a common equity Tier 1 risk-based capital ratio of 7.0%,
a Tier 1 risk-based capital ratio of 8.5%, and
a total risk-based capital ratio of 10.5%.
The rules allowed banks and their holding companies with less than $250 billion in assets a one-time opportunity to opt-out of a requirement to include unrealized gains and losses in accumulated other comprehensive income in their capital calculation. Bancorp opted out of this requirement.
For Bancorp, the key differences under Basel III include risk weighting for commitments under one year and higher risk weighting for certain commercial real estate and construction loans. These differences resulted in higher risk-weighted assets, and therefore, somewhat lower risk-based capital ratios. Bancorp estimates the effect of these key differences decreased the Tier 1 risk-based capital ratio 0.30% and the total risk based-capital ratio 0.34%.
Management believes that as of September 30, 2015, Bancorp meets the requirements to be considered well-capitalized under the new rules.
e)
Non-GAAP Financial Measures
In addition to capital ratios defined by banking regulators, Bancorp considers various ratios when evaluating capital adequacy, including tangible common equity to tangible assets, and tangible common equity per share, all of which are non-GAAP measures. Bancorp believes these ratios are important because of their widespread use by investors as means to evaluate capital adequacy, as they reflect the level of capital available to withstand unexpected market conditions. Because US GAAP does not include capital ratio measures, there are no US GAAP financial measures comparable to these ratios.
The following table reconciles Bancorp’s calculation of measures to amounts reported under US GAAP.
(in thousands, except per share data)
Total equity
Less core deposit intangible
Less goodwill
Tangible common equity
Total tangible assets
Total shareholders' equity to total assets
Tangible common equity ratio
Number of outstanding shares
Book value per share
Tangible common equity per share
f)
Recently Issued Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers, which outlines a single comprehensive model for use in accounting for revenue arising from contracts with customers, and supersedes most current revenue recognition guidance. The ASU was originally effective for fiscal years and interim periods beginning after December 15, 2016. In August 2015, FASB issued ASU 2015-14 which delays the effective date. The effective date will be annual reporting periods beginning after December 15, 2017, and the interim periods within that year. Bancorp is still evaluating the potential impact of adoption of ASU 2014-09.
In April 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2015-03, Interest – Imputation of Interest, which changes the presentation of debt issuance costs in financial statements. Under the ASU, an entity presents such costs in the balance sheet as a direct deduction from the related debt liability rather than as an asset. Amortization of the costs is reported as interest expense. Subsequent to the issuance of ASU 2015-03, the SEC staff made an announcement regarding the presentation of debt issuance costs associated with line-of-credit arrangements, which was codified in August 2015 when FASB issued ASU 2015-15. This guidance allows an entity to present debt issuance costs as an asset and amortize the deferred debt issuance costs ratably over the term of the line-of-credit arrangement, regardless of whether there are any outstanding borrowings on the line-of-credit arrangement. The SEC guidance is effective upon adoption of ASU 2015-03. ASU 2015-03 is effective for fiscal years and interim periods beginning after December 15, 2016. The adoption of ASU 2015-03 is not expected to have a significant impact on Bancorp’s operations or financial statements.
In September 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2015-16, Business Combinations, which eliminates the requirement for an acquirer to retrospectively adjust the financial statements for measurement-period adjustments that occur in periods after a business combination is consummated. The ASU is effective for fiscal years and interim periods beginning after December 15, 2015. The adoption of ASU 2015-16 is not expected to have a significant impact on Bancorp’s operations or financial statements.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Information required by this item is included in Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Item 4. Controls and Procedures
Bancorp maintains disclosure controls and procedures designed to ensure that it is able to collect the information it is required to disclose in reports it files with the Securities and Exchange Commission (“SEC”), and to record, process, summarize and report this information within the time periods specified in the rules and forms of the SEC. Based on their evaluation of Bancorp’s disclosure controls and procedures as of the end of the quarterly period covered by this report, the Chief Executive and Chief Financial Officers believe that these controls and procedures are effective to ensure that Bancorp is able to collect, process and disclose the information it is required to disclose in reports it files with the SEC within the required time periods.
Based on the evaluation of Bancorp’s disclosure controls and procedures by the Chief Executive and Chief Financial Officers, there were no significant changes during the quarter ended September 30, 2015 in Bancorp’s internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, Bancorp’s internal control over financial reporting.
PART II – OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
The following table shows information relating to the repurchase of shares of common stock by Bancorp during the three months ended September 30, 2015.
Total number of
purchased (1)
Average price
paid per share
shares purchased as
part of publicly
announced plan (2)
Maximum number of
shares that may yet be
purchased under the
plan
July 1 - July 31
August 1 - August 31
September 1 - September 30
Activity represents shares of stock withheld to pay taxes due upon exercise of stock appreciation rights. This activity has no impact on the number of shares that may be purchased under a Board-approved plan.
Since 2008, there has been no active share buyback plan.
Item 6. Exhibits
The following exhibits are filed or furnished as a part of this report:
Exhibit
101
The following financial statements from the Stock Yards Bancorp, Inc. September 30, 2015 Quarterly Report on Form 10-Q, filed on November 5, 2015, formatted in eXtensible Business Reporting Language (XBRL):
Consolidated Statements of Income
Consolidated Statements of Comprehensive Income
Consolidated Statements of Changes in Stockholders’ Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Date: November 5, 2015
By: /s/ David P. Heintzman
David P. Heintzman, Chairman
and Chief Executive Officer
By: /s/ Nancy B. Davis
Nancy B. Davis, Executive Vice President,
Treasurer and Chief Financial Officer
58