UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
For the quarterly period ended March 31, 2004
OR
For the transition period from to
Commission file number 0-4887
UMB FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
(State or other jurisdiction
of Incorporation or organization)
(I.R.S. – Employer
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 April 30, 2004, UMB Financial Corporation had 21,673,619 shares of common stock outstanding.
INDEX
PART I –FINANCIAL INFORMATION
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 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
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PART I – FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
(unaudited, dollars in thousands, except per share data)
December 31,
2003
ASSETS
Loans:
Commercial, financial and agricultural
Real estate construction
Consumer
Real estate
Leases
Allowance for loan losses
Net loans
Securities available for sale:
U.S. Treasury and agencies
State and political subdivisions
Mortgage backed
Commercial paper
Total securities available for sale
Securities held to maturity:
State and political subdivisions (market value of $312,915, $406,848 and $314,705, respectively)
Federal Reserve Bank stock and other
Total securities held to maturity
Federal funds sold
Securities purchased under agreements to resell
Interest bearing due from banks
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, 27,528,365, 27,528,365 and 27,528,365 issued, 21,673,446, 21,765,436 and 21,694,078 shares outstanding, respectively.
Capital surplus
Retained earnings
Accumulated other comprehensive income
Treasury stock, 5,854,919, 5,762,929 and 5,834,287 shares, at cost, respectively
Total shareholders’ equity
Total liabilities and shareholders’ equity
See Notes to Condensed Consolidated Financial Statements.
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(unaudited, dollars in thousands except share and per share data)
Three Months
Ended March 31,
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 for loan losses
NONINTEREST INCOME
Trust and securities processing
Trading and investment banking
Service charges on deposits
Insurance and brokerage
Bankcard fees
Gain on sales of securities available for sale, net
Other
Total noninterest income
NONINTEREST EXPENSE
Salaries and employee benefits
Occupancy, net
Equipment
Supplies, postage and telephone
Marketing and business development
Processing fees
Legal and consulting
Amortization of other intangibles
Total noninterest expense
Income before income taxes
Income tax provision
NET INCOME
PER SHARE DATA
Net income - basic
Net income - diluted
Dividends
Weighted average shares outstanding
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(unaudited, dollars in thousands)
Balance - January 1, 2003
Net income
Comprehensive income, change in unrealized gain on securities of $7,789, net of tax $2,804
Total comprehensive income
Cash dividends ($0.20 per share)
Purchase of treasury stock
Sale of treasury stock
Exercise of stock options
Balance - March 31, 2003
Balance - January 1, 2004
Comprehensive income, change in unrealized gain on securities of $10,932, net of tax $3,988 and the reclassification adjustment for gains included in net income of $141 net of tax $51
Cash dividends ($0.21 per share)
Balance - March 31, 2004
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Three Months Ended
March 31,
Operating Activities
Net Income
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
Deferred income taxes
Net decrease/(increase) 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 securities held to maturity
Proceeds from sales of securities available for sale
Proceeds from maturities of securities available for sale
Purchases of securities held to maturity
Purchases of securities available for sale
Net decrease in loans
Net decrease in fed funds and resell agreements
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 debt
Proceeds from long-term debt
Repayment of long-term debt
Cash dividends
Proceeds from exercise of stock options and sales of treasury shares
Purchases of treasury stock
Net cash 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
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FOR THE THREE MONTHS ENDED MARCH 31, 2004
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 2003 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. Income is recognized on a basis that 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. Commercial loans are evaluated for impairment on a loan-by-loan basis.
The adequacy of the allowance for loan losses is based on management’s 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. Unrealized holding gains and losses are excluded from earning and reported in accumulated other comprehensive income until realized. Realized gains and losses on sales are computed by the specific identification method at the time of disposition and are shown separately as a component of noninterest income.
Securities held to maturity are carried at amortized historical cost based on management’s intentions and the Company’s ability to hold them 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.
Trading securities, generally acquired for subsequent sale to customers are carried at market value. Market adjustments fees and gains or losses on the sale of trading securities are considered to be a normal part of operations and are included in trading and investment banking income. Interest income on trading securities is included in income from earning assets.
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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 that date in 2003 and 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 year to date per share data includes the diluted effect of 73,351 and 19,564 shares issueable under options granted by the Company at March 31, 2004 and 2003, 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 March 31, 2004 and 2003, 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.”
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
Consolidation of Variable Interest Entities In January 2003, the FASB issued FIN No. 46, “Consolidation of Variable Interest Entities”, which was revised by FIN No. 46 (Revised December 1, 2003), “Consolidation of Variable Interest Entities”. FIN No. 46 requires consolidation by business enterprises of variable interest entities that meet certain requirements. FIN No. 46 (R) changes the effective date of FIN No. 46 for certain entities. Public companies shall apply either FIN No. 46 or FIN No. 46 (R) to their interests in special purpose entities (SPE) as of the first interim or annual period ending after December 15, 2003. The decision to apply FIN No 46 or FIN No. 46(R) may be made on an SPE by SPE basis. The Company’s adoption of FIN No. 46 and FIN No. 46(R) did not have a significant impact on its consolidated financial statements.
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4. Allowance for Loan Losses
This table provides an analysis of the allowance for loan losses for the three months ended March 31, 2004 and 2003(dollars in thousands):
Allowance - January 1,
Additions(deductions):
Charge-offs
Recoveries
Net charge-offs
Provision charged to expense
Allowance - March 31,
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 three months ended March 31, 2004 and 2003 and December 31, 2003 (dollars in thousands):
Total impaired loans as of March 31 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 during the period
5. Goodwill and other intangibles
Changes in the carrying amount of goodwill for the three months ended March 31, 2004 and 2003 by operating segment are as follows (dollars in thousands):
Balances as of January 1, 2003
Goodwill acquired during period
Balances as of March 31, 2003
Balances as of January 1, 2004
Balances as of March 31, 2004
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Following are the intangible assets that continue to be subject to amortization as of March 31, 2004 and 2003 (dollars in thousands):
Core deposit intangible assets
Other intangible assets
Total
Core deposit intangibles assets
Aggregate amortization expense
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
For the year ended December 31, 2008
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 contract or notional amount of those instruments reflects the extent of involvement the Company has in particular classes of financial instruments.
The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments 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
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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 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 payable upon the non-performance of a customer’s obligations to a third party. The Company issues 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 March 31, 2004 and 2003 were $172.0 million and $176.6 million, respectively. As of March 31, 2004 and 2003, standby letters of credit totaling $26.7 million and $38.5 million, respectively were with related parties to the Company.
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 such items as those described for commitments to extend credit.
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 $40.6 million and $37.7 million during the three months ended March 31, 2004 and 2003, respectively. Net futures activity resulted in losses of $0.7 million for the three months ended March 31, 2004 and $0.3 million for the same period in 2003. 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 three months ended March 31, 2004, contracts to purchase and to sell foreign currency averaged approximately $14.8 million compared to $8.5 million during the same period in 2003. The net gains on these foreign exchange contracts for the three months ended March 31, 2004 and 2003 were $0.4 million and $0.3 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 March 31, 2004, the Company did not have any significant credit concentrations in any particular industry.
In the normal course of business, the Company and its subsidiaries are named defendants 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.
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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
Forward foreign exchange contracts
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. Lines of business financial results produced by the Company’s internal management accounting system are evaluated regularly in deciding how to allocate resources and assess performance per individual Business Segment. The management accounting system assigns balance sheet and income statement items to each line of business using methodologies which are refined on an ongoing basis. The Business Segments were redefined at the end of 2002, adding the Investment Services Group (described below) in the place of the Investment Banking segment used in previous Business Segment reporting. With the acquisition of Sunstone Financial Group, Inc. (now known as UMB Fund Services, Inc.), revenues resulting from mutual fund back office activities have created a need to recognize the Investment Services Group as a line of business. The Investment Banking segment shown in previous reports on Business Segments consists primarily of the Company’s investment portfolio, and is now allocated to the Business Segments shown below. For comparability purposes, amounts in all periods are based on methodologies in effect at March 31, 2004. These methodologies may be modified as management accounting systems are enhanced and changes occur in the organizational structure or product lines.
The Company utilizes a funds transfer pricing model to neutralize the interest rate risk affecting the financial results of the business segments on a stand alone basis. This model records cost of funds or credit for funds using matched maturity funding for certain assets and liabilities, or a blended rate based on various maturities for the remaining assets and liabilities. The allowance for loan losses is allocated using specifically identified reserves assigned to loans where available, with general reserves assigned to the remaining loan portfolio based on historical losses, economic outlook and other factors. The related loan loss provision is assigned based on the amount necessary to maintain reserves adequate for each line of business. Noninterest income and noninterest expense directly attributable to a line of business is assigned to that line of business. Direct expenses incurred by areas whose services support the overall Company are allocated to the Business Segments based on standard unit costs applied to actual volume measurements. Administrative expenses are allocated based on the estimated time expended for each segment. Any remaining expenses such as corporate overhead are assigned based on the ratio of an individual business segment’s noninterest expense to total noninterest expense incurred by all business lines. Virtually all interest rate risk is assigned to the Treasury and Other business segment which is the offset to the funds transfer pricing charges and credits assigned to each business segment.
The following summaries provide information about the activities of each line of business.
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, bond sales and loan syndication services.
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Retail Banking delivers a full range of products and services through the Company’s affiliate bank and branch network. Retail Banking is a major provider of funds for the Company. This line of business offers a variety of consumer products, including deposit accounts, installment loans, credit cards, home equity lines of credit, residential mortgages, and brokerage and insurance services for individuals.
Trust and Wealth Management provides estate planning, trust, employee benefit and asset management services to individuals and corporate customers. The private client services division offers full trust and personal banking services to high net worth individuals. The Company’s proprietary funds, Scout Funds, are also included in this segment.
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.
Treasury and Other includes asset and liability management activities and miscellaneous other items of a corporate nature not allocated to specific business lines.
Business Segment Information
Line of business/segment financial results were as follows (dollars in thousands):
Noninterest income
Noninterest expense
Net income (loss)
Average assets
Expenditures for additions to premises and equipment
13
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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 three-month period ended March 31, 2004. 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.
Overview
Management believes the two factors having the greatest impact on the Company’s earnings are the sustained low rate environment, and the overall health of the equity and financial markets.
The sustained low interest rate environment adversely impacts the Company’s net interest income as our balance sheet is structured to be both very short in duration and liquid. Management believes that strong liquidity and capital are necessary given the types of products and services the Company offers, particularly as it relates to treasury and cash management products and services. A strong liquidity and capital position provide assurances that the cash needs of the Company can be met. This position adversely impacts the Company’s net interest income in a declining rate environment. However, in an increasing rate environment, this position should benefit the Company. Management believes that we will be entering into a period of rising interest rates given the overall expansion of the economy and the size of both the Federal and trade deficits. Item 3, Quantitative Disclosures about Market Risk discusses in detail the impact of rising and declining rates on net interest income.
Net interest income is the main source of revenue for the Company. Net interest income is negatively impacted by smaller spreads between the yield on earning assets and the interest-free sources of funds. As the yields on loans and investments declined, interest-free sources of funds could not, by definition, be lowered to match the decrease in yield on earning assets. In addition, a competitive deposit pricing environment prevented the lowering of rates on interest bearing deposits to match the decrease in yields on earning assets. A sustained low rate environment will continue to put pressure on the Company’s net interest income. Table 2 appearing in the “Results of Operations – Net Interest Income” section of the Management’s Discussion and Analysis shows the impact of the declining rate environment and also shows the declining benefits derived from the Company’s interest free source of funds.
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Management continues to focus on diversifying the revenue sources so that the net income of the Company is less susceptible to changes in interest rates. Management has also focused on reducing expenses that are not necessary to the delivery of products and services to the Company’s customer base.
As some of the Company’s fee-based business is the direct result of the market value of its customer’s investments, the overall health of the equity and financial markets plays an important role in the recognition of fee income, particularly in the trust, mutual fund servicing and investment management areas of the Company. As the overall equity and financial markets improve, the basis on which certain fee income is calculated should grow.
The Company’s goal is to differentiate itself from its large super-regional and national competitors through superior service, attention to detail, customer knowledge and responsiveness. The Company’s size allows it to meet this goal and at the same time offer the wide range of products most customers need. This strategy has worked especially well during a period of bank consolidation and should continue to be a benefit. The Company has experienced growth in the new markets it entered during 2001 and 2000. There has been a demand in these markets for bank services delivered with a customer-centric focus. The Company will continue to focus its efforts to attract a customer base that values the advantages of banking with a company headquartered in their market while still possessing the products and services of a much larger institution.
Earnings Summary
The Company recorded consolidated net income of $10.8 million for the three-months ended March 31, 2004, compared to $14.5 million for the same period a year earlier. This represents a 25.8% decrease over the three-month period ended March 31, 2003, which was primarily due to lower net interest income. Earnings per share for the first quarter 2004 were $0.50 per share compared to $0.66 per share for the first quarter 2003. Return on average assets and return on average common shareholders’ equity for the three-month period ended March 31, 2004 was 0.60% and 5.26% respectively, as compared to 0.77% and 7.23% for the three-month period ended March 31, 2003.
Net interest income for the first quarter of 2004 declined 11.0% from the first quarter 2003. The decline in 2004 compared to 2003 was due to lower loans, investments and interest bearing deposit rates.
Provision for loan losses declined $2.2 million in the first quarter of 2004 due to lower net charge-offs and an adequate reserve for loan losses compared to management’s estimate of inherent losses within the loan portfolio.
Noninterest income increased $2.1 million in the first quarter of 2004 primarily due to the sale of employee benefit accounts to Marshall & Ilsley Trust Company, n.a. The Company received $3.1 million in gross proceeds from the sale which were partially offset by associated costs of the sale of $2.4 million for a net gain of $0.76 million.
Noninterest expenses increased $4.0 million in the first quarter of 2004 primarily due to costs associated with the sale of the employee accounts in the amount of $2.4 million.
Results of Operations
Net Interest Income
Net interest income is a significant source of the Company’s earnings and represents the amount by which interest income on earning assets exceeds the interest expense paid on liabilities. The volume of interest earning assets and the related funding sources, the overall mix of these assets and liabilities and the rates paid on each, affects net interest income. For the three-month period ended March 31, 2004 net interest income declined $5.6 million due to lower rates. Table 1 shows the lower rates that were experienced in all of the categories of earnings assets and interest-bearing liabilities. Analysis of changes in net interest income in table 2 also shows that the net interest income declined due to lower rates. The earning asset portfolio, by design, is very short in duration and has been negatively impacted by the continuation of lower interest rates.
Management believes that the overall outlook in its net interest income is positive. In the short-term, a recovering economy is expected to spur higher demand for commercial and consumer loans. Loan-related earning
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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 rise, which will depend on actions by the Federal Reserve Bank. Given the term of Company’s earning assets, a rising rate environment would have a positive impact on the Company’s net interest income. However, there will be a one-to-two quarter lag before any positive impact of interest margin is realized. Finally, management is undertaking a strategic initiative to focus additional efforts on marketing, product enhancements and streamlining the approval process for its consumer loan product suite. These efforts should result in increased volumes of new applications and booked loans.
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 3.44% for the three-months ended March 31, 2004 and 3.88% for the same period in 2003:
Loans, net of unearned interest
Taxable
Tax-exempt
Total securities
Other earning assets
Interest-bearing deposits
Borrowed funds
Total interest-bearing liabilities
Noninterest-bearing demand deposits
Shareholders’ equity
Net interest spread
Net interest margin
Table 2 presents the dollar amount of change in the 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 total earning assets less interest-bearing liabilities) increased $157.9 million for the three-month period ended March 31, 2004 compared to the same period in 2003.
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Table 2
ANALYSIS OF CHANGES IN NET INTEREST INCOME AND MARGIN (unaudited, dollars in thousands)
ANALYSIS OF CHANGES IN NET INTEREST INCOME
March 31, 2004 and 2003
Change in interest earned on:
Federal funds sold and resell agreements
Interest income
Change in interest incurred on:
Other borrowed funds
Interest expense
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 its ALL to the level considered appropriate by management. The adequacy of the ALL is reviewed quarterly, 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 the consistent application of the loan policy and standards.
Management of the Company increased the ALL from 1.57% of total loans to 1.65% for the three-months ended 2003 and 2004. This increase was primarily due to an increase in total loans of $152.1 million as of March 31, 2004 compared to March 31, 2003.
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The Company recorded a provision for loan losses of $1.8 million for the first quarter 2004 compared to $4.0 million for the first quarter 2003. The Company decreased its loan loss provision due to lower net charge-offs and an adequate reserve compared to management’s estimate of inherent losses within the loan portfolio.
Table 3 presents a summary of the Company’s ALL for the first quarter ended March 31, 2004 and first quarter ended March 31, 2003 and for the year ended December 31, 2003. Also please see “Credit Risk Management” under Risk Management section of Item 3 in this report for information relating to non-accrual, past due, restructured loans and other credit risk matters.
Table 3
ANALYSIS OF ALLOWANCE FOR LOAN LOSSES (dollars in thousands)
Year EndedDecember 31,
Allowance-January 1
Charge-offs:
Commercial:
Consumer:
Bankcard
Agricultural
Total charge-offs
Recoveries:
Total recoveries
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
A key objective of the Company is the growth of noninterest income to enhance profitability as fee-based services are non-credit related, provide steady income and are not directly affected by fluctuations in interest rates. Fee-based services provide the opportunity to offer multiple products and services to customers and, therefore, more closely align the customer with the Company. The Company’s ongoing focus is to develop and offer multiple products and services to its customers, the quality of which will differentiate it from the competition. Fee-based services that have been emphasized include trust and securities processing, securities trading/brokerage and cash management. Management believes that it can offer these products and services both efficiently and profitably as most of these are driven off of common platforms and support structures.
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Table 4
SUMMARY OF NONINTEREST INCOME (dollars in thousands)
Trust and securities processing fees
Service charge on deposit accounts
Gains on sales of securities available for sale, net
Noninterest income (summarized in Table 4) increased 3.6% for the first quarter 2004 compared to the same period in 2003. The increase in 2004 was primarily a result of the sale of the employee benefit accounts to Marshall & Ilsley Trust Company, n.a. in the amount of $3.1 million. Under the terms of the contract for the sale of the employee benefit accounts to Marshall & Ilsley Trust Company, n.a., the Company may be entitled to additional sale proceeds in the form of an earnout payable to the Company in the first quarter of 2005. The earnout payment is based upon projected gross revenues of those employee benefit accounts retained by Marshall & Ilsley during certain periods after the closing date and cannot yet be determined by the Company. This was partially offset by lower trust and securities processing fees.
Trust and securities processing consists of fees earned on personal and corporate trust accounts, custody of securities services, trust investments and money management services and servicing of mutual fund assets. These fees decreased $2.0 million in the first quarter of 2004 compared to the first quarter of 2003. The decrease was caused by a decrease in employee benefit accounts fees in the amount of $3.1 million due to the sale of these accounts. This decrease was partially offset by higher corporate trust fees in the amount of $0.6 million and higher fees from UMB Scout Funds of $0.5 million. Trust and securities processing fees may continue to be lower this year compared to last year due to the sale of the employee benefits accounts. However, management of the Company believes that the current rebound in the securities market is having a positive impact on fees. If the securities market and public and market confidence in mutual funds 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. In addition, management believes that the overall quality and performance of both its investment management and UMB Scout Funds will attract both increased and new investable dollars to it as assets under management. Management is also introducing a wrap product which will allow our brokerage operations and UMB Investment Advisors to provide an investment advisory product offering various Mutual Funds including the UMB Scout Funds to retail clients. Finally, the Company has put a special emphasis on selling the Scout Funds through our institutional channels by the establishment of a dedicated sales force.
Trading and investment banking consists mostly of fees earned from the sale of bonds to the Company’s correspondent banking market and throughout its brokerage operations. Fees decreased $1.0 million for the first quarter of 2004 compared to first quarter of 2003. The bond market in 2003 was very active and rising; however, in 2004 the bond market has retrenched which is the primary reason for the decline.
Fees and service charges on deposit accounts increased $1.1 million for the three-months ended March 31, 2004 compared to the same period in 2003. The increase in fees was primarily related to new corporate deposit relationships and the sale of additional cash management services. Corporate service charges also increased due to lower compensating balances maintained by corporate customers and the lower earnings credit rate allowed on those balances. An increase in the interest rate 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 corresponding number of transactions in customer accounts which would offset any adverse impact in fees caused by a rise in interest rates.
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Other income increased $3.7 million for the three-months ended March 31, 2004 compared to same period in 2003. The increase was primarily due to the sale of employee benefit accounts to Marshall & Ilsley Trust Company, n.a. in the amount of $3.1 million. Under the terms of the contract for the sale of the employee benefit accounts to Marshall & Ilsley Trust Company, n.a., the Company may be entitled to additional sale proceeds in the form of an earnout payable to the Company in the first quarter of 2005. The earnout payment is based upon projected gross revenues of those employee benefit accounts retained by Marshall & Ilsley during certain periods after the closing date and cannot yet be determined by the Company.
Noninterest Expense
Table 5
SUMMARY OF NONINTEREST EXPENSE (dollars in thousands)
Noninterest expense increased $4.0 million for the three months ended March 31, 2004 compared to the same period in 2003. The increase was primarily due to costs associated with the sale of the employee benefit accounts in the amount of $2.4 million. There will be no additional expenses related to the sale of the employee benefit accounts. This cost is reflected in the Other expense line shown above.
Salaries and employee benefits declined $1.1 million for the three months ended March 31, 2004 compared to the same period in 2003. Salaries decreased $1.8 million primarily due to lower staffing levels reflecting a concentrated effort on the part of management to decrease overhead costs. To illustrate, the Company’s full time equivalent employees dropped from 4,007 at March 31, 2003 to 3,705 at March 31, 2004. This decrease in salaries is expected to continue as the Company is committed to becoming more efficient.
Occupancy, net expense increased primarily due to higher depreciation on building improvements, higher repairs and maintenance, higher utilities and lower rent income.
Equipment expenses increased due to higher software costs related to conversion and upgrading of some of our mainframe computer software.
Processing fees increased due to higher Federal Reserve processing charges and higher outside data processing costs.
Legal and consulting fees increased due to higher consulting fees associated with the upgrading of two of our mainframe computer systems.
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Strategic Lines of Business
The Company’s operations are strategically aligned into four major lines of business: Commercial Banking; Retail Banking; Trust and Wealth Management; and, Investment Services Group. The lines of business are differentiated by the products and services offered. The Treasury and Other category, includes items not directly associated with the other lines of business. Note 7 to the Condensed Consolidated Financial Statements describes how these segments were identified and presents financial results of the lines of business for the three months ended March 31, 2004 and 2003. Table 6 below summarized the net income (loss) for each line of business for the three months ended March 31, 2004 and 2003.
Table 6
NET INCOME (LOSS) BY LINE OF BUSINESS (dollars in thousands):
Commercial Banking
Retail Banking
Trust and Wealth Management
Investment Services Group
Treasury and Other
Total Consolidated Company
Commercial Banking’s net income remained flat for the first quarter of 2004 compared to first quarter of 2003 at $14.8 million. Net interest income decreased compared to 2003 due to the sustained low rate environment and the corresponding impact of repricing of earning assets, but was offset by higher noninterest income resulting from strong sales of cash management products and services. A lower provision for loan losses, due to a reduction in net charge-offs, also contributed to the improvement in net income. An increase in interest rates, as expected by most economists, would have the most significant impact on this business segment, causing net interest income to rise. Because deposit service charges are also affected by interest rates due to the earnings credit on commercial accounts, noninterest income is expected to decrease in a rising rate environment. Management believes the decrease in deposit service charges would be more than offset by the increase in net interest income. Management also believes that an anticipated improving economy would spur an increase in both loan commitments and outstanding loan balances which would generate increased net interest income.
Retail Banking’s net income decreased $2.5 million in the first quarter of 2004 compared to the same period in 2003. The increase in net loss was primarily due to a decrease in the net interest income resulting from the sustained low rate environment. Retail banking is a source of funding for other activities within the Company. Due to the competitive nature of deposit pricing within the Company’s markets, the Company’s affiliates and subsidiaries were unable to continue to lower deposit rates to keep pace with the decreases in earning asset yields and still remain competitive. The greatest potential for improving net income for this business segment lies in the continued focus on offering products and services in the most efficient manner and by booking more loans through the branch structure. Management’s intent is to aggressively market its home equity line of credit, direct auto loans and credit card products to more efficiently optimize its branch network as a source of earning assets.
Trust and Wealth Management’s net income decreased $1.3 million in the first quarter of 2004 compared to the same period in 2003, due mostly to the costs associated with the sale of employee benefit accounts. Despite these costs amounting to $2.4 million, reduced expenses in other categories limited the increase in total noninterest expense to $1.9 million. Increased sales of trust products and services and an improved equity market resulted in an increase in noninterest income. The Company sold its employee benefit account processing in 2003. Management does not believe that the sale of the employee benefit account processing will have an impact on the net income of this business segment due to the comparable revenues and expenses related to this activity. The greatest impact for earnings improvement in this business segment lies in continued increased sales of products and services and improved equity and financial markets, since most revenues are related to the market value of customer investments.
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Investment Services Group net income decreased $1.0 million in the first quarter of 2004 compared to the same period in 2003 due to increased noninterest expense resulting from increased costs of new technology to improve processing to better serve our customers. Improvement in the equity and financial markets, and in particular improvements in the mutual fund industry, would provide the greatest opportunity for improved earnings for this business segment. Management believes that the Company has a distinct advantage over its competitors by being able to provide the full range of services to mutual fund providers under one umbrella.
The net loss for the Treasury and Other category was $4.0 million for the first quarter of 2004, compared to a net loss of $5.0 million for the same period in 2003. The net loss for all years includes unallocated income tax expense for the consolidated Company. The decrease in net loss is related primarily to lower taxes resulting from lower taxable income.
Balance Sheet Analysis
Table 7
SELECTED BALANCE SHEET INFORMATION (dollars in thousands)
Total Assets
Loans, Net of Unearned Interest
Total Investment Securities
Total Earning Assets
Total Deposits
Total Borrowed Funds
Loans represent the Company’s largest source of interest income. Loan balances have now stabilized due to management’s effort to focus on new commercial and consumer loan relationships, as well as the overall improvement in the economy. Management plans to continue to focus on growing our consumer and middle market business as these market niches represent our best opportunity to cross-sell fee-related services, such as cash management. In addition, management intends to develop a small business initiative as this segment represents a growth opportunity for the Company. With both the recent hiring of Peter deSilva as President and Chief Operating Officer of the Company and the establishment of a management committee to run the day-to-day operations of the Company, R. Crosby Kemper III, the Chairman and Chief Executive Officer, and other members of the Commercial Banking Division’s management team, will focus more on acquiring new customers and selling our products and services.
Nonaccrual, past due and restructured loans are discussed under “Credit Risk Management” within the quantitative and qualitative disclosure about market risk in Item 3 of this report.
Securities
The Company’s security portfolio provides significant liquidity as a result of the composition and average life of the underlying securities. This liquidity can be used to fund loan growth or to offset the outflow of traditional funding sources. In addition to providing a potential source of liquidity, 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. The Company maintains very high liquidity levels while investing in only high-grade securities. The security portfolio generates the Company’s second largest component of interest income.
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Securities available for sale and securities held to maturity comprised 52%, 59% and 56% respectively, of the earning assets as of March 31, 2004, March 31, 2003 and December 31, 2003. Securities totaled $3.2 billion as of March 31, 2004 compared to $3.7 billion as of March 31, 2003 and compared to $3.7 billion at December 31, 2003. The decreases in securities as of March 31, 2004 compared to March 31, 2003 and December 31, 2003 resulted from lower trust and mutual fund clients’ related to deposits and borrowed funds. Loan demand is expected to be the primary factor impacting changes in the level of security holdings.
Deposits and Borrowed Funds
Deposits represent the Company’s primary funding source for its 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. The Company continually strives to expand, improve and promote its cash management services in order to attract and retain commercial funding customers. Management believes it is one of the Company’s core competencies given both its scale and competitive product mix.
Federal funds purchased and securities sold under agreement to repurchase totaled $959 million at March 31, 2004, compared to $955 million at March 31, 2003 and $1.2 billion at December 31, 2003. 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.
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 $823.9 million at March 31, 2004, compared to $799.8 million at March 31, 2003 and $811.9 million at December 31, 2003. 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 three months ended March 31, 2004 and 2003, the Company acquired 22,123 shares and 218,457 shares, respectively, of its common stock. The Company’s Board of Directors authorized at its April 29, 2004 meeting the repurchase of the Company’s common stock up to one million shares during the next 12 months.
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 20.23% and total capital ratio of 21.41% 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.
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Table 8
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
Off-balance Sheet Arrangements
The Company’s main off-balance sheet arrangements are loan commitments, commercial and standby letters of credit, futures contracts and forward exchange contracts, which have maturity dates rather than payment due dates. Please see note 6, “Commitments, Contingencies and Guarantees” in the Notes to Condensed Consolidated Financial Statements for detailed information on these arrangements. There was no material change from December 31, 2003.
Critical Accounting Policies and Estimates
Management’s Discussion and Analysis of financial condition and results of operations discusses the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments, including those related to customers and suppliers, allowance for loan losses, bad debts, investments, financing operations, long-lived assets, contingencies and litigation. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which have formed the basis for making such judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from the recorded estimates under different assumptions or conditions.
Management believes that the Company’s critical accounting policies are those relating to: allowance for loan losses; goodwill and other intangibles; impairment of long-lived assets; revenue recognition; and, accounting for stock-based compensation. The allowance for loan losses represents management’s judgment of the losses inherent in the Company’s loan portfolio. The adequacy is reviewed quarterly, considering such items as historical trends, a review of individual loans, current economic conditions, loan growth and characteristics. The allowance for loan losses are maintained on a bank-by-bank basis, however, the Company uses a centralized credit administration function, which provides information on affiliate bank risk levels, delinquencies, and internal ranking systems.
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Goodwill and other intangibles are now to be accounted for under the SFAS No. 142, which was effective January 1, 2002. Goodwill is no longer amortized, in accordance with SFAS No. 142, but is tested periodically for impairment. The Company has performed three impairment tests of goodwill since inception of the new standard. As a result of those tests, the Company has not recorded an impairment charge. The Company is amortizing other intangibles over their estimated useful life of 10 years.
Long-lived assets including goodwill, other intangible assets and premises and equipment, are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of an asset or a group of assets may not be recoverable. Goodwill and other intangibles were addressed above. The impairment review for long-lived assets other than goodwill includes a comparison of future cash flows expected to be generated by the asset or group of assets to their current carrying value. If the carrying value of the asset or group of assets exceeds expected cash flows (undiscounted and with interest charges) an impairment loss is recognized to the extent the carrying value exceeds its fair value.
Revenue recognition is the recording of interest on loans and securities and is recognized based on rate multiplied by the principal amount outstanding. Interest accrual is discontinued when, in the opinion of management, the likelihood of collection becomes doubtful. Annual bankcard fees are recognized on a straight-line basis over the period that cardholders may use the card. Other noninterest income is recognized as services are performed or revenue-generating transactions are executed.
Stock-based compensation is recognized using the intrinsic value method for disclosure purposes. Per the requirements of FAS 123 proforma net income and earnings per share is disclosed in the footnotes to the financial statements as if the fair value method had been applied.
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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 March 31, 2004 and 2003 and December 31, 2003. Table 9 sets forth, for March 31, 2004 and 2003 and December 31, 2003, 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 9 includes both instruments entered into for trading purposes and the instruments entered into for other than trading purposes.
The net portfolio value as of March 31, 2004 is higher than December 31, 2003 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, 2003. 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 March 31, 2004 is higher than March 31, 2003. The increase was due to total assets, investment securities and deposits at higher levels at March 31, 2003. The Company should benefit from rate increases.
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Table 9
MARKET RISK (dollars in thousands)
(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 March 31, 2004 and 2003 and December 31, 2003. Table 10 shows the net interest income, increase or decrease over the next twelve months as of March 31, 2004 and 2003, and December 31, 2003. The three periods show that if rates rise 100 or 200 basis points, net interest income will increase. 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 10
Hypothetical change
in interest rate
(in Basis Points)
(Rate Shock)
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.
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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.
Other Market Risk
The Company does not have material commodity price risks or derivative risks. The Company also has foreign currency risks as a result of foreign exchange contracts. Please see note 6 “Commitments, Contingencies and Guarantees” in the notes to the condensed consolidated financial statements.
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 increased $3.0 million at March 31, 2004, compared to March 31, 2003 and decreased $0.2 million compared to December 31, 2003. The major portion of nonperforming loans is due to six commercial loan customers.
The Company had $58 thousand in other real estate owned as of March 31, 2004 compared to $5.0 million as of March 31, 2003 and $78 thousand as of December 31, 2003. Loans past due more than 90 days totaled $3.3 million as of March 31, 2004, compared to $6.0 million as of March 31, 2003 and $3.1 million as of December 31, 2003.
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.
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TABLE 11
LOAN QUALITY (dollars in thousands)
Nonaccrual loans
Restructured loans
Total nonperforming loans
Other real estate owned
Total nonperforming assets
Loans past due 90 days or more
Allowance 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
Allowance for Loan Losses a % of loans
Allowance for Loan Losses a multiple of nonperforming loans
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 March 31, 2004 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.
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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. 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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PART II - OTHER INFORMATION
None.
ISSUER PURCHASE OF EQUITY SECURITIES
Period
(a) Total
Number of
Shares (or Units)
Purchased
(b) Average
Price Paid
per Share
(or Unit)
( c ) Total Number ofShares (or
Units) Purchased
as Part of PubliclyAnnounced Plans
or Programs
January 1-January 31, 2004
February 1-February 29, 2004
March 1-March 31, 2004
On April 18, 2003, the Company announced a plan to purchase up to one million shares of common stock. This plan will terminate April 18, 2004. This is the only plan that the Company has issued and there were no plans that expired or terminated during the three-month period January 1, 2004 through March 31, 2004. On April 29, 2004 the Company announced a plan to repurchase up to one million shares of common stock. This plan will terminate April 29, 2005.
a) The following exhibits are filed herewith:
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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
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