UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended September 30, 2003
OR
For the transition period from to
Commission file number 0-4887
UMB FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
(I.R.S. – Employer of Incorporation
or organization Identification Number)
1010 Grand Boulevard
Kansas City, Missouri 64106
(Address of principal executive offices and Zip Code)
(Registrant’s telephone number, including area code) (816) 860-7000
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨
Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date.
As of October, 31, 2003, UMB Financial Corporation had 21,734,022 shares of common stock outstanding.
INDEX
PART I
ITEM 1.FINANCIAL STATEMENTS
CONDENSED CONSOLIDATED BALANCE SHEETS
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
STATEMENTS OF CHANGES IN CONSOLIDATED SHAREHOLDERS’ EQUITY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
ITEM 2.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
ITEM 4.CONTROLS AND PROCEDURES
PART II
OTHER INFORMATION
ITEM 1.LEGAL PROCEEDINGS
ITEM 2.CHANGES IN SECURITIES AND USE OF PROCEEDS
ITEM 3.DEFAULTS UPON SENIOR SECURITIES
ITEM 4.SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS
ITEM 5.OTHER INFORMATION
ITEM 6.EXHIBITS AND REPORTS ON FORM 8-K
SIGNATURES
CERTIFICATION PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT
CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
2
ITEM 1. FINANCIAL STATEMENTS
(unaudited, dollars in thousands, except per share data)
December 31,
2002
ASSETS
Loans:
Commercial, financial and agricultural
Consumer (net of unearned interest)
Real estate mortgage
Leases
Allowance for loan losses
Net loans
Securities available for sale:
U.S. Treasury and agencies
State and political subdivisions
Commercial paper and other
Total securities available for sale
Securities held to maturity:
State and political subdivisions (market value of $361,234, $481,532 and $418,264, respectively)
Federal funds sold and resell agreements
Trading securities and other
Total earning assets
Cash and due from banks
Bank premises and equipment, net
Accrued income
Goodwill on purchased affiliates
Other intangibles
Other assets
Total assets
LIABILITIES
Deposits:
Noninterest-bearing demand
Interest-bearing demand and savings
Time deposits under $100,000
Time deposits of $100,000 or more
Total deposits
Federal funds purchased and repurchase agreements
Short-term debt
Long-term debt
Accrued expenses and taxes
Other liabilities
Total liabilities
SHAREHOLDERS’ EQUITY
Common stock, $1.00 par value; authorized 33,000,000 shares; issued 27,528,365, 27,528,365 and 27,528,365 shares, respectively
Capital surplus
Retained earnings
Accumulated other comprehensive income
Treasury stock, 5,791,081, 5,439,415 and 5,545,396 shares, at cost, respectively
Unearned ESOP shares
Total shareholders’ equity
Total liabilities and shareholders’ equity
See Notes to Condensed Consolidated Financial Statements.
3
For the Three Months
Ended September 30,
For the Nine Months
INTEREST INCOME
Loans
Securities:
Taxable interest
Tax-exempt interest
Total securities income
Federal funds and resell agreements
Total interest income
INTEREST EXPENSE
Deposits
Federal funds and repurchase agreements
Total interest expense
Net interest income
Provision for loan losses
Net interest income after provision
NONINTEREST INCOME
Trust and securities processing
Trading and investment banking
Service charges on deposits
Other service charges and fees
Bankcard fees
Net investment security gains
Other
Total noninterest income
NONINTEREST EXPENSE
Salaries and employee benefits
Occupancy, net
Equipment
Supplies and services
Marketing and business development
Processing fees
Legal and consulting
Amortization of intangibles
Total noninterest expense
Income before income taxes
Income tax expense
NET INCOME
PER SHARE DATA
Net income - Basic
Net income - Diluted
Dividends
Weighted average shares outstanding
4
(unaudited, dollars in thousands)
Common
Stock
Capital
Surplus
Retained
Earnings
Accumulated
Comprehensive
Income
Treasury
Unearned
ESOP
Balance - January 1, 2002
Net income
Other comprehensive income, change in unrealized gain on securities of $7,523, net of tax $2,790 and the reclassification adjustment for gains included in net income of $2,477 net tax of $902
Total comprehensive income
Cash dividends
Earned ESOP shares
Purchases of treasury stock
Sales of treasury stock
Exercise of stock options
Balance - September 30, 2002
Balance - January 1, 2003
Other comprehensive income, change in unrealized loss on securities of $20,672, net of tax $7,528
Balance - September 30, 2003
5
Nine Months Ended
September 30,
Operating Activities
Net Income
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
Deferred income taxes
Net decrease in trading securities and other earning assets
Gains on sales of securities available for sale
Amortization of securities premiums, net of discount accretion
Changes in:
Other assets and liabilities, net
Net cash provided by operating activities
Investing Activities
Proceeds from maturities of investment securities
Proceeds from sales of securities available for sale
Proceeds from maturities of securities available for sale
Purchases of investment securities
Purchases of securities available for sale
Net (increase) decrease in loans
Net increase in fed funds and resell agreements
Investment in consolidated subsidiary
Purchases of bank premises and equipment
Net change in unsettled securities transactions
Proceeds from sales of bank premises and equipment
Net cash provided by investing activities
Financing Activities
Net decrease in demand and savings deposits
Net decrease in time deposits
Net decrease in fed funds/ repurchase agreements
Net decrease in short term borrowings
Proceeds from long term debt
Repayment of long term debt
Proceeds from exercise of stock options and sales of treasury stock
Net used in financing activities
Decrease in cash and due from banks
Cash and due from banks at beginning of period
Cash and due from banks at end of period
6
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2003
1. Financial Statement Presentation
The consolidated financial statements include the accounts of UMB Financial Corporation and its subsidiaries (collectively, the “Company”) after elimination of all material intercompany transactions. In the opinion of management of the Company, all adjustments, which were of a normal recurring nature and necessary for a fair presentation of the financial position and results of operations, have been made. The results of operations and cash flows for the interim periods presented may not be indicative of the results of the full year. The financial statements should be read in conjunction with the Management’s Discussion and Analysis of Financial Condition and Results of Operations and in conjunction with the Company’s 2002 Annual Report on Form 10-K.
2. Summary of Accounting Policies
The Company is a multi-bank holding company and financial holding company which offers a wide range of banking services to its customers through its branches and offices in the states of Missouri, Kansas, Colorado, Illinois, Oklahoma, Nebraska and Wisconsin. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. These estimates and assumptions also impact reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Following is a summary of the more significant accounting policies to assist the reader in understanding the financial presentation.
Loans. Affiliate banks enter into lease financing transactions that are generally recorded as financial leases. Management recognizes income on a basis that it believes results in an approximately level rate of return over the life of the lease.
A loan is considered to be impaired when management believes it is probable that the Company will be unable to collect all principal and interest due according to the contractual terms of the loan. If a loan is impaired, the Company records a loss valuation allowance equal to the carrying amount of the loan in excess of the present value of the estimated future cash flows discounted at the loan’s effective rate, based on the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. Real estate and consumer loans are collectively evaluated for impairment. Management evaluates the possible impairment of commercial loans on a loan-by-loan basis.
Management bases the adequacy of the allowance for loan losses on its continuing evaluation of the pertinent factors underlying the quality of the loan portfolio, including actual loan loss experience, current economic conditions, detailed analysis of individual loans for which full collectibility may not be assured, determination of the existence and realizable value of the collateral and guarantees securing such loans. The actual losses, notwithstanding such considerations, however, could differ significantly from the amounts estimated by management.
Securities. Debt securities available for sale by the Company principally include U.S. Treasury and agency securities and mortgage-backed securities. Securities classified as available for sale are measured at fair value. The Company excludes unrealized holding gains and losses from earnings and reports them in accumulated other comprehensive income until realized. The Company computes realized gains and losses on sales by the specific identification method at the time of disposition and states them separately as a component of noninterest income.
The Company carries securities held to maturity at amortized historical cost based on management’s intention, and the Company’s ability, to hold them to maturity. The Company classifies most securities of state and political subdivisions as held to maturity. Certain significant unforeseeable changes in circumstances may change the Company’s intent to hold these securities to maturity. For example, such changes may include deterioration in the issuer’s credit-worthiness that is expected to continue or a change in tax law that eliminates the tax-exempt status of interest on the security.
The Company carries trading securities, generally acquired for subsequent sale to customers, at market value. The Company considers market adjustments, fees and gains or losses on the sale of trading securities to be a normal part of operations and includes such adjustments, fees and gains or losses in trading and investment banking income. The Company includes interest income on trading securities in income from earning assets.
7
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)
Goodwill and Other Intangibles. Effective January 1, 2002, the Company adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 142, as required for goodwill and indefinite-lived intangible assets resulting from business combinations. The new rules require that goodwill and intangible assets deemed to have indefinite lives are no longer amortized, but are tested at least annually for impairment. Prior to January 1, 2002, goodwill and other intangibles were amortized using the straight-line method over periods up to 40 years. As a result of the adoption of SFAS No. 142, the Company has segregated goodwill acquired from prior acquisitions into the separate line items of goodwill and other intangibles in the accompanying consolidated balance sheets. Goodwill is no longer amortized but is tested for impairment annually. Effective January 1, 2002, the Company performed the transitional impairment test of goodwill in accordance with SFAS No. 142, which resulted in no impairment charge. The Company has elected November 30 as its annual measurement date for testing impairment and as a result of the impairment test performed on November 30, 2002, no impairment charge was recorded. Other intangible assets are amortized over a period of 10 years.
Per Share Data. Basic income per share is computed based on the weighted average number of shares of common stock outstanding during each period. Diluted quarterly per share data includes the diluted effect of 65,637 and 59,889 shares issueable under options granted by the Company at September 30, 2003 and 2002, respectively. Diluted year to date per share data includes the diluted effect of 38,042 and 69,713 shares issueable under options granted by the Company at September 30, 2003 and 2002, respectively.
Accounting for Stock-Based Compensation. Stock-based compensation is recognized using the intrinsic value method for accounting purposes. Pro forma net income and earnings per share are disclosed as if the fair value method had been applied.
The Company applies Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for its plans. Accordingly, no compensation cost has been recognized for the stock option plan. The table below in accordance with SFAS No. 148 “Accounting for Stock Based Compensation – Transition and Disclosure, an Amendment to FASB Statement 123”, discloses the effect on the Company’s net income and per share data for the three months ended September 30, 2003 and 2002, and for the nine months ended September 30, 2003 and 2002, had compensation costs for the Company’s plans been determined based upon the fair value at the grant date for awards under these plans consistent with the methodology prescribed under SFAS No. 123, “Accounting for Stock-Based Compensation.”
Three Months Ended
Net income, as reported
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects
Pro forma net income
Earnings per share:
Basic-as reported
Basic-pro forma
Diluted-as reported
Diluted-pro forma
3. New Accounting Pronouncements
Amendment of Statement 133 on Derivative Instruments and Hedging Activities. In April, 2003, FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” The statement amends and clarifies financial accounting and reporting for derivative instruments, including certain
8
derivative instruments embedded in other contracts under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. This statement is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. Implementation of this statement did not have a material effect on the Company’s consolidated financial statements.
Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. In May 2003, FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” The statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were formerly classified as equity. This statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatory, redeemable financial instruments of nonpublic entities. Implementation of this statement did not have a material effect on the Company’s consolidated financial statements.
4. Allowance for loan losses
The following is an analysis of the allowance for loan losses for the three and nine months ended September 30, 2003 and 2002 (in thousands):
Allowance - July 1, and January 1,
Additions(deductions):
Charge-offs
Recoveries
Net (charge-offs) recoveries
Provision charged to expense
Allowance - September 30,
Impaired loans under SFAS No. 114. SFAS No. 114, “Accounting by Creditors for Impairment of a Loan” requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, at the loan’s observable market price, or at the fair value of the collateral securing the loan. The summary below provides an analysis of impaired loans under SFAS No. 114 for the nine months ended September 30, 2003 and 2002 and for the year ended December 31, 2002 (in thousands):
Year Ended
Total impaired loans as of September 30 and December 31
Amount of impaired loans which have a related allowance
Amount of related allowance
Remaining impaired loans with no allowance
Average recorded investment in impaired loans (approximately) during the period
5. Goodwill and other intangibles
Changes in the carrying amount of goodwill for the nine months ended September 30, 2003 by operating segment are as follows (in thousands):
Community
Banking
Trust and
Securities
Processing
Balances as of January 1, 2003
Goodwill acquired during the period
Balances as of September 30, 2003
9
Following are the intangible assets that continue to be subject to amortization (in thousands):
Gross
Carrying
Amount
Amortization
Net
Core deposit intangible assets
Other intangible assets
Total
Three Months
Ended
Nine Months
Aggregate amortization expense
Estimated amortization expense of intangible assets on future years:
For the year ended December 31, 2003
For the year ended December 31, 2004
For the year ended December 31, 2005
For the year ended December 31, 2006
For the year ended December 31, 2007
6. Commitments, Contingencies and Guarantees:
In the normal course of business, the Company is a party to financial instruments with off-balance-sheet risk in order to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit, commercial letters of credit, standby letters of credit, and futures contracts. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet.
The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, commercial letters of credit, and standby letters of credit is represented by the contract or notional amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the agreement. These conditions generally include, but are not limited to, each customer being current as to repayment terms of existing loans and no deterioration in the customer’s financial condition. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The interest rate is generally a variable rate. If the commitment has a fixed interest rate, the rate is generally not set until such time as credit is extended. For credit card customers, the Company has the right to change or terminate any terms or conditions of the credit card account at any time. Since a large portion of the commitments and unused credit card lines are never actually drawn upon, the total commitment amount does not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on an individual basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation. Collateral held varies but may include accounts receivable, inventory, real estate, plant and equipment, stock, securities and certificates of deposit.
Commercial letters of credit are issued specifically to facilitate trade or commerce. Under the terms of a commercial letter of credit, as a general rule, drafts will be drawn when the underlying transaction is consummated as intended. Standby letters of credit are conditional commitments issued by the Company with respect to the performance of a customer of its obligations to a third party.
The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities. The Company holds collateral supporting those commitments when deemed necessary. Collateral varies but may include accounts receivable, inventory, real estate, plant and equipment, stock, securities and certificates of deposit.
10
Futures contracts are contracts for delayed delivery of securities or money market instruments in which the seller agrees to make delivery at a specified future date, of a specified instrument, at a specified yield. Risks arise from the possible inability of counterparties to meet the terms of their contracts and from movement in securities values and interest rates. Instruments used in trading activities are carried at market value and gains and losses on futures contracts are settled in cash daily. Any changes in the market value are recognized in trading and investment banking income.
The Company’s use of futures contracts is very limited. The Company uses contracts to offset interest rate risk on specific securities held in the trading portfolio. Open futures contract positions averaged $39.8 million and $45.0 million for the nine months ended September 30, 2003 and 2002, respectively. Net futures activity resulted in losses of $0.9 million for the nine months ended September 30, 2003, and $3.1 million for the same period in 2002. The Company controls the credit risk of its futures contracts through credit approvals, limits and monitoring procedures.
The Company also enters into foreign exchange contracts on a limited basis. For operating purposes, the Company maintains certain balances in foreign banks. Foreign exchange contracts are purchased on a monthly basis to avoid foreign exchange risk on these foreign balances. The Company will also enter into foreign exchange contracts to facilitate foreign exchange needs of customers. The Company will enter into a contract to buy or sell a foreign currency at a future date only as part of a contract to sell or buy the foreign currency at the same future date to a customer. During the nine months ended September 30, 2003, contracts to purchase and sell foreign currency averaged approximately $11.4 million compared to $59.8 million for the same period in 2002. The net gain on these foreign exchange contracts for the nine months ended September 30, 2003 and 2002 was $1.3 million and $0.9 million, respectively.
With respect to group concentrations of credit risk, most of the Company’s business activity is with customers in the states of Missouri, Kansas, Colorado, Oklahoma, Nebraska and Illinois. At September 30, 2003, the Company did not have any significant credit concentrations in any particular industry.
In the normal course of business, the Company is named defendant in various lawsuits and counter-claims. In the opinion of management, after consultation with legal counsel, none of these lawsuits are expected to have a materially adverse effect on the financial position or results of operations of the Company.
The Company has issued standby letters of credit, which in many respects are comparable to guarantees of its customers’ obligations. Standby letters of credit are conditional commitments issued by the Company payable upon the non-performance of a customer’s obligations to a third party. The Company issues these standby letters of credit for terms ranging from three months to three years. The Company generally requires the customer to pledge collateral to support the letter of credit. The maximum liability to the Company under standby letters of credit at September 30, 2003 was $164.1 million. It is unlikely that the Company would ever have to payout on any significant portion of the $164.1 million. As of September 30, 2003, the Company has issued standby letters of credit totaling $30.5 million to related parties of the Company.
Contract or Notional Amount (dollars in thousands)
Commitments to extend credit for loans (excluding credit card loans)
Commitments to extend credit under credit card loans
Commercial letters of credit
Standby letters of credit
Futures contracts
11
7. Business Segment Reporting
The Company has strategically aligned its operations into four major lines of business, as shown below (collectively, “Business Segments”). The Business Segments are differentiated based on the products and services provided. The Chairman of the Board and Chief Executive Officer regularly evaluates lines of business financial results shown on reports produced by the Company’s internal management accounting system in deciding how to allocate resources and assess performance of each individual Business Segment. Management assigns balance sheet and income statement items to each line of business using consistently applied methodologies, which are constantly being refined.
These methodologies may be modified as management enhances the Company’s accounting systems and as changes occur in the organizational structure or product lines. The Company assigns noninterest income and noninterest expense directly attributable to each line of business. The Company allocates direct and corporate overhead expenses incurred by areas supporting the overall Company to the Business Segments based on the ratio of an individual Business Segment’s noninterest expenses to total noninterest expense incurred by all business lines. Equity is allocated based on credit, operational and business risks.
Commercial Banking serves medium and small businesses, corporate businesses and governmental entities by offering various products and services, including commercial loans and lines of credit, deposits, cash management, capital market products, international trade finance, letters of credit, foreign exchange management services and loan syndication services.
Community Banking delivers a full range of products and services through the Company’s affiliate bank and branch network.
Trust and Wealth Management provides estate planning, trust, employee benefit and asset management services to individuals and corporate customers. The private client services division markets full trust and personal banking services to high net worth individuals.
Investment Services Group provides a full range of mutual fund services, including fund administration and accounting, transfer agency, distribution services, marketing, shareholder communications, custody and cash management. Certain revenues from this segment are subject to the performance of the equity markets.
Otherincludes divested business lines and miscellaneous other items of a corporate nature not allocated to specific business lines.
BUSINESS SEGMENT INFORMATION (dollars in thousands)
Line of business/segment financial results were as follows:
EARNINGS SUMMARY
Interest Income
Interest Expense
Net Interest Income
Provision for Loan Losses
Noninterest income
Intersegment revenue
Noninterest expense
Net Income before taxes
Income Taxes
Average Assets
12
(dollars in thousands)
Intersegment income
Depreciation & Amortization
13
Trust and Wealth
Management
Investment Services
Group
14
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following financial review presents management’s discussion and analysis of the condensed consolidated financial condition and results of operations of the Company. This review highlights the material changes in the results of operations and changes in financial condition for the nine-month period ended September 30, 2003. It should be read in conjunction with the accompanying consolidated financial statements, notes to condensed consolidated financial statements and other financial statistics appearing elsewhere in this report. Results of operations for the periods included in this review are not necessarily indicative of results to be attained during any future period.
SPECIAL CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS
Certain matters discussed in this report and the documents incorporated herein by reference contain forward-looking statements of expected future developments within the meaning of and pursuant to the safe harbor provisions established by Section 21E of the Securities Exchange Act of 1934, as amended by the Private Securities Litigation Reform Act of 1995. These forward-looking statements may refer to projections of future financial performance and financial items, plans and objectives of future operations, and other matters. These forward-looking statements reflect management’s expectations and are based on currently available data; however, actual future results are subject to future events and uncertainties, which could materially affect actual performance and cause future results to differ materially from those referred to in the forward-looking statements. Such future events and uncertainties include, but are not limited to, changes in: loan demand, the ability of customers to repay loans, consumer saving habits, employee costs, pricing, interest rates, competition, legal or regulatory requirements or restrictions, U.S. or international economic or political conditions such as inflation or fluctuation in interest rates or in the values of securities traded in the equity markets. Any forward-looking statements should be read in conjunction with information about risks and uncertainties set forth in this report and in documents incorporated herein by reference. Forward-looking statements speak only as of the date they are made, and the Company does not intend to review or revise any particular forward-looking statement in light of events that occur thereafter or to reflect the occurrence of unanticipated events.
Earnings Summary
The Company earned income of $13.2 million for the three months ended September 30, 2003, compared to $11.5 million for the same period a year earlier. This represents a 15.2% increase over the three month period ended September 30, 2002, which was primarily due to higher noninterest income and lower income taxes. Earnings per share for the third quarter 2003 were $0.61 per share compared to $0.52 per share for the third quarter 2002. Return on average assets and return on average common shareholders’ equity for the three month period ended September 30, 2003, was 0.76% and 6.53%, respectively, as compared to 0.64% and 5.68% for the three month period ended September 30, 2002. Return on average assets is calculated by dividing annualized net income by the daily average of total assets. Return on average common shareholders’ equity is calculated by dividing annualized net income by the daily average common shareholders’ equity.
Net interest income for the third quarter of 2003 declined 5.6% from the third quarter of 2002. The decline in 2003 compared to 2002 was due to lower loans, investments and interest bearing deposit portfolio volumes and rates.
The Company had an increase of 3.2% in noninterest income for the third quarter 2003 compared to the third quarter of 2002. The increase was primarily due to higher service charges on deposits and higher trading and investment banking income.
Noninterest expense remained flat for the third quarter of 2003 compared to the third quarter of 2002. The Company reduced its expenses through a 4.8% decrease in salary and employee benefit costs as described below offset by increases in costs related to the Company’s new mortgage loan programs as well as the loss on the sale of a foreclosed property.
15
Income taxes were $1.8 million lower for the three months ended September 30, 2003, compared to the same period in 2002. The variance was primarily due to a reduction in the tax reserve resulting from favorable management conclusions and with respect to reduced risks associated with tax positions taken in past years.
The Company earned $41.2 million for the nine months ended September 30, 2003, compared to, $45.0 million for the same period in 2002. This represents an 8.5% decrease over the year to date for September 30, 2002; which was primarily due to lower net interest income. Earnings per share year to date September 30, 2003 were $1.89 per share compared to $2.04 for the year to date September 30, 2002. Return on average assets and return on average common shareholder’s equity for the year to date September 30, 2003 were 0.77% and 6.83%, respectively compared to 0.78% and 7.62% for the year to date September 30, 2002.
Net interest income for the year to date September 30, 2003 declined $16.3 million or 9.8% from year to date September 30, 2002. This decrease was due to declining rates and volumes of loans, investments and interest bearing deposit portfolios.
The Company had a $1.7 million or 0.98% increase in noninterest income for the year to date September 30, 2003, compared to the same period in 2002. The increase was primarily due to higher service charges on deposits and higher trading and investment banking income.
Noninterest expense declined $5.6 million or 2.0% for the nine-months ended September 30, 2003, compared to the same period in 2002. The decrease was primarily due to lower salaries and employee benefit and employment costs as described below.
Results of Operations
For the three month and nine month period ended and year to date September 30, 2003, the Company experienced lower net interest income of $2.9 and $16.3 million respectively, primarily driven by the volume decreases in earning assets and lower rates. This decrease in net interest income has occurred due to several factors, primarily a reduction in demand for loans due to the soft economy; a reduction in mutual fund and trust related money market balances largely driven by the economic factors impacting the overall securities industry; and an earning asset portfolio that, by design, is very short in duration and has been negatively impacted by the overall decline in interest rates over the past couple of years.
Management believes that the overall outlook in its net interest income is positive. In the short term, a recovering economy should spur higher demand for commercial and consumer loans. Loan-related earning assets tend to have a higher spread than those earned in the Company’s investment portfolio. In addition, over the next several quarters, most economists believe that interest rates will begin to rise given U.S. Budget deficits and an expanding economy. A rise in short term interest rates, given the tenor of our earning assets, would have a positive impact on the Company’s net interest income.
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Table 1
AVERAGE BALANCES/YIELDS AND RATES (tax equivalent basis) (unaudited, dollars in thousands)
The following table presents, for the periods indicated, the total dollar amount of interest income from average interest-earning assets and resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed in both dollars and rates. All average balances are daily average balances. The average yield on earning assets without the tax-equivalent basis would have been 3.86% for the three months ended September 30, 2003 and 4.52% for the same period in 2002, and 3.87% for the nine months ended September 30, 2003 and 4.44% for the same period in 2002.
Assets
Loans, net of unearned interest
Taxable
Tax-exempt
Total securities
Other earning assets
Liabilities and Shareholders’ Equity
Interest-bearing deposits
Borrowed funds
Total interest-bearing liabilities
Noninterest-bearing demand deposits
Shareholders’ equity
Net interest spread
Net interest margin
17
Table 2 presents the dollar amount of change in net interest income and margin due to volume and rate. Table 2 also reflects the effect that interest free funds have on net interest margin. Interest free funds (the net of earning assets less interest bearing liabilities) increased $174.6 million for the three month period ended September 30, 2003 and $63.4 million for the nine-months ended September 30, 2003 compared to the same period in 2002.
Table 2
ANALYSIS OF CHANGES IN NET INTEREST INCOME AND MARGIN (unaudited, dollars in thousands)
ANALYSIS OF CHANGES IN NET INTEREST INCOME
September 30, 2003 vs. 2002
Change in interest earned on:
Interest income
Change in interest incurred on:
Other borrowed funds
Interest expense
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ANALYSIS OF NET INTEREST MARGIN
Average earning assets
Interest-bearing liabilities
Interest free funds
Free funds ratio (free funds to earning assets)
Tax-equivalent yield on earning assets
Cost of interest-bearing liabilities
Benefit of interest free funds
Provision and Allowance for Loan Losses
The allowance for loan losses (“ALL”) represents management’s judgment of the losses inherent in the Company’s loan portfolio. The provision for loan losses is the amount necessary to adjust the ALL to the level considered appropriate by management. Management of the Company reviews the adequacy of the ALL periodically, considering such items as historical loss trends, a review of individual loans, current economic conditions, loan growth and characteristics, industry or segment concentration and other factors. Bank regulatory agencies require that the adequacy of the ALL be maintained on a bank-by-bank basis for each of the Company’s subsidiaries. The Company utilizes a centralized credit administration function, which provides information on affiliate bank risk levels, delinquencies, an internal ranking system and overall credit exposure. In addition, loan requests are centrally reviewed to ensure that the Company consistently applies its loan policy and standards.
Management of the Company increased the ALL from 1.42% of total loans to 1.64% for the nine months ended 2002 and 2003, respectively because of an increase in nonperforming loans in 2003 caused by the overall softening of the economy in the region that the Company serves. Although no assurance can be given, management of the Company believes that the present ALL is adequate considering the Company’s loss experience, delinquency trends and current economic conditions.
The Company recorded a provision for loan losses of $2.9 million for the third quarter 2003 and $9.9 million for the year to date September 30, 2003, compared to $3.9 million for the third quarter and $10.5 million for the year to date September 30, 2002. The Company decreased its loan loss provisions for the year to date September 30, 2003 due to the $5.0 million decrease in net charge-offs.
Table 3 presents a summary of the Company’s ALL for the year to date September 30, 2003 and year to date September 30, 2002 and for the year ended 2002. Also, please see “Credit Risk” under the Risk Management section of Item 3 in this report for information relating to non-accrual, past due, restructured loans and other credit risk matters.
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Table 3
ANALYSIS OF ALLOWANCE FOR LOAN LOSSES (in thousands)
Year EndedDecember 31,
Allowance-January 1
Charge-offs:
Commercial
Consumer:
Bankcard
Real estate
Agricultural
Total charge-offs
Recoveries:
Total recoveries
Net charge-offs
Allowance-end of period
Average loans, net of unearned interest
Loans at end of period, net of unearned interest
Allowance to loans at end of period
Allowance as a multiple of net charge-offs
Net charge-offs to:
Average loans
Noninterest Income
Table 4
SUMMARY OF NONINTEREST INCOME (in thousands)
Trust and securities processing fees
Service charge on deposit accounts
Gains on sales of securities available for sale, net
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Noninterest income (summarized in Table 4) increased $1.9 million for the quarter ended September 30, 2003, compared to the same period in 2002. Noninterest income also increased $1.7 million from year to date September 30, 2002.
Trust and securities processing fees consist of fees earned on trust and money management related activities, custody of securities and the servicing of mutual fund assets. These fees decreased $5.2 million for the year to date September 30, 2003 compared to the same period in 2002. Part of this decrease was caused by the decline in equity markets as trust fees are derived from the market value of the assets in the trust. In addition, due to the overall market decline in mutual fund volumes, fees relating to both the custody of securities and the servicing of mutual fund assets were negatively impacted. Management of the Company believes that the rebound in the securities market is beginning to have a positive impact as fees were flat for the three months ended September 30, 2003 and 2002 respectively. If the securities markets continue to rebound, as is anticipated by most analysts, the Company’s fees for custody of securities and the servicing of mutual fund assets would increase although the sale of the Company’s Employee Benefit Division to Marshall & Isley (“M&I”), would probably offset a portion of such possible increase in revenues.
Trading and investment banking consists mostly of fees earned by the sale of bonds to the Company’s correspondent banking market and through its brokerage operations. Fees increased $1.1 million for the three months ended September 30, 2003 and $2.9 million year to date September 30, 2003, compared to the same period in 2002. The increase was mainly market driven as customers took advantage of rate opportunities within their respective portfolios.
Fees and service charges on deposit accounts increased $1.2 million for the three months ended September 30, 2003 and $4.2 million year to date September 30, 2003, compared to the same periods in September 2002. The increase in fees was primarily related to new corporate deposit account relationships and the sale of additional cash management services. Corporate and retail deposit fees also increased because of adjustments to fee schedules reflecting market price increases. Corporate service charge fees also increased due to lower compensating balances maintained by corporate customers and the lower earnings credit rate allowed on those balances. An increase in interest rates would have a negative impact on fees within this business sector. However, management believes that the overall economic recovery should increase the Company’s number of cash management customers and the number of transactions and offset any adverse impact in fees caused by a rise in interest rates.
Bankcard fees increased $0.4 million for the three months ended September 30, 2003 and $1.6 million year to date for September 30, 2003 compared to the same periods in 2002. The increase was primarily due to higher ATM interchange fees and merchant discount income. This increase in ATM interchange fees is not expected to continue, as it is expected that future interchange fees will decline as a result of recently settled industry lawsuit involving MasterCard and Visa.
For the nine months ended September 30, 2002, the Company recorded $2.5 million in gains on sale of securities available for sale. However, in the nine months ended September 30, 2003, the Company did not sell any securities available for sale because the replacement securities would have had lower interest rates.
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Noninterest Expense
Table 5
SUMMARY OF NONINTEREST EXPENSE (in thousands)
Noninterest expense was flat for the three months ended September 30, 2003 and decreased $5.6 million year to date September 30, 2003, compared to the same periods in 2002. The reasons for the decrease are described below.
Salaries and employee benefits declined $2.5 million for the three months ended September 30, 2003 and $6.2 million year to date September 30, 2003, compared to the same periods in 2002. Of that decrease, the decline in salaries represented roughly half of the overall decrease, primarily due to lower staffing levels reflecting a concerted effort on the part of management to decrease overhead costs. To illustrate, the Company’s full time equivalent employees dropped from 4,083 on September 30, 2002 to 3,852 on September 30, 2003. This decrease in salary expense is expected to continue as the Company is committed to becoming more efficient. In addition, as the transfer of our Employee Benefits business to M&I is completed during the first quarter of 2004, the Company expects to garner additional salary and benefit related savings. The year to date September 30, 2003 decreases in salary and benefit expenses were partially offset by a $0.5 million increase in the amount the Company paid for medical insurance premiums, compared to year to date September 30, 2002. Expected increases in medical premiums for 2004 will partially offset the expense decreases related to reductions in staffing levels.
Equipment costs continue to decline, compared to the same periods in 2002. The decrease was primarily due to lower depreciation and equipment maintenance costs. Management expects these expenses to increase somewhat in 2004 due to the conversion and upgrading of some of our mainframe computer systems.
Other expenses increased due to higher loan processing cost related to the Company’s new mortgage loan program, such costs will continue and will be based on volume of loans. A loss on the sale of foreclosed property was recognized in the third quarter.
Balance Sheet Analysis
Table 6
Selected Balance Sheet Information (dollars in thousands)
Total Assets
Loans, Net of Unearned Interest
Total Investment Securities
Total Earning Assets
Total Deposits
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Loans represent the Company’s largest source of interest income. Average loan balances have now stabilized due to both management’s effort to focus on new loan relationships, as well as the overall improvement in the economy. Management plans to continue to focus on growing our consumer and middle market as these market niches proved our best opportunity to cross sell fee related services, such as cash management. During the first quarter of 2003, the Company reviewed the classifications of loans to ensure that loans were properly recorded on the loan system, which resulted in the reclassification of $92 million in loans from commercial category to commercial real estate category.
Nonaccrual, past due and restructured loans are discussed under “Credit Risk” within the Risk Management section of Item 3 of this report.
Management believes that the Company’s security portfolio provides significant liquidity as a result of both the composition and average life of the underlying securities. This liquidity can be used to fund loan growth or to offset the outflow of deposits and borrowed funds which are sensitive to market forces. In addition to providing a source of potential liquidity, management believes the security portfolio can be used as a tool to manage interest rate sensitivity. The Company’s goal in the management of its securities portfolio is to maximize return within the Company’s parameters of liquidity goals, interest rate risk and credit risk. Historically, the Company has maintained very high liquidity levels while investing in only high-grade securities. The security portfolio generates the Company’s second largest component of interest income.
Securities available for sale and securities held to maturity comprised 54%, 53% and 59% respectively, of the earning assets as of September 30, 2003, September 30, 2002 and December 31, 2002. Securities remained flat at September 30, 2003, compared to September 30, 2002. The decrease in securities as of, September 30, 2003, compared to December 31, 2002 was primarily due to lower trust and mutual fund clients’ related deposits and borrowed funds.
Deposits and Borrowed Funds
Deposits represent the primary funding source for the Company’s asset base. In addition to the core deposits garnered by the Company’s retail branch structure, the Company continues to focus on its cash management services as well as its trust and mutual fund servicing lines of business in order to attract and retain additional core deposits.
Federal funds purchased and securities sold under agreement to repurchase totaled $785 million at September 30, 2003, compared to $1 billion at September 30, 2002 and $1,210 million at December 31, 2002. Repurchase agreements are transactions involving the exchange of investment funds by the customer, for securities by the Company, under an agreement to repurchase the same or similar issues at an agreed-upon price and date.
During the first quarter of 2003, the Company paid off a $15 million senior note originated in1993 as described in item 3 under the caption Liquidity Risk.
Capital and Liquidity
The Company places a significant emphasis on the maintenance of a strong capital position, which promotes investor confidence, provides access to funding sources under favorable terms, and enhances the Company’s ability to capitalize on business growth and acquisition opportunities. Higher levels of liquidity, however, bear corresponding costs, measured in terms of lower yields on short-term, more liquid earning assets and higher expenses for extended liability maturities. Management manages capital for each subsidiary based upon the subsidiary’s respective risks and growth opportunities as well as regulatory requirements.
Total shareholders’ equity was $808.5 million at September 30, 2003, compared to $800.5 million at September 30, 2002. During each year, management has the opportunity to repurchase shares of the Company’s stock at prices, which, in management’s opinion, would enhance overall shareholder value. During the nine months ended September 30, 2003 and 2002, the Company acquired 248,327 and 127,939 shares, respectively, of its common stock.
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Risk-based capital guidelines established by regulatory agencies establish minimum capital standards based on the level of risk associated with a financial institution’s assets. A financial institution’s total capital is required to equal at least 8% of risk-weighted assets. At least half of that 8% must consist of Tier 1 core capital, and the remainder may be Tier 2 supplementary capital. The risk-based capital guidelines indicate the specific risk weightings by type of asset. Certain off-balance-sheet items (such as standby letters of credit and binding loan commitments) are multiplied by credit conversion factors to translate them into balance sheet equivalents before assigning them specific risk weightings. Due to the Company’s high level of core capital and substantial portion of earning assets invested in government securities, the Tier 1 capital ratio of 19.85% and total capital ratio of 20.99% substantially exceed the regulatory minimums.
For further discussion of capital and liquidity, please see “Liquidity Risk” under Risk Management of Item 3 in this report.
Table 7
The Company’s capital position is summarized in the table below and exceeds regulatory requirements
RATIOS
Return on average assets
Return on average equity
Average equity to assets
Tier 1 risk-based capital ratio
Total risk-based capital ratio
Leverage ratio
The Company’s per share data is summarized in the table below.
Per Share Data
Earnings Basic
Earnings Diluted
Cash Dividends
Dividend payout ratio
Book value
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Risk Management
Market risk is a broad term for the risk of economic loss due to adverse changes in the fair value of a financial instrument. These changes may be the result of various factors, including interest rates, foreign exchange prices, commodity prices or equity prices. Financial instruments that are subject to market risk can be classified either as held for trading or held for purposes other than trading.
The Company is subject to market risk primarily through the effect of changes in interest rates of its assets held for purposes other than trading. The following discussion of interest risk, however, combines instruments held for trading and instruments held for purposes other than trading because the instruments held for trading represent such a small portion of the Company’s portfolio that the interest rate risk associated with them is immaterial.
Interest Rate Risk
Like all banks, the Company is subject to a major risk exposure through changing interest rates. To minimize the effect of interest rate changes to net interest income and exposure levels to economic losses, the Company manages its exposure to changes in interest rates through asset and liability management within guidelines established by its Funds Management Committee (“FMC”) and approved by the Company’s Board of Directors. The FMC is responsible for approving and ensuring compliance with asset/liability management policies, including interest rate exposure. The Company uses the following methods (simulation tools) for measuring and analyzing consolidated interest rate risk Market Value of Equity Modeling (“Net Portfolio Value”), Net Interest Income Simulation Analysis, and Repricing Mismatch Analysis. The Company does not use hedges or swaps to manage interest rate risk except for the use of future contracts to offset interest rate risk on specific securities held in its trading portfolio.
Market Value of Equity (Net Portfolio Value) Modeling
The Company uses the Net Portfolio Value to measure and manage interest rate sensitivity. The Net Portfolio Value measures the degree to which the market values of the Company’s assets and liabilities will change given a change in interest rates. This model is designed to represent, as of the respective date selected, the increase or decrease in the market value of assets and liabilities that would result from a hypothetical change in interest rates on such date. The Company uses a hypothetical rate change (rate shock) of 100 basis points and 200 basis points up or down. To perform these calculations, the Company uses the current loan, investment and deposit portfolios. The Company then makes assumptions regarding new loans and deposits based on historical analysis, management’s outlook and repricing strategies. The Company also analyzes loan prepayments and other market risks from industry estimates of prepayment yields and other market changes. Given the low level of current interest rates, the down 200 basis point scenario cannot be completed as of September 30, 2003 and 2002 and December 31, 2002. Table 8 sets forth, for September 30, 2003 and 2002 and December 31, 2002, the increase or decrease (as applicable) in Net Portfolio Value that would be caused by the following hypothetical immediate changes in interest rates on such date: an immediate increase of 200 basis points; an immediate increase of 100 basis points; and an immediate decrease of 100 basis points. Table 8 includes both instruments entered into for trading purposes and the instruments entered into for other than trading purposes. The Company believes that the former represents such a small portion of the Company’s portfolio; any difference in the interest rate risk associated with it (as compared with the risk associated with instruments entered into for other than trading purposes) is immaterial.
The net portfolio value as of September 30, 2003 is higher than December 31, 2002 at both 100 and 200 basis point increases. The increase was due to, total assets, loans, investment securities and deposits being at higher levels at December 31, 2002. The Company should benefit from rate increases because a majority of its earning assets and deposits have been repriced. The net portfolio value as of September 30, 2003 is lower than September 30, 2002. The decrease was due to higher levels of loans and deposits. The Company should benefit from rate increases, however, not as much due to higher loan and deposit levels at September 30, 2003.
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Table 8
MARKET RISK (in thousands)
Net portfolio value
(in Basis Points)(Rate Shock)
200
100
Static
(100)
Net Interest Income Modeling
Another tool used to measure interest rate risk and the effect of interest rate changes on net interest income and net interest margin is Net Interest Income Simulation Analysis. This analysis incorporates substantially all of the Company’s assets and liabilities together with forecasted changes in the balance sheet and assumptions that reflect the current interest rate environment. Through these simulations management estimates the impact on net interest income of a 200 basis point upward or downward gradual change of market interest rates over a one year period. These simulations include assumptions about how the balance sheet is likely to change with changes in loan and deposit growth. Assumptions are made to project rates for new loans and deposits based on historical analysis, management outlook and repricing strategies. Loan prepayment and other market risks are developed from industry estimates of prepayment spreads and other market changes. Since the results of these simulations can be significantly influenced by assumptions utilized, management evaluates the sensitivity of the simulation results to changes in assumptions. Due to the low level of current interest rates, the scenarios that simulate a 100 basis point and a 200 basis point decrease cannot be completed as of September 30, 2003 and December 31, 2002. Table 9 shows the net interest income, increase or decrease over the next twelve months as of September 30, 2003, 2002, and December 31, 2002. The three periods show that if rates rise 100 or 200 basis points, net interest income will increase. At September 30, 2002, the table shows that a decrease in rates will mean a decrease in net interest income. This is a result of being asset sensitive, meaning assets reprice more quickly than liabilities, giving rise to an improved net interest income in an increasing rate environment and lower net interest income in a decreasing rate environment.
Table 9
Hypothetical change
in interest rate
(in Basis Points)
(Rate Shock)
September 30, 2003
Amount of change
September 30, 2002
December 31, 2002
Repricing Mismatch Analysis
The Company also evaluates its interest rate sensitivity position in an attempt to maintain a balance between the amount of interest-bearing assets and interest-bearing liabilities which are expected to mature or reprice at any point in time. While a traditional repricing mismatch analysis (“gap analysis”) provides a snapshot of interest rate risk, it does not take into consideration that assets and liabilities with similar repricing characteristics may not in fact reprice at the same time or the same degree. Also, it does not necessarily predict the impact of changes in general levels of interest rates on net interest income.
Management attempts to structure the balance sheet to provide for the repricing of approximately equal amounts of assets and liabilities within specific time intervals. The Company is in a positive gap position because assets maturing or repricing exceed liabilities.
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Other Market Risk
The Company does not have material commodity price risks or derivative risks.
Credit Risk Management
Credit risk represents the risk that a customer or counterparty may not perform in accordance with contractual terms. Credit risk is inherent in the financial services business and results from extending credit to customers. The Company utilizes a centralized credit administration function, which provides information on affiliate bank risk levels, delinquencies, an internal ranking system and overall credit exposure. In addition, loan requests are centrally reviewed to ensure the consistent application of the loan policy and standards. The Company has an internal loan review staff that operates independently of the affiliate banks. This review team performs periodic examinations of each bank’s loans for credit quality, documentation and loan administration. The respective regulatory authority of each affiliate bank also reviews loan portfolios.
Another means of ensuring loan quality is diversification. By keeping its loan portfolio diversified, the Company has avoided problems associated with undue concentrations of loans within particular industries. The Company has no significant exposure to highly leveraged transactions and has no foreign credits in its loan portfolio.
A primary indicator of credit quality and risk management is the level of nonperforming loans. Nonperforming loans include both nonaccrual loans and restructured loans. The Company’s nonperforming loans decreased $7.9 million at September 30, 2003, compared to September 30, 2002 and increased $4.2 million compared to December 31, 2002. The major portion of nonperforming loans is due to five commercial loan customers.
The Company had $62 thousand in other real estate owned as of September 30, 2003 compared to $5.0 million as of September 30, 2002 and December 31, 2002. Loans past due more than 90 days totaled $4.30 million as of September 30, 2003, compared to $4.35 million as of September 30, 2002 and $7.67 million as of December 31, 2002.
A loan is generally placed on nonaccrual status when payments are past due 90 days or more and/or when management has considerable doubt about the borrower’s ability to repay on the terms originally contracted. The accrual of interest is discontinued and recorded thereafter only when actually received in cash.
TABLE 10
LOAN QUALITY (in thousands)
Nonaccrual loans
Restructured loans
Total nonperforming loans
Other real estate owned
Total nonperforming assets
Loans past due 90 days or more
Reserve for Loans Losses
Ratios
Nonperforming loans as a % of loans
Nonperforming assets as a % of loans plus other real estate owned
Nonperforming assets as a % of total assets
Loans past due 90 days or more as a % of loans
Reserve for Loan Losses a % of loans
Reserve for Loan Losses a multiple of nonperforming loans
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Liquidity Risk
Liquidity represents the Company’s ability to meet financial commitments through the maturity and sale of existing assets or availability of additional funds. The most important factor in the preservation of liquidity is maintaining public confidence that facilitates the retention and growth of a large, stable supply of core deposits and wholesale funds. Ultimately, public confidence is generated through profitable operations, sound credit quality and a strong capital position. The primary source of liquidity for the Company is regularly scheduled payments on and maturity of assets, which include $2.9 billion of high-quality securities available for sale. The liquidity of the Company and its affiliate banks is also enhanced by its activity in the federal funds market and by its core deposits. Neither the Company nor its subsidiaries are active in the debt market. The traditional funding source for the Company’s subsidiary banks has been core deposits. The Company has not issued any debt since 1993 when $25 million of medium-term notes were issued to fund bank acquisitions. Prior to being paid off in February, 2003 these notes were rated A3 by Moody’s Investor Service and A- by Standard and Poor’s. Based upon regular contact with investment banking firms, management is confident in its ability to raise debt or equity capital on favorable terms, should the need arise.
The Company also has other commercial commitments that may impact liquidity. These commitments include unused commitments to extend credit, standby letters of credit and financial guarantees, and commercial letters of credit. The total amount of these commercial commitments at September 30, 2003 was $1.9 billion. Since many of these commitments expire without being drawn upon, the total amount of these commercial commitments does not necessarily represent the future cash requirements of the Company.
The Company’s cash requirements consist primarily of dividends to shareholders, debt service and treasury stock purchases. Management fees and dividends received from subsidiary banks traditionally have been sufficient to satisfy these requirements and are expected to be sufficient in the future. The Company’s subsidiary banks are subject to various rules regarding payment of dividends to the Company. For the most part, all banks can pay dividends at least equal to their current year’s earnings without seeking prior regulatory approval. From time to time, approvals have been requested to allow a subsidiary bank to pay a dividend in excess of its current earnings. All such requests have been approved.
Operational Risk
The Company is exposed to numerous types of operational risk. Operational risk generally refers to the risk of loss resulting from the Company’s operations, including, but not limited to: the risk of fraud by employees or persons outside the Company; the execution of unauthorized transactions by employees or others; errors relating to transaction processing and systems; and breaches of the internal control system and compliance requirements. This risk of loss also includes the potential legal or regulatory actions that could arise as a result of an operational deficiency, or as a result of noncompliance with applicable regulatory standards. Included in the legal and regulatory issues with which the Company must comply are a number of recently imposed rules resulting from the enactment of the Sarbanes-Oxley Act of 2002.
The Company operates in many markets and places reliance on the ability of its employees and systems to properly process a high number of transactions. In the event of a breakdown in the internal control systems, improper operation of systems or improper employee actions, the Company could suffer financial loss, face regulatory action and suffer damage to its reputation. In order to address this risk, management maintains a system of internal controls with the objective of providing proper transaction authorization and execution, safeguarding of assets from misuse or theft, and ensuring the reliability of financial and other data.
The Company maintains systems of controls that provide management with timely and accurate information about the Company’s operations. These systems have been designed to manage operational risk at appropriate levels given the Company’s financial strength, the environment in which it operates, and considering factors such as competition and regulation. The Company has also established procedures that are designed to ensure that policies relating to conduct, ethics and business practices are followed on a uniform basis. In certain cases, the Company has experienced losses from operational risk. Such losses have included the effects of operational errors that the Company has discovered and included as expense in the statement of income. While there can be no assurance that the Company will not suffer such losses in the future, management continually monitors and works to improve its internal controls, systems and corporate-wide processes and procedures.
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Furthermore, management believes the plans to streamline the organization through further systems integration and policies enacted to push down reporting accountabilities further in the organization have improved the Company’s ability to identify and limit operational risk.
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ITEM 4. CONTROLS AND PROCEDURES
At the end of the period covered by this Report, the Company’s Chief Executive Officer and Chief Financial Officer has each evaluated the effectiveness of the Company’s “Disclosure Controls and Procedures” and believes as of the date of evaluation, that the Company’s disclosure controls and procedures are reasonably designed to be effective for the purposes for which they are intended. As such term is used above, the Company’s Disclosure Controls and Procedures are controls and other procedures of the Company that are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities Exchange Commission’s rules and forms. Disclosure Controls and Procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the Company in such reports is accumulated and communicated to the Company’s management, including its principal executive officer or officers and principal financial officer or officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.
No significant changes in the Company’s disclosure controls or in other factors occurred that could significantly affect such controls after the date that the Company’s Chief Executive Officer and Chief Financial Officer conducted their evaluations of the Disclosure Controls and Procedures.
While the Company believes that its existing disclosure controls and procedures have been effective to accomplish the Company’s objectives, the Company intends to continue to examine, refine, and formalize its disclosure controls and procedures and to monitor ongoing developments in this area.
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ITEM 1. LEGAL PROCEEDINGS
None.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS
ITEM 5. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a) The following exhibits are filed herewith:
Reports on Form 8-K:
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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 hereunto duly authorized.
/s/R, Crosby Kemper III
R. Crosby Kemper III
Chairman and Chief Executive Officer
/s/Daniel C. Stevens
Daniel C. Stevens
Chief Financial Officer
Date: November 12, 2003
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