ITEM 1. BUSINESS
General
Merchants Bancorp, Inc. (the "Company") was incorporated under the laws of the State of Ohio on March 29, 1996 at the direction of the Board of Directors of the Merchants National Bank (the "Bank") for the purpose of becoming a bank holding company by acquiring all of the outstanding shares of the Bank. In December, 1996 the Company became the sole shareholder of the Bank. The principal office of the Company is located at 100 North High Street, Hillsboro, Ohio 45133. Hillsboro, situated in south central Ohio, is centrally located between the cities of Columbus, Cincinnati and Dayton, and is the county seat of Highland County. Highland County has a population of approximately 41,000. The company, through its banking affiliate, also conducts business in the neighboring counties of Madison and Fayette, which have populations of approximately 40,000 and 28,000 respectively.
This tri-county area is primarily agricultural. Madison County is one of Ohio's principal producers of corn and soybeans, and Fayette County is a significant horsebreeding area. However, manufacturing also provides a significant source of employment in the area, accounting for approximately 30% of all jobs in the three counties. Area manufacturers produce a wide array of products, including textiles, electrical components and automotive parts. Some of the area's principal manufacturers include the Hobart Corp., Johnson Controls, Inc., the Showa Aluminum Corp., Yamashita Rubber and Calmas, Inc. The Bank has operated in Hillsboro, Ohio as a national banking association since its charter was granted on December 26, 1879.
The Company, through its banking affiliate, offers a broad range of banking services to the commercial, industrial and consumer market segments which it serves. The primary business of the Bank consists of accepting deposits through various consumer and commercial deposit products, and using such deposits to fund various loan products. The Bank's primary loan products (and the general terms for each) are as follows: (1) loans secured by residential real estate, including loans for the purchase of one to four family residences which are secured by 1st and 2nd mortgages (15 to 30 year terms with fixed and adjustable rate options) and home equity loans (10 year maturities tied to prime rate); (2) consumer loans, including new and used automobile loans (up to 60 months), loans for the purchase of mobile homes (10 to 15 year terms) and debt consolidation loans (exact terms depending upon available collateral); (3) agricultural loans, including loans for the purchase of real estate used in connection with agricultural purposes (15 to 30 year terms), operating loans (1 year terms) and loans for the purchase of equipment (5 to 7 year terms); and (4) commercial loans, including loans for the purchase of real estate used in connection with office or retail activities (15 to 20 year terms), loans for the purchase of equipment (7 to 10 year terms) and loans for the purchase of inventory (1 year terms).
The primary risks inherent in any type of lending include interest rate risk and credit risk associated with the credit quality of individual borrowers. For further information regarding interest rate risk, see the section captioned "Market Risk Management" under "Management's Discussion and Analysis of Financial Condition and Results of Operations." Credit risk is generally offset both through the use of security and mortgage interests, and through the implementation of designated loan approval processes. Senior mortgages in real estate provide the greatest protection in the event of borrower default, while junior mortgages and security interests in depreciating assets provide somewhat less protection. Loans not secured by real or personal property present the greatest risk of loss upon default. All loans, whether secured or unsecured, are approved in accordance with a loan policy adopted by the Company's Board of Directors. While loan officers do have authority to make credit decisions outside of the parameters of the Board's loan policy, such loan officers must satisfy designated documentation
requirements when doing so. Credit risk is further mitigated both by restricting the types of loans and by establishing maximum amounts which can be approved by individual loan officers. Loans made beyond these individual limitations must be affirmatively approved by a committee comprised of loan officers. The Bank also engages in certain government guarantee programs, which help to reduce the risk inherent in certain types of loans.
All of the Bank's deposit and lending services are available at its four full service offices. The remaining three offices of the Bank are engaged primarily in deposit-related services. The Company has no foreign operations, assets or investments.
The Bank is a national banking association organized under the laws of the United States. The Bank is regulated by the Office of the Comptroller of the Currency ("OCC"), and its deposits are insured by the Federal Deposit Insurance Company ("FDIC") to the extent permitted by law and, as a subsidiary of the Company, is regulated by the Board of Governors of the Federal Reserve. As of December 31, 2002, the Company and its subsidiary had consolidated total assets of approximately $319 million, consolidated total deposits of approximately $263 million and consolidated total shareholders' equity of approximately $33.5 million.
Employees
As of December 31, 2002, the Bank had 84 full-time and 9 part-time employees. The Bank provides a number of benefits for its full-time employees, including health and life insurance, pension, profit sharing and 401(k) plans, workers' compensation, social security, paid vacations, and certain bank services.
Competition
The Bank's market consists of the following Ohio Counties: Fayette; Highland; and Madison. The commercial banking business in this market is very competitive. The Company and the Bank are in competition with other commercial banks operating in the primary market area. Some competitors of the Company and the Bank are substantially larger than the Bank. In addition to local bank competition, the Bank competes with larger commercial banks headquartered in metropolitan areas, savings banks, savings and loan associations, credit unions, finance companies and other financial institutions for loans and deposits.
Pursuant to Deposit Market Share statistical information compiled by the Federal Deposit Insurance Corporation, there are approximately twenty (20) financial institutions operating in the Bank's market. As of June 30, 2002 (the most recent date for which the compiled statistical information is available) the Bank possessed the second largest market share with $247 million in total deposits, representing a market share of approximately 17.9%. Three other depositary institutions also possess over 10% of the market share in the Bank's market.
The principal methods of competition within the financial services industry include improving customer service through the quality and range of services provided, improving efficiencies, and pricing services competitively. The Bank views its primary competitive advantages as being the provider of outstanding customer service and maintaining strong relationships with its core customer base. Rarely does the Bank offer the highest rates on deposit accounts or the lowest rates on loans. Fees and service charges are priced to meet the competition. The Bank believes that its distinguishing characteristics are knowing its customers, offering quality customer service and timely loan decisions and closings. By focusing on these key attributes, the Bank has built a loyal customer base, which also serves as its greatest source of new business by way of customer referrals.
SUPERVISION AND REGULATION
General
Merchants Bancorp, Inc. is a corporation organized under the laws of the State of Ohio. The business in which the Company and its subsidiary are engaged is subject to extensive supervision, regulation and examination by various bank regulatory authorities. The supervision, regulation and examination to which the Company and its subsidiary are subject are intended primarily for the protection of depositors and the deposit insurance funds that insure the deposits of banks, rather than for the protection of shareholders.
Several of the more significant regulatory provisions applicable to banks and bank holding companies to which the Company and its subsidiary are subject are discussed below, along with certain regulatory matters concerning the Company and its subsidiary. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory provisions. Any change in applicable law or regulation may have a material effect on the business and prospects of the Company and its subsidiary.
Regulatory Agencies
The Company, upon approval from the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"), became a bank holding company on December 31, 1996, and continues to be subject to regulation under the Bank Holding Company Act of 1956 and to inspection, examination and supervision by the Federal Reserve Board.
The Bank is a national banking association chartered under the laws of the United States of America. It is subject to regulation and examination primarily by the Office of the Comptroller of the Currency (the "OCC") and secondarily by the Federal Reserve Board and the FDIC.
Holding Company Activities
As a bank holding company incorporated and doing business within the State of Ohio, the Company is subject to regulation and supervision under the Bank Holding Act of 1956, as amended (the "Act"). The Company is required to file with the Federal Reserve Board on a quarterly basis information pursuant to the Act. The Federal Reserve Board may conduct examinations or inspections of the Company and its subsidiary.
The Company is required to obtain prior approval from the Federal Reserve Board for the acquisition of more than five percent of the voting shares or substantially all of the assets of any bank or bank holding company. In addition, the Company is generally prohibited by the Act from acquiring direct or indirect ownership or control of more than five percent of the voting shares of any company which is not a bank or bank holding company and from engaging directly or indirectly in activities other than those of banking, managing or controlling banks or furnishing services to its subsidiaries. The Company may, however, subject to the prior approval of the Federal Reserve Board, engage in, or acquire shares of companies engaged in activities which are deemed by the Federal Reserve Board by order or by regulation to be so closely related to banking or managing and controlling a bank as to be a proper activity.
On November 12, 1999, the Gramm-Leach-Bliley Act (the "GLB Act") was enacted into law. The GLB Act made sweeping changes with respect to the permissible financial services which various
types of financial institutions may now provide. The Glass-Steagall Act, which had generally prevented banks from affiliation with securities and insurance firms, was repealed. Pursuant to the GLB Act, bank holding companies may elect to become a "financial holding company," provided that all of the depository institution subsidiaries of the bank holding company are "well capitalized" and "well managed" under applicable regulatory standards.
Under the GLB Act, a bank holding company that has elected to become a financial holding company may affiliate with securities firms and insurance companies and engage in other activities that are financial in nature. Activities that are "financial in nature" include securities underwriting, dealing and market-making, sponsoring mutual funds and investment companies, insurance underwriting and agency, merchant banking, and activities that the Federal Reserve Board has determined to be closely related to banking. No Federal Reserve Board approval is required for the Company to acquire a company, other than a bank holding company, bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve Board. Prior Federal Reserve Board approval is required before the Company may acquire the beneficial ownership or control of more than 5% of the voting shares, or substantially all of the assets, of a bank holding company, bank or savings association. If any subsidiary bank of the Company ceases to be "well capitalized" or "well managed" under applicable regulatory standards, the Federal Reserve Board may, among other actions, order the Company to divest the subsidiary bank. Alternatively, the Company may elect to conform its activities to those permissible for a bank holding company that is not also a financial holding company. If any subsidiary bank of the Company receives a rating under the Community Reinvestment Act of 1977 of less than satisfactory, the Company will be prohibited from engaging in new activities or acquiring companies other than bank holding companies, banks or savings associations. The Company has not elected to become a financial holding company and has no current intention of making such an election.
Affiliate Transactions
Various governmental requirements, including Sections 23A and 23B of the Federal Reserve Act, limit borrowings by holding companies and non-bank subsidiaries from affiliated insured depository institutions, and also limit various other transactions between holding companies and their non-bank subsidiaries, on the one hand, and their affiliated insured depository institutions on the other. Section 23A of the Federal Reserve Act also generally requires that an insured depository institution's loan to its non-bank affiliates be secured, and Section 23B of the Federal Reserve Act generally requires that an insured depository institution's transactions with its non-bank affiliates be on arms-length terms.
Interstate Banking and Branching
Under the Riegle-Neal Interstate Banking and Branching Efficiency Act ("Riegle-Neal"), subject to certain concentration limits and other requirements, bank holding companies such as the Company are permitted to acquire banks and bank holding companies located in any state. Any bank that is a subsidiary of a bank holding company is permitted to receive deposits, renew time deposits, close loans, service loans and receive loan payments as an agent for any other bank subsidiary of that bank holding company. Banks are permitted to acquire branch offices outside their home states by merging with out-of-state banks, purchasing branches in other states and establishing de novo branch offices in other states, The ability of banks to acquire branch offices is contingent, however, on the host state having adopted legislation "opting in" to those provisions of Riegle-Neal. In addition, the ability of a bank to merge with a bank located in another state is contingent on the host state not having adopted legislation "opting out" of that provision of Riegle-Neal. The Company could from time to time use Riegle-Neal to acquire banks in additional states.
Control Acquisitions
The Change in Bank Control Act prohibits a person or group of persons from acquiring "control" of a bank holding company, unless the Federal Reserve Board has been notified and has not objected to the transaction. Under the rebuttable presumption established by the Federal Reserve Board, the acquisition of 10% or more of a class of voting stock of a bank holding company with a class of securities registered under Section 12 of the Exchange Act, such as the Company, would, under the circumstances set forth in the presumption, constitute acquisition of control of the bank holding company. In addition, a company is required to obtain the approval of the Federal Reserve Board under the Bank Holding Company Act before acquiring 25% (5% in the case of an acquiror that is a bank holding company) or more of any class of outstanding voting stock of a bank holding company, or otherwise obtaining control or a "controlling influence" over that bank holding company.
Liability for Banking Subsidiaries
Under the current Federal Reserve Board policy, a bank holding company is expected to act as a source of financial and managerial strength to each of its subsidiary banks and to maintain resources adequate to support each subsidiary bank. This support may be required at times when the bank holding company may not have the resources to provide it. In the event of a bank holding company's bankruptcy, any commitment by the bank holding company to a U.S. federal bank regulatory agency to maintain the capital of a subsidiary bank would be assumed by the bankruptcy trustee and entitled to priority of payment. Any depository institution insured by the FDIC can be held liable for any loss incurred, or reasonably expected to be incurred, by the FDIC in connection with (1) the "default" of a commonly controlled FDIC-insured depository institution; or (2) any assistance provided by the FDIC to both a commonly controlled FDIC-insured depository institution "in danger of default." The Company's subsidiary bank is an FDIC-insured depository institution. If a default occurred with respect to the Bank, any capital loans to the Bank from its parent holding company would be subordinate in right of payment to payment of the Bank's depositors and certain of its other obligations.
Regulatory Capital Requirements
The Company is required by the various regulatory authorities to maintain certain capital levels. Bank holding companies are required to maintain minimum levels of capital in accordance with Federal Reserve capital adequacy guidelines. If capital falls below minimum guideline levels, a bank holding company, among other things, may be denied approval to acquire or establish additional banks or non-bank businesses. The required capital levels and the Company's capital position at December 31, 2002 are summarized in the table included in Note 13 to the consolidated financial statements.
FDICIA
The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), and the regulations promulgated under FDICIA, among other things, established five capital categories for insured depository institutions-well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized-and requires U.S. federal bank regulatory agencies to implement systems for "prompt corrective action" for insured depository institutions that do not meet minimum capital requirements based on these categories. Unless a bank is well capitalized, it is subject to restrictions on its ability to offer brokered deposits and on certain other aspects of its operations. An undercapitalized bank must develop a capital restoration plan and its parent bank holding company must guarantee the bank's compliance with the plan up to the lesser of 5% of the bank's or thrift's assets at the time it became undercapitalized and the amount needed to comply with the plan. As of December 31,
2002, the Company's banking subsidiary was well capitalized pursuant to these prompt corrective action guidelines.
Dividend Restrictions
The ability of the Company to obtain funds for the payment of dividends and for other cash requirements will be largely dependent on the amount of dividends which may be declared by its banking subsidiary. Various U.S. federal statutory provisions limit the amount of dividends the Company's banking subsidiaries can pay to the Company without regulatory approval. Dividend payments by national banks are limited to the lesser of (1) the level of undivided profits; (2) the amount in excess of which the bank ceases to be at least adequately capitalized; and (3) absent regulatory approval, an amount not in excess of net income for the current year combined with retained net income for the preceding two years.
In addition, U.S. federal bank regulatory authorities have authority to prohibit the Company's banking subsidiary from engaging in an unsafe or unsound practice in conducting their business. The payment of dividends, depending upon the financial condition of the bank in question, could be deemed to constitute an unsafe or unsound practice. The ability of the Company's banking subsidiary to pay dividends in the future is currently, and could be further, influenced by bank regulatory policies and capital guidelines.
Deposit Insurance Assessments
The deposits of the Company's banking subsidiary are insured up to regulatory limits by the FDIC, and, accordingly, are subject to deposit insurance assessments to maintain the Bank Insurance Fund (the "BIF") and/or the Savings Association Insurance Fund (the "SAIF") administered by the FDIC.
Depositor Preference Statute
In the "liquidation or other resolution" of an institution by any receiver, U.S. federal legislation provides that deposits and certain claims for administrative expenses and employee compensation against the insured depository institution would be afforded a priority over general unsecured claims against that institution, including federal funds and letters of credit.
Government Monetary Policy
The earnings of the Company are affected primarily by general economic conditions, and to a lesser extent by the fiscal and monetary policies of the federal government and its agencies, particularly the Federal Reserve. Its policies influence, to some degree, the volume of bank loans and deposits, and interest rates charged and paid thereon, and thus have an effect on the earnings of the Company's subsidiary Bank.
Additional Regulation
The Bank is also subject to federal regulation as to such matters as required reserves, limitation as to the nature and amount of its loans and investments, regulatory approval of any merger or consolidation, issuance or retirement of their own securities, limitations upon the payment of dividends and other aspects of banking operations. In addition, the activities and operations of the Bank are subject to a number of additional detailed, complex and sometimes overlapping laws and regulations. These include state usury and consumer credit laws, state laws relating to fiduciaries, the Federal Truth-in-Lending Act and
Regulation Z, the Federal Equal Credit Opportunity Act and Regulation B, the Fair Credit Reporting Act, the Truth in Savings Act, the Community Reinvestment Act, anti-redlining legislation and antitrust laws.
Future Legislation
Changes to the laws and regulations, both at the federal level and in the states where the Company and its subsidiary do business, can affect the operating environment of the Company and its subsidiary in substantial and unpredictable ways. The Company cannot accurately predict whether those changes in laws and regulations will occur, and, if those changes occur, the ultimate effect they would have upon the financial condition or results of operations of the Company or its subsidiary.
ITEM 2.
ITEM 2. PROPERTIES.
The Bank owns the real property used in its business as follows:
Main Office: Greenfield Main 100 N. High Street 117 S. Washington Street Hillsboro, Ohio 45133 Greenfield, Ohio 45123
Hillsboro Branch Greenfield Branch 1478 N. High Street 102 Jefferson Street Hillsboro, Ohio 45133 Greenfield, Ohio 45123
Hillsboro Uptown Branch Washington Court House Branch 145 W. Beech Street 128 S. North Street Hillsboro, Ohio 45133 Washington Court House, Ohio 43160
London Branch 279 LaFayette Street London, Ohio 43140
All such properties are suitable for carrying on the general business of commercial banking. No such properties are subject to any material encumbrance.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
Currently, there are no legal proceedings of a material nature pending to which either the Company or the Bank is a party, or to which any of their property is the subject. Additionally, management of the Company is not aware of the contemplation of any proceedings the institution of which would have a material adverse impact upon the financial condition of the Company or the Bank.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
There was no matter submitted during the fourth quarter of the fiscal year covered by this report to a vote of the Company's security holders.
PART II
ITEM 5.
ITEM 5. MARKET PRICE OF AND DIVIDENDS ON THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
a. Market Information
There is no established public trading market for the Company's common stock and the shares of the Company are not listed on any exchange. Sale price information provided below on a quarterly basis for the two most recent fiscal years is based on information reported to the Company by individual buyers and sellers of the Company's stock, based on actual transactions of which information was obtained at the time of transfer. Not all sales transaction information during these periods was obtained.
- -------------------------------------------- (1) Adjusted to reflect a 3 for 1 stock split effective March 5, 2001.
The Company currently has 3,000,000 shares of common stock outstanding. All of such shares are eligible for sale in the open market without restriction or registration under the Securities Act of 1933, as amended (the "Securities Act"), except for shares held by "affiliates" of the Company. Shares held by affiliates are subject to the resale limitations of Rule 144, as promulgated under the Securities Act. For purposes of Rule 144, "affiliates" are deemed to be all Directors, Executive Officers and ten percent beneficial owners of the Company. As of December 31, 2002, affiliates of the Company had beneficial ownership of an aggregate of 502,669 shares of the Company's common stock. The Company has one shareholder with beneficial ownership of more than ten percent of its outstanding shares, and such individual is also a Director of the Company.
Rule 144 subjects affiliates to certain restrictions in connection with the resale of Company securities that do not apply to individuals currently holding outstanding shares of Company stock. Commencing ninety days after the effective date of this Registration Statement, affiliates of the Company may sell within any three-month period a number of shares that does not exceed the greater of one percent of the number of then outstanding shares of Company common stock, or the average weekly trading volume of the common stock in the over-the-counter market during the four calendar weeks preceding filing by the selling affiliate of the requisite notice of sale with the SEC on Form 144. Sales under Rule 144 are also subject to certain requirements as to the manner of sale, notice to the Securities and Exchange Commission, and the availability of current public information about the Company.
The Company has no outstanding options or warrants to purchase shares of its common stock or securities convertible into shares of common stock.
b. Holders
The number of holders of record of the Company's common stock at December 31, 2002 was 743.
c. Dividends
Dividends are generally declared by the Board of Directors of the Company semiannually (June 30 and December 31, respectively). Dividends per share declared by the Company on its common stock during the years of 2002 and 2001 are as follows:
The Company currently expects that comparable semiannual cash dividends will continue to be paid in the future. For information on regulatory restrictions to the Board's ability to declare and pay dividends, please refer to the following: (1) Supervision and Regulation -- Dividend Restrictions and (2) Note 13 to the Company's Consolidated Financial Statements, Regulatory Matters.
The Company's Quarterly Financial Data for 2002 and 2001 follows:
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
The following table sets forth certain information derived from the consolidated financial information of the Company for each of the years as of December 31 (in thousands, except per share data).
SELECTED FINANCIAL DATA
- -------------------------------------------------------------------------------- (1) Per share amounts have been retroactively restated to reflect the 3 for 1 stock split in 2001. (2) Computed by dividing noninterest expense by the sum of net interest income and noninterest income.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis comparing 2002 to prior years should be read in conjunction with the audited consolidated financial statements at December 31, 2002 and 2001 and for the three years ended December 31, 2002. In addition to the historical information contained herein with respect to the Company, the following discussion contains forward-looking statements that involve risks and uncertainties. Economic circumstances, the Company's operation and the Company's actual results could differ significantly from those discussed in the forward-looking statements. Forward-looking statements are typically identified by words or phrases such as "believe," "expect," "anticipate," "intend," "estimate," "may increase," "may fluctuate," and similar expressions or future or conditional verbs such as "will," "should," "would" and "could." These forward-looking statements involve risks and uncertainties including, but not limited to, economic conditions, portfolio growth, the credit performance of the portfolios, including bankruptcies, and seasonal factors; changes in general economic conditions including the performance of financial markets, the prices of crops, prevailing inflation and interest rates, and losses on lending activities; results of various investment activities; the effects of competitors' pricing policies, of changes in laws and regulations on competition and of demographic changes on target market populations' savings and financial planning needs; industry changes in information technology systems on which we are dependent; and the resolution of legal proceedings and related matters. In addition, the policies and regulations of the various regulatory authorities could affect the Company's results. These statements are representative only on the date hereof, and the Company undertakes no obligation to update any forward-looking statements made.
Critical Accounting Policies
Management believes that the determination of the allowance for loan losses represents a critical accounting policy. The Company maintains an allowance for loan losses to absorb probable loan losses inherent in the portfolio. The allowance for loan losses is maintained at a level management considers to be adequate to absorb probable loan losses inherent in the portfolio, based on evaluations of the collectibility and historical loss experience of loans. Credit losses are charged and recoveries are credited to the allowance. Provisions for loan losses are based on management's review of the historical loan loss experience and such factors which, in management's judgment, deserve consideration under existing economic conditions in estimating probable credit losses. The allowance is based on ongoing assessments of the probable estimated losses inherent in the loan portfolio. The Company's methodology for assessing the appropriate allowance level consists of several key elements, as described below.
Larger commercial loans that exhibit probable or observed credit weaknesses are subject to individual review. Where appropriate, reserves are allocated to individual loans based on management's estimate of the borrower's ability to repay the loan given the availability of collateral, other sources of cash flow and available legal options. Included in the review of individual loans are those that are impaired as provided in Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan," as amended. Any specific reserves for impaired loans are measured based on the fair value of the underlying collateral. The Company evaluates the collectibility of both principal and interest when assessing the need for a specific reserve. Historical loss rates are applied to other commercial loans not subject to specific reserve allocations.
Homogenous loans, such as consumer installment and residential mortgage loans, are not individually reviewed for impairment by management. Reserves are established for each pool of loans based on the expected net charge-offs. Loss rates are based on the average five-year net charge-off history by loan category.
Historical loss rates for commercial and consumer loans may be adjusted for significant factors that, in management's judgment, reflect the impact of any current conditions on loss recognition. Factors which management considers in the analysis include the effects of the local economy, trends in the nature and volume of loans (delinquencies, charge-offs, nonaccrual and problem loans), changes in the internal lending policies and credit standards, collection practices, and examination results from bank regulatory agencies and the Company's internal credit review function.
An unallocated reserve is maintained to recognize the imprecision in estimating and measuring loss when evaluating reserves for individual loans or pools of loans.
Specific reserves on individual loans and historical loss rates are reviewed throughout the year and adjusted as necessary based on changing borrower and/or collateral conditions and actual collection and charge-off experience.
The Company has not substantively changed any aspect of its overall approach in the determination of the allowance for loan losses since January 1, 2002. There have been no material changes in assumptions or estimation techniques as compared to prior years that impacted the determination of the current year allowance.
Based on the procedures discussed above, management believes the allowance for loan losses was adequate to absorb estimated loan losses associated with the loan portfolio at December 31, 2002. See further information regarding the allowance for loan losses in Notes 1 and 4 of the Notes to the consolidated financial statements.
I. RESULTS OF OPERATIONS
Overview
Net income for 2002 was $4.8 million, an increase of 8.3% from 2001 net income of $4.4 million, which was an increase of 4.8% over 2000 net income of $4.2 million. Net income per share was $1.59 in 2002, compared to $1.47 in 2001, and $1.40 in 2000. The increase between years is primarily due to increases in net interest income year over year and increased service charges and fees received from deposit accounts. Net interest income before the provision for loan losses increased to $13.0 million in 2002, from $11.6 million in 2001 and $11.2 million in 2000, representing an increase of 11.5% and 3.6% in 2002 and 2001, respectively. The provision for loan losses was $436,000, $177,000, and $177,000 in 2002, 2001 and 2000, respectively. Noninterest income was $1.5 million in 2002 and 2001, which was an increase of 15.4% from $1.3 million in 2000. Noninterest expense increased 8.1%, to $7.1 million for 2002, from $6.6 million in 2001, which was an increase of 8.2% from $6.1 million in 2000.
Selected Statistical Information
The following tables set forth certain statistical information relating to the Company and its subsidiary on a consolidated basis and should be read together with the consolidated financial statements of the Company.
CONSOLIDATED AVERAGE BALANCE SHEETS AND TAXABLE EQUIVALENT INCOME/EXPENSE AND YIELDS/RATES
The following table presents the daily average balance of each category of interest-earning assets and interest-bearing liabilities, and the interest earned or paid on such amounts (dollars in thousands).
CONSOLIDATED AVERAGE BALANCE SHEETS AND TAXABLE EQUIVALENT INCOME/EXPENSE AND YIELDS/RATES (IN THOUSANDS)
(1) Nonaccrual loans are included in loan totals and do not have a significant impact on the information presented. Interest on nonaccrual loans is recorded when received. (2) Interest includes fees on loans of $675, $590, and $483, in 2002, 2001,and 2000, respectively. (3) Tax-exempt income on loans and securities is reported on a fully taxable equivalent basis using a 34% rate. (4) Net interest spread represents the difference between the average yield on interest-earning assets and the average rate on interest-bearing liabilities. (5) Net interest margin represents the net interest income as a percentage of average interest earning assets.
NET INTEREST DIFFERENTIAL
The following table illustrates the summary of the changes in interest earned and interest paid resulting from changes in volume and rates for the major components of interest-earning assets and interest-bearing liabilities on a fully taxable equivalent basis for the periods indicated (dollars in thousands).
Results of Operations
The Company reported net income of $4.8 million, $4.4 million, and $4.2 million for the years ended 2002, 2001, and 2000, respectively. During the same periods, basic and diluted earnings per share were $1.59, $1.47, and $1.40, respectively.
Net interest income increased to $13.0 million in 2002 from $11.6 million in 2001 and $11.2 million in 2000. Noninterest income remained at $1.5 million in 2002 and 2001, an increase from $1.3 million in 2000, while noninterest expense was $7.1 million, $6.6 million, and $6.1 million for the respective years.
Return on average assets was 1.55%, 1.53%, and 1.58%, in 2002, 2001, and 2000, respectively. Return on average equity was 14.74%, 15.00%, and 16.48%, for the respective years.
Net Interest Income
Net interest income increased to $13.0 million in 2002 from $11.6 million in 2001 and $11.2 million in 2000, representing an increase of 11.5% and 3.6% in 2002 and 2001, respectively. The Company's tax equivalent yield on average interest-earning assets decreased to 7.33% in 2002 from 8.33% in 2001, which was lower than the 8.66% yield in 2000. The decrease in yield is primarily a result of the Bank's declining Prime Rate and decreasing yields on the investment portfolio during the year.
Because a large portion of commercial loans are tied to the Prime Rate, the unusual decline in interest rates negatively impacted our yield. The interest and fees on loans decreased 7.6% during 2002. The decrease in interest and fees was primarily due to the low interest rate environment.
The Company's average interest-earning assets increased approximately $19.0 million (6.9%) in 2002 and $20.0 (7.9%) million in 2001. The lower growth rate in 2002 as compared to 2001 is primarily due to the lower interest rate environment and many customers opting for fixed rate residential real estate loans, which are generally sold to independent parties shortly after origination. In addition, the Company experienced an increase in its securities portfolio due to an increase in funds caused by the increase in deposits.
The previously mentioned decline in interest rates also impacted the Company's interest expense. Falling interest rates caused interest expense to decrease 26.9% to $7.9 million in 2002 as compared to $10.8 million in 2001 while the average interest-bearing liabilities increased $13.9 million, or 6%, during 2002 as compared to $17.2 in 2001. The cost of funds decreased to 3.21% in 2002 from 4.66% in 2001. The average balance of certificates of deposit decreased $11.1 million, or 7.6%, in 2002. The fluctuation in cost of funds and certificate of deposit growth between each year can be largely attributed to the changing interest rate environment.
The Company's tax equivalent net interest margin was 4.63% in 2002, 4.37% in 2001 and 4.55% in 2000. The increase in net interest margin in 2002 was primarily due to the large decline in the Bank's cost of funds. The decline in 2001 from 2000 was primarily attributable to increased cost of funds due to local competition.
The Company's securities portfolio experienced an increase in average balances and a decrease in yield during 2002. The average balance of the portfolio increased $8.2 million (23.1%) as compared to 2001, and the tax equivalent yield decreased to 6.10% in 2002 from 6.66% in 2001. The decrease in yield is primarily due to receiving prepayments on higher yielding securities and the adjustable rate securities repricing downward. The Company's reinvestment rate was lower in 2002 than in 2001.
For further information, see the table titled "Consolidated Average Balance Sheets and Taxable Equivalent Income/Expense and Yields/Rates" in the Selected Statistical Information.
Provision for Loan Losses
The provision for loan losses was $436,000 in 2002, $177,000 in 2001 and $177,000 in 2000. The increase in the provision in 2002 was due to management's current assessment of the loan portfolio characteristics during the year. Net charge-offs in 2002 were $290,000 compared to $128,000 in 2001 and $171,000 in 2000. The ratio of the allowance for loan losses as a percentage of total loans at December 31 was 0.85% in 2002, 0.88% in 2001, and .86% in 2000. For further information about the provision and management's methodology for estimating the allowance for loan losses, see "Allowance for Loan Losses" and "Critical Accounting Policies" within Management's Discussion and Analysis.
Noninterest Income
Total noninterest income was $1.5 million in 2002, $1.5 million in 2001, and $1.3 million in 2000, representing a nominal increase in 2002 and 15.4% in 2001. As a percentage of average assets, noninterest income was 0.49%, 0.51%, and 0.48%, in 2002, 2001, and 2000, respectively. Service charges and fees have increased over the last three years due to increased charges and growth in the number of accounts.
Noninterest Expense
Total noninterest expense was $7.1 million in 2002, $6.6 million in 2001, and $6.1 million in 2000, representing an increase of 8.1% in 2002 and 7.3% in 2001. As a percentage of average assets, noninterest expense was 2.30%, 2.28%, and 2.31% in 2002, 2001, and 2000, respectively.
Salaries and benefits expense comprises the largest component of noninterest expense, with totals of $3.5 million in 2002, $3.3 million in 2001, and $3.3 million in 2000. As a percentage of assets, salaries and benefits expense was 1.14%, 1.16%, and 1.23% in 2002, 2001, and 2000, respectively. The average number of full-time equivalent employees was 88 in 2002, 86 in 2001, and 85 in 2000.
Included in salaries and benefits expense was net pension costs of approximately $145,000 in 2002 and $110,000 in 2001, which are based upon specific actuarial assumptions, including a long-term rate of return of 7.50%. Management believes the rate of return is a reasonable assumption of projected equity and bond indices long-term return projections as well as actual long-term historical plan returns realized. Management will continue to evaluate the actuarial assumptions, including the expected rate of return, annually, and will adjust the assumptions as necessary.
The Company based its determination of pension expense on a market-related valuation of assets. Investment gains or losses are computed as the difference between the expected return calculated using the market-related value of assets and the actual return based on the market-related value of assets. The future value of assets will be impacted as previously deferred gains or losses are recognized.
The discount rate that the Company utilizes for determining future pension obligations decreased to 6.50% in 2002 from 7.50% in 2001, based on management's evaluation of current yields on long-term yields on highly-rated bonds.
Lowering the expected long-term rate of return on plan assets or the discount rate by .25% would not have had a significant impact on pension expense in 2002.
II. FINANCIAL CONDITION
Assets
The Company's total assets increased to $318.8 million in 2002 from $304.9 million in 2001, representing an increase of 4.6%. Average total assets increased to $308.4 million in 2002 from $288.2 million in 2001, an increase of 7.0%. Average interest-earning assets increased to $291.6 in 2002 from $272.7 million in 2001, and remained at approximately 95% of total average assets.
Securities available for sale
The Company reported securities available for sale (at fair value) of $40.0 million and $38.2 million at 2002 and 2001, respectively, and average securities available for sale of $43.4 million in 2002
and $35.2 million in 2001. As a percentage of average assets, average securities were 14.07% in 2002, 12.2% in 2001 and 14.6% in 2000. As of December 31, 2002 and 2001, the Company did not classify any securities as trading or held to maturity. It is the general practice of management to hold securities until they are called or matured. But, by classifying securities in the available for sale category, management has the flexibility to sell the securities should the need arise. The available for sale portion of the portfolio includes mortgage-backed securities, U.S. Treasuries and municipals with an average life of 4 years, and average repricing term of 4 years, and an average tax-equivalent yield of 6.10% for the year ended December 31, 2002. Total available for sale securities consisted of the following: U.S. Treasuries and Agencies -- 9%; fixed-rate mortgage-backed securities and CMO's -- 40%; and fixed-rate tax-exempt municipal securities -- 51%.
INVESTMENT PORTFOLIO
The amortized cost and fair values of securities available for sale as of December 31, 2002 and 2001 are presented in Note 2 to the consolidated financial statements. The amortized cost of securities as of December 31, 2002, 2001, and 2000, is presented below (dollars in thousands):
INVESTMENT PORTFOLIO MATURITIES
The maturity distribution and weighted average interest rates of securities available for sale as of December 31, 2002, are as follows (dollars in thousands):
The calculations of the weighted average interest rates for each maturity category are based on yield weighted by the respective costs of the securities. The weighted average rates on states and political subdivisions are computed on a taxable equivalent basis using a 34% tax rate. For purposes of the above presentation, maturities of U.S. Treasury and agency obligations and obligations of states and political subdivisions are based on average life or earliest call date; mortgage-backed securities are based on estimated maturities.
Excluding those holdings of U.S. Treasury securities and other agencies of the U.S. Government, the Company did not hold any securities of any one issuer that exceeded 10% of the shareholders' equity of the Company at December 31, 2002.
Loans
The Company reported total loans of $248.2 million and $223.7 million at 2002 and 2001, respectively. As a percentage of average assets, average loans were 77.1% in 2002, and 78.8% in 2001.
The table below shows the Company's loans outstanding at period-end by type of loan. The portfolio composition has remained relatively consistent during the three years ended December 31, 2002. Commercial and industrial loans totaled $25.8 million in 2002, representing an increase from $24.1 million in 2001, and $22.9 million in 2000. The increase was primarily a result of increased origination of working capital and equipment loans. Residential real estate loans increased $2.5 million to $99.7 million in 2002 from $97.1 million in 2001 due to the increased demand by the Company's customers for home equity loans.
For interest rate risk management purposes commencing in 2000, the Company started selling the majority of fixed-rate residential real estate loans originated, while holding the adjustable-rate loans in the portfolio. The Company recognizes a gain on sale of loans based on the premium received from the sale of loans to an independent party. The Company did not have any loans held for sale at December 31, 2002 and 2001. At December 31, 2002, the Company serviced approximately $2.3 million of mortgage loans previously sold, for the benefit of others. The servicing asset and the related servicing fees generated from serviced loans are not material to the Company's financial statements.
The Company has experienced an increase in commercial lending, both real estate and industrial, because of the movement of the Company into new markets. The Company focused its commercial lending on small- to medium-sized companies in its market area, most of which are companies with long established track records. The Company expects to continue to grow in the real estate and commercial portfolios. At December 31, 2002, the Company serviced approximately $3.8 million of commercial loans previously sold, for the benefit of others.
The Company will also continue to focus on agriculture lending and continue to use the Farm Service Agency (FSA) Guarantee Program which will guarantee up to 90% of the loan to qualified borrowers and therefore limits the Company's loss exposure while servicing the agricultural industry.
Installment loans as a percentage of total loans outstanding has remained relatively consistent between 2002, 2001, and 2000.
LOAN PORTFOLIO
The following table displays the loan portfolio composition at December 31 for each respective year (dollars in thousands).
The following tables show the Company's loan maturities and composition of fixed and adjustable rate loans at December 31, 2002 (in thousands).
Allowance for Loan Losses
Federal regulations and generally accepted accounting principles require that the Company establish prudent allowances for loan losses. The Company maintains an allowance for loan losses to absorb probable loan losses inherent in the portfolio, based on evaluations of the collectibility and historical loss experience of loans. Loan losses are charged and recoveries are credited to the allowance.
Provisions for loan losses are based on management's review of the historical loan loss experience and such factors which, in management's judgment, deserve consideration under existing economic conditions in estimating probable loan losses. The allowance is based on ongoing assessments of the probable estimated losses inherent in the loan portfolio. The Company's methodology for assessing the appropriate allowance level consists of several key elements, described below.
Larger commercial loans that exhibit probable or observed credit weaknesses are subject to individual review. Where appropriate, reserves are allocated to individual loans based on management's estimate of the borrower's ability to repay the loan given the availability of collateral, other sources of cash flow and available legal options. Included in the review of individual loans are those that are impaired as provided in Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan," as amended. Any specific reserves for impaired loans are measured based on the fair value of the underlying collateral. The Company evaluates the collectibility of both principal and interest when assessing the need for a specific reserve. Historical loss rates are applied to other commercial loans not subject to specific reserve allocations.
Homogenous loans, such as consumer installment and residential mortgage loans, are not individually reviewed by management. Reserves are established for each pool of loans based on the expected net charge-offs. Loss rates are based on the average five-year net charge-off history by loan category.
Historical loss rates for commercial and consumer loans may be adjusted for significant factors that, in management's judgment, reflect the impact of any current conditions on loss recognition. Factors which management considers in the analysis include the effects of the local economy, trends in the nature and volume of loans (delinquencies, charge-offs, nonaccrual and problem loans), changes in the internal lending policies and credit standards, collection practices, and examination results from bank regulatory agencies and the Company's internal credit review function.
Specific reserves on individual loans and historical loss rates are reviewed throughout the year and adjusted as necessary based on changing borrower and/or collateral conditions and actual collection and charge-off experience.
A portion of the allowance is not allocated to any particular loan type and is maintained in recognition of the inherent inability to precisely determine the loss potential in any particular loan or pool of loans. Among the factors used by management in determining the unallocated portion of the allowance are current economic conditions, trends in the Company's loan portfolio delinquency, losses and recoveries, level of underperforming and nonperforming loans, and concentrations of loans in any one industry.
The Company has not substantively changed any aspect of its overall approach in the determination of the allowance for loan losses during 2002. There have been no material changes in assumptions or estimation techniques as compared to prior years that impacted the determination of the current year allowance.
Real estate acquired, or deemed acquired, by the Company as a result of foreclosure proceedings is classified as other real estate owned ("OREO") until it is sold. Interest accrual, if any, ceases no later than the date of acquisition of the real estate, and all costs incurred from such date in maintaining the property are expensed. OREO is recorded by the Company at the lower of cost or fair value less estimated costs of disposal, and any write-down resulting there from is charged to the allowance for loan losses. When the foreclosed property is sold, the difference between proceeds received on OREO and the recorded value is recognized in current earnings.
As discussed above, the allowance is maintained at a level necessary to absorb probable losses in the portfolio. Management's determination of the adequacy of the reserve is based on reviews of specific loans, loan loss experience, general economic conditions and other pertinent factors. If, as a result of charge-offs or increases in risk characteristics of the loan portfolio, the reserve is below the level considered by management to be adequate to absorb probable loan losses, the provision for loan losses is increased.
The allowance for loan losses was 0.85% of total loans as of December 31, 2002, a decrease from 0.88% at the end of 2001. As a percentage of total loans, the allowance has declined from the 1.14% level in 1998, primarily as a result of credit quality and declining net charge-offs. In 2002, the Company experienced net charge-offs of $290,000, or 0.12% of average loans, compared to net charge-offs of $128,000 (0.06%) in 2001 and $171,000 (0.08%) in 2000. The Company recorded a provision for loan losses of $436,000, $177,000 and $177,000 in 2002, 2001, and 2000, respectively. As a percentage of the provision for loan losses, net charge-offs were 66.5%, 72.3%, and 96.6% in 2002, 2001, and 2000, respectively.
The amount of nonaccrual loans increased to $476,000 in 2002 from $383,000 in 2001. As a percentage of total loans, nonaccrual loans represented ..19% in 2002 and .17% in 2001. The Company would have reported additional interest income of approximately $79,000, $49,000 and $30,000 in 2002, 2001 and 2000, respectively, if nonaccrual loans had been accruing interest. Interest income from nonaccrual loans of approximately $2,000 has been included in net income in each of the years ended 2002, 2001 and 1999. Nonaccrual loans at December 31, 2002 consisted of 17 relationships. Nonaccrual loans are expected to be resolved through payments or through liquidation of collateral in the normal course of business. Management estimates losses from these nonaccrual loans to be approximately $64,000, which has been included in the allowance for loan losses.
The category of accruing loans which are past due 90 days or more decreased at December 31, 2002 to $1,133,000 as compared to $1,649,000 at December 31, 2001. As a percentage of total loans, loans past due 90 days and still accruing interest represented 0.46% in 2002 and 0.74% in 2001. Management has analyzed these credits as to the borrower's current circumstances, value of the security pledged and the likely ultimate disposition of these loans. In management's opinion, appropriate specific reserves have been allocated to absorb any probable loss and these accounts are expected to be resolved through payments or liquidation of collateral in the normal course of business. The $1,133,000 of delinquent loans is represented by 40 accounts as follows:
o 13 residential real estate accounts with outstanding balances of $613,000 of which $33,000 has been included as a specific reserve in the allowance for loan losses; o 5 commercial loan accounts with outstanding balances of $242,000 of which $41,000 has been specifically reserved; o 21 consumer installment loans with outstanding balances of $128,000 of which $31,000 has been specifically reserved; o 1 dealer floor plan agreement with outstanding balance of $150,000 with $18,000 specifically reserved.
As a percentage of the allowance for loan losses, total nonaccrual loans and loans past due 90 days or more were 76.4% in 2002 and 103.7% in 2001.
ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES
Activity in the allowance for loan losses for the years ended December 31 are as follows (in thousands).
ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
The following table indicates the portion of the loan loss reserve management has allocated to each loan type at December 31 (in thousands).
NONPERFORMING ASSETS
The following table represents the total of nonaccrual loans and loans 90 days past due and accruing interest at December 31 (in thousands).
Deposits
Deposits have traditionally been the primary source of the Company's funds for use in lending and other investment activities. In addition to deposits, the Company derives funds from interest payments and principal repayments on loans and income on earning assets. Loan payments are a relatively stable source of funds, while deposit inflows and outflows fluctuate more in response to general interest rates and money market conditions.
Deposits are attracted principally from within the Company's market area through the offering of numerous deposit instruments, including checking accounts, regular passbook savings accounts, NOW accounts, money market deposit accounts, term certificate accounts and individual retirement accounts ("IRAs"). Interest rates paid, maturity terms, service fees and withdrawal penalties for the various types of accounts are established periodically by the Company's management based on the Company's liquidity requirements, growth goals and market trends.
The table below presents a summary of period end deposit balances. The composition of deposit categories has remained relatively consistent as a percentage of total deposits throughout the three-year period ended December 31, 2002. As a percentage of total deposits, interest-bearing demand accounts have increased slightly to 24% in 2002 from 22% in 2001, while certificates of deposits (less than
$100,000) have decreased to 40% in 2002 from 44% in 2001. This shift was caused by the lower rate environment in 2002 and a slightly less aggressive marketing strategy. Savings accounts continue to remain consistent in each year as a percentage of deposits, and money market accounts have increased to 6% in 2002 from 3% in 2001 and 2000. Certificates of deposit $100,000 and over are primarily short-term public funds. Balances of such large certificates fluctuate depending on the Company's pricing strategy and funding needs at any particular time and were comparable as a percentage of total deposits in 2002 and 2001.
Interest rates, maturity terms, service fees, and withdrawal penalties for the various types of accounts are established periodically by management based on the Company's liquidity requirements, growth goals and market trends. The amount of deposits currently from outside the Company's market area is not significant.
DEPOSIT COMPOSITION
The following table indicates the total deposits by type at December 31 (dollars in thousands):
The following table indicates the average amount of and the average rate paid on deposit categories which exceeded 10% of average total deposits at December 31 (in thousands):
MATURITIES OF TIME DEPOSITS GREATER THAN $100,000
The following table indicates the amount of the Company's time deposits greater than $100,000 by time remaining until maturity as of December 31, 2002(dollars in thousands):
Other Borrowings
Periodically, the Company will borrow long term money from the Federal Home Loan Bank (FHLB) as a way to provide funding for loan demand. At December 31, 2002, the Company had outstanding, $17.5 million of total borrowings from the FHLB with a weighted average cost of 5.0%. Borrowings of $7 million consist of three fixed-rate notes with maturities in 2008 and 2010. At the option of the FHLB, these notes can be converted at certain dates to instruments that adjust quarterly at the three-month LIBOR rate. The note amount and nearest optional conversion dates at December 31, 2002, are $3 million in March 2003; $1 million in April 2003; and $3 million in March 2003 if the three month LIBOR reaches 8%. The Company borrowed a $500,000 amortizing note to match against a loan to earn a 2.55% spread. Additionally, the Company utilized a borrowing of $10 million, due in 2012, with a rate that can adjust quarterly if the three-month LIBOR reaches 7.75%. With the funds, the Company purchased $10 million in securities classified as available for sale with an average yield of 5% and call features ranging from 2011 to 2013, resulting in a net spread of 2.7%. on the borrowing.
Capital
The declaration and payment of dividends by the Company are subject to the discretion of the Board of Directors and to the earnings and financial condition of the Company and applicable laws and regulations. The dividend payout ratio was increased to 37.7% in 2002 from 35.4% in 2001. At December 31, 2002 consolidated Tier 1 risk based capital was 13.9%, and total risk-based capital was 14.7%. The minimum Tier 1 and total risk-based capital ratios required by the Board of Governors of the Federal Reserve are 4% and 8%, respectively.
Liquidity
Effective liquidity management ensures that the cash flow requirements of depositors and borrowers, as well as company cash needs, are met. The Company manages liquidity on both the asset and liability sides of the balance sheet. Community bank liquidity management currently involves the challenge of attracting deposits while maintaining positive loan growth at a reasonable interest rate spread. The loan to deposit ratio at December 31, 2002, was 94.5%, compared to 85.2% in 2001. Loans to total assets were 77.9% at the end of 2002, compared to 73.4% in 2001. The securities portfolio is available for sale and consists of securities that are readily marketable. Approximately 44% of the available for sale portfolio is pledged to secure public deposits, short-term and long-term borrowings and for other purposes as required by law. The balance of the available for sale securities could be sold if
necessary for liquidity purposes. Also, a stable deposit base, consisting of 90% core deposits, makes the Company less susceptible to large fluctuations in funding needs. The Company also has both short- and long-term borrowings capacity available through FHLB with unused available credit of approximately $25.4 million as of December 31, 2002 The Company has the ability to obtain deposits in the brokered certificate of deposit market to help provide liquidity to fund loan growth, if necessary. Generally, the Company uses short-term borrowings to fund overnight and short-term funding needs in the Company's balance sheet. Longer-term borrowings have been primarily used to fund mortgage-loan originations. This has occurred when FHLB longer-term rates are a more economical source of funding than traditional deposit gathering activities. Additionally, the Company occasionally uses FHLB borrowings to fund larger commercial loans.
Impact of Inflation, Changing Prices and Local Economic Conditions
The majority of the Company's assets and liabilities are monetary in nature. Therefore, the Company differs greatly from most commercial and industrial companies that have significant investments in non-monetary assets, such as fixed assets and inventories. However, inflation does have an important impact on the growth of assets in the banking industry and on the resulting need to increase equity capital at higher than normal rates in order to maintain an appropriate equity to assets ratio. Inflation also affects other expenses, which tend to rise during periods of general inflation.
Management believes the most significant impact on financial and operating results is the Company's ability to react to changes in interest rates. Management seeks to maintain an essentially balanced position between interest sensitive assets and liabilities in order to protect against the effects of wide interest rate fluctuations.
The Company's success is dependent on the general economic conditions of the communities we serve. Unlike larger banks that are more geographically diversified, we provide financial and banking services primarily in south central Ohio. The economies of our markets are dependent to a significant extent on the agricultural industry. The economic conditions in these areas have a significant impact on loan demand, the ability of borrowers to repay these loans, and the value of the collateral securing these loans. A significant decline in general economic conditions, and in particular the agricultural industry, could affect these local economic conditions and could negatively impact the financial results of our banking operations. Factors influencing general conditions include inflation, recession, unemployment, and other factors beyond our control.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
III. MARKET RISK MANAGEMENT
Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to variations in interest rates, exchange rates, equity price risk and commodity prices. The Company does not maintain a trading account for any class of financial instrument, and is not currently subject to currency exchange rate risk, equity price risk or commodity price risk. The Company's market risk is composed primarily of interest rate risk.
The major source of the Company's interest rate risk is the difference in the maturity and repricing characteristics between the Company's core banking assets and liabilities -- loans and deposits. This difference, or mismatch, poses a risk to net interest income. Most significantly, the Company's core banking assets and liabilities are mismatched with respect to repricing frequency, maturity and/or index.
Most of the Company's commercial loans, for example, reprice rapidly in response to changes in short-term interest. In contrast, many of the Company's consumer deposits reprice slowly, if at all, in response to changes in market interest rates.
The Company's Senior Management is responsible for reviewing the interest rate sensitivity position of the Company and establishing policies to monitor and limit exposure to interest rate risk. The guidelines established by senior management are approved by the Company's Board of Directors. The primary goal of the asset/liability management function is to maximize net interest income within the interest rate risk limits set by approved guidelines. Techniques used include both interest rate gap management and simulation modeling that measures the effect of rate changes on net interest income and market value of equity under different rate scenarios. The interest rate gap analysis schedule quantifies the asset/liability static sensitivity as of December 31, 2002. As shown, the Company was asset-sensitive through 3 months, liability-sensitive 3 through 12 months, and asset-sensitive within the one- to five-year period. The cumulative gap as a percent of total assets through one year at the end of 2002 was 7.94%. The balances of transaction type NOW and MMDA accounts are scheduled to run off over their expected lives. Although the entire balance of these deposits is subject to repricing or withdrawal in a relatively short period of time, they have demonstrated over time to be a stable base of retail core deposits for the company. Also, their sensitivity to changes in interest rates is significantly less than some other deposits, such as certificates of deposits.
INTEREST RATE GAP ANALYSIS
The following table displays the Company's interest rate gap analysis at December 31, 2002 (in thousands):
In the Company's simulation models, each asset and liability balance is projected over a time horizon. Net interest income is then projected based on expected cash flows and projected interest rates under a stable rate scenario and analyzed. The results of this analysis are factored into decisions made concerning pricing strategies for loan and deposits, balance sheet mix, securities portfolio strategies, liquidity and capital adequacy.
Simulation models are also performed under an instantaneous parallel 200 basis point increase or decrease in interest rates. The model includes assumptions as to repricing and expected prepayments, anticipated calls, and expected decay rates of transaction accounts under the different rate scenarios. The results of these simulations include changes in both net interest income and market value of equity.
The Company's rate shock simulation models provide results in extreme interest rate environments and results are used accordingly. Reacting to changes in economic conditions, interest rates and market forces, the Company has been able to alter the mix of short and long-term loans and investments, and increase or decrease the emphasis on fixed and variable rate products in response to changing market conditions. By managing the interest rate sensitivity of its asset composition in this manner, the Company has been able to maintain a fairly stable flow of net interest income.
Complicating management's efforts to control non-trading exposure to interest rate risk is the fundamental uncertainty of the maturity, repricing, and/or runoff characteristics of some of the Company's core banking assets and liabilities. This uncertainty often reflects options embedded in these financial instruments. The most important embedded options are contained in consumer deposits and loans.
For example, many of the Company's interest bearing retail deposit products (e.g., interest checking, savings and money market deposits) have no contractual maturity. Customers have the right to withdraw funds from these deposit accounts freely. Deposit balances may therefore run off unexpectedly due to changes in competitive or market conditions. To forestall such runoff, rates on interest bearing
deposits may have to be increased more (or reduced less) than expected. Such repricing may not be highly correlated with the repricing of prime rate-based or U.S. Treasury-based loans. Finally, balances that leave the banking franchise may have to be replaced with other more expensive retail or wholesale deposits. Given the uncertainties surrounding deposit runoff and repricing, the interest rate sensitivity of core bank liabilities cannot be determined precisely.
The following table indicates the Company's interest rate-sensitive instruments and their repricing year and current average yield/(cost) for the periods ended December 31 (in thousands).
(1) For the purpose of this table, securities include FHLB Stock and FRB Stock
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Registrant's Financial Statements are attached hereto as an exhibit.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information required by this item is set forth in the Company's definitive Proxy Statement for the 2003 Annual Meeting of Shareholders to be held April 22, 2003 under the sections captioned "ELECTION OF DIRECTORS AND VOTING PROCEDURES," "EXECUTIVE COMPENSATION AND RELATED ITEMS" and "SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE," and is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The information required by this item is set forth in the Company's definitive Proxy Statement for the 2003 Annual Meeting of Shareholders to be held April 22, 2003 under the section captioned "EXECUTIVE COMPENSATION AND RELATED ITEMS," and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
The information required by this item is set forth in the Company's definitive Proxy Statement for the 2003 Annual Meeting of Shareholders to be held April 22, 2003 under the section captioned "SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT," and is incorporated herein by reference.
The Company currently has no securities authorized for issuance under equity compensation plans which would require the disclosures mandated by Section 201(d) of Regulation S-K.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required by this item is set forth in the Company's definitive Proxy Statement for the 2003 Annual Meeting of Shareholders to be held April 22, 2003 under the section captioned "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS," and is incorporated herein by reference.
ITEM 14.
ITEM 14. CONTROLS AND PROCEDURES.
Within the 90 days prior to the date of this report, the Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective in timely alerting them to material information relating to
the Company (including its consolidated subsidiaries) required to be included in the Company's periodic SEC filings.
There were no significant changes made in the Company's internal controls or in other factors that could significantly affect these internal controls subsequent to the date of the evaluation performed by the Company's Chief Executive Officer and Chief Financial Officer.
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
A. Annual Financial Statements
Independent Auditors' Report Consolidated Balance Sheets, December 31, 2002 and 2001 Consolidated Statements of Income, Years ended December 31, 2002, 2001 and 2000 Consolidated Statements of Changes in Shareholders' Equity Years ended December 31, 2002, 2001 and 2000 Consolidated Statements of Cash Flows, Years ended December 31, 2002, 2001 and 2000 Notes to Consolidated Financial Statements, December 31, 2002, 2001 and 2000
B. Exhibits
(3) (I) Articles of Incorporation, filed as Exhibit (3)(I) to the Form 10 filed with the SEC on April 30, 2002 and incorporated herein by reference. (II) Code of Regulations, filed as Exhibit (3)(II) to the Form 10 filed with the SEC on April 30, 2002 and incorporated herein by reference.
(10) Material Contracts:
10.1 The Merchants National Bank Defined Benefit Retirement Plan, filed as Exhibit 10.1 to the Form 10 filed with the SEC on April 30, 2002 and incorporated herein by reference. 10.2 The Merchants National Bank Profit Sharing and 401(k) Savings Retirement Plan and Trust, filed as Exhibit 10.2 to the Form 10 filed with the SEC on April 30, 2002 and incorporated herein by reference. o Defined Contribution Prototype Plan; and o Non-Standardized 401(k) Savings Plan and Trust Prototype Plan Adoption Agreement 10.3 The Merchants National Bank Profit Sharing Bonus Plan, filed as Exhibit 10.3 to the Form 10 filed with the SEC on April 30, 2002 and incorporated herein by reference. 10.4 The Merchants National Bank of Hillsboro, Ohio Executive Investment Plan, filed as Exhibit 10.4 to the Form 10 filed with the SEC on April 30, 2002 and incorporated herein by reference.
10.5 The Merchants National Bank Directors' Deferred Compensation Plan, filed as Exhibit 10.5 to the Form 10 filed with the SEC on April 30, 2002 and incorporated herein by reference.
(21) Subsidiaries of the Registrant, filed as Exhibit (21) to the Form 10 filed with the SEC on April 30, 2002 and incorporated herein by reference.
(99.1) Certification of the Chief Executive and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act or 1934, the registrant has duly caused this registration statement to be signed on its behalf by the undersigned, thereunto duly authorized.
Merchants Bancorp, Inc. ----------------------------------- (Registrant)
Date March 28, 2003 By /s/ Paul W. Pence, Jr. ------------------------ ----------------------------------- Paul W. Pence, Jr., President
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
CERTIFICATIONS
I, Paul W. Pence, Jr., certify that:
1. I have reviewed this annual report on Form 10-K of Merchants Bancorp, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) Designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
b) Evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and
c) Presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function):
a) All significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and
b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date or our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date March 28, 2003 ------------------------------------------------------------------
By /s/ Paul W. Pence, Jr. ------------------------------------------------------------------ Paul W. Pence, Jr., Principal Executive Officer and Principal Financial Officer
INDEPENDENT AUDITORS' REPORT
Board of Directors and Shareholders Merchants Bancorp, Inc. Hillsboro, Ohio
We have audited the accompanying consolidated balance sheets of Merchants Bancorp, Inc. and subsidiary (the "Corporation") as of December 31, 2002 and 2001, and the related consolidated statements of income, changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 2002. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Corporation as of December 31, 2002 and 2001, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America.
/s/ Deloitte & Touche LLP January 17, 2003 Cincinnati, Ohio
MERCHANTS BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS DECEMBER 31, 2002 and 2001 (IN THOUSANDS, EXCEPT SHARE DATA) - --------------------------------------------------------------------------------
See notes to consolidated financial statements.
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MERCHANTS BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000 (IN THOUSANDS EXCEPT PER SHARE DATA) - --------------------------------------------------------------------------------
See notes to consolidated financial statements.
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MERCHANTS BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000 (IN THOUSANDS EXCEPT PER SHARE DATA) - --------------------------------------------------------------------------------
See notes to consolidated financial statements.
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MERCHANTS BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000 (IN THOUSANDS) - --------------------------------------------------------------------------------
See notes to consolidated financial statements.
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MERCHANTS BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000 - --------------------------------------------------------------------------------
1. SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING POLICIES
The accounting and reporting policies of Merchants Bancorp, Inc. (the "Corporation") conform with accounting principles generally accepted in the United States of America and with general practices within the banking industry. 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 amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. The significant estimates used by management include the allowance for loan losses, fair value of financial instruments, and pension obligations.
DESCRIPTION OF BUSINESS--The Corporation is a bank holding company whose subsidiary, the Merchants National Bank (the "Bank"), provides a full range of banking services. Substantially all assets, liabilities, revenues, and expenses are related to banking operations, including lending, investing of funds, and obtaining of deposits and other financing. All of the Corporation's business offices and majority of its business activities are located in the Ohio Counties of Fayette, Highland, and Madison. The Corporation manages its business as one operating segment and reportable unit--community banking.
The following is a summary of the Corporation's significant accounting policies:
PRINCIPLES OF CONSOLIDATION--The consolidated financial statements include the accounts of Merchants Bancorp, Inc. and its wholly-owned subsidiary, the Merchants National Bank. All significant intercompany balances and transactions have been eliminated in consolidation.
CASH AND DUE FROM BANKS--The Corporation was required to maintain funds with the Federal Reserve Bank in accordance with regulatory reserve requirements of approximately $4,114,000 and $3,482,000 at December 31, 2002 and 2001, respectively.
INVESTMENT SECURITIES-- Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities," requires securities to be classified as held to maturity, available for sale or trading. Only those securities classified as held to maturity, which the Corporation intends and has the ability to hold until maturity, are reported at amortized cost. Available for sale and trading securities are reported at fair value with unrealized gains and losses included in shareholders' equity or income, respectively. All of the Corporation's investment securities are classified as available for sale at December 31, 2002 and 2001.
Amortization of premiums and accretion of discounts are recorded as interest income using methods which approximate a level yield over the period to maturity. Gains and losses realized on sales of securities are computed using the adjusted cost of the specific securities sold.
LOANS--Loans are reported at the carrying value of unpaid principal reduced by unearned interest, net deferred loan origination fees and an allowance for loan losses. Loan origination costs and fees on certain loans are deferred and the net amount is amortized as an adjustment of the related loan's yield over the estimated life of the loan.
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Income is recorded on the effective yield basis. Interest accrual is discontinued when management believes, after considering economic and business conditions and collection efforts, that the borrower's financial condition is such that collection of interest is doubtful. Any loan greater than 90 days past due must be well secured and in the process of collection to continue accruing interest. Cash payments received on nonaccrual loans generally are applied against principal, and interest income is only recorded once principal recovery is reasonably assured. Loans are not reclassified as accruing until principal and interest payments are brought current and future payments appear reasonably certain.
A loan is considered impaired when it is probable the Corporation will be unable to collect all contractual principal and interest payments due in accordance with the terms of the loan agreement. Impaired loans are measured based on the loan's observable market price or the estimated fair value of the collateral if the loan is collateral dependent. The amount of impairment, if any, and any subsequent changes are included in the allowance for loan losses.
The allowance for loan losses is established through a provision for loan losses charged to operating expense. Loan losses are charged against the allowance when management believes the loans are uncollectible. Subsequent recoveries, if any, are credited to the allowance.
The Corporation maintains an allowance for loan losses to absorb probable loan losses inherent in the portfolio. The allowance for loan losses is maintained at a level management considers to be adequate to absorb probable loan losses inherent in the portfolio, based on evaluations of the collectibility and historical loss experience of loans. The allowance is based on ongoing assessments of the probable estimated losses inherent in the loan portfolio. The Corporation's methodology for assessing the appropriate allowance level consists of several key elements, as described below.
Larger commercial loans that exhibit probable or observed credit weaknesses are subject to individual review. Where appropriate, reserves are allocated to individual loans based on management's estimate of the borrower's ability to repay the loan given the availability of collateral, other sources of cash flow and available legal options. Included in the review of individual loans are those that are impaired as provided in Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan." As mentioned above, specific reserves for impaired loans are measured based on the fair value of the underlying collateral. The Corporation evaluates the collectibility of both principal and interest when assessing the need for a specific reserve. Historical loss rates are applied to other commercial loans not subject to specific reserve allocations.
Homogenous loans, such as consumer installment and residential mortgage loans, are not individually reviewed by management. Reserves are established for each pool of loans based on the expected net charge-offs. Loss rates are based on the average five-year net charge-off history by loan category.
Historical loss rates for commercial and consumer loans may be adjusted for significant factors that, in management's judgment, reflect the impact of any current conditions on loss recognition. Factors which management considers in the analysis include the effects of the local economy, trends in the nature and volume of loans (delinquencies, charge-offs, nonaccrual and problem loans), changes in the internal lending policies and credit standards, collection practices, and examination results from bank regulatory agencies and the Corporation's internal credit review function.
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A portion of the allowance is not allocated to any particular loan type and is maintained in recognition of the inherent inability to precisely determine the loss potential in any particular loan or pool of loans. Among the factors used by management in determining the unallocated portion of the allowance are current economic conditions, trends in the Corporation's loan portfolio delinquency, losses and recoveries, level of underperforming and nonperforming loans, and concentrations of loans in any one industry.
The Corporation has not substantively changed any aspect of its overall approach in the determination of the allowance for loan losses. There have been no material changes in assumptions or estimation techniques as compared to prior years that impacted the determination of the current year allowance.
BANK PREMISES AND EQUIPMENT--Bank premises and equipment are stated at cost, less accumulated depreciation computed using the straight-line method over their estimated useful lives, which range from five to twenty-five years.
NONMARKETABLE SECURITIES--The Corporation's investments in the Federal Home Loan Bank and Federal Reserve Bank are carried at cost and included in other assets. The Corporation owned Federal Home Loan Bank and Federal Reserve Bank stock totaling $2,147,700 and $2,057,000 as of December 31, 2002 and 2001, respectively.
OTHER REAL ESTATE OWNED--Real estate assets acquired through foreclosure are recorded at the lower of the recorded loan balance or fair value. Other real estate owned at December 31, 2002 and 2001 was $141,000 and $42,000, respectively, and is included in other assets.
REVENUE RECOGNITION--Interest income on loans is based on the principal balance outstanding, with the exception of interest on certain installment loans which is computed using the sum-of-the-digits method (which approximates the interest yield method) over the lives of the loans
INCOME TAXES--Deferred income taxes represent the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for federal income tax purposes.
EARNINGS PER SHARE--Basic earnings per share is computed using the weighted average number of shares of common stock outstanding during the year. For the years ending 2002, 2001, and 2000, the Corporation had three million shares issued and outstanding, restated in prior years for the 3-for-1 stock split in 2001. There were no common stock equivalents outstanding during the respective periods.
STATEMENTS OF CASH FLOWS--Cash and cash equivalents is defined to include cash on-hand, noninterest and interest-bearing amounts due from other banks and federal funds sold. Generally, federal funds are sold for one day periods. The Corporation reports cash flow on a net basis for customer loan transactions and deposit transactions.
NEW ACCOUNTING PRONOUNCEMENTS--ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS - In August 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which was required to be adopted January 1, 2002. SFAS No. 144 supercedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of, and APB Opinion No. 30, Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, and combines the two accounting models into a single model based on the framework established in SFAS No. 121. Effects
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of adopting SFAS No. 144 on January 1, 2002 have had no material impact on the Corporation's earnings and financial position.
RESCISSION OF FASB STATEMENTS NO. 4, 44, AND 64, AMENDMENT OF FASB STATEMENT NO. 13, AND TECHNICAL CORRECTIONS - In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections, which is required to be adopted January 1, 2003. SFAS No. 145 rescinds SFAS No. 4, Reporting Gains and Losses from Extinguishment of Debt, and an amendment of that Statement, SFAS No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. Under SFAS No. 4, all gains and losses from extinguishment of debt were required to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. This Statement eliminates Statement 4 and, thus, the exception to applying APB Opinion No. 30 to all gains and losses related to extinguishments of debt (other than extinguishments of debt to satisfy sinking-fund requirements--the exception to application of Statement 4 noted in SFAS No. 64). As a result, gains and losses from extinguishment of debt should be classified as extraordinary items only if they meet the criteria in APB Opinion No. 30. Applying the provisions of Opinion 30 will distinguish transactions that are part of an entity's recurring operations from those that are unusual or infrequent or that meet the criteria for classification as an extraordinary item. SFAS No. 145 also rescinds SFAS No. 44, Accounting for Intangible Assets of Motor Carriers. SFAS No. 145 amends SFAS No. 13, Accounting for Leases, to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. SFAS No. 145 also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. Management has determined that the adoption of this Statement will have no material effect on the Corporation's financial position, results of operations, or cash flows.
ACCOUNTING FOR COSTS ASSOCIATED WITH EXIT OR DISPOSAL ACTIVITIES - In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which is required to be adopted January 1, 2003. SFAS No. 146 requires recording costs associated with exit or disposal activities at their fair values when a liability has been incurred. Under previous guidance, certain exit costs were accrued upon management's commitment to an exit plan, which is generally before an actual liability has been incurred. Management has determined that the adoption of this Statement will have no material effect on the Corporation's financial position, results of operations, or cash flows.
ACQUISITIONS OF CERTAIN FINANCIAL INSTITUTIONS - SFAS No. 147, Acquisitions of Certain Financial Institutions, was issued in October 2002. This statement clarifies that, if certain criteria are met, an acquisition of a less-than-whole financial institution (such as a branch acquisition) should be accounted for as a business combination. SFAS No. 147 states that, in such instances, the excess of the fair value of liabilities assumed over the value of tangible and identifiable intangible assets acquired represents goodwill. Prior to SFAS No. 147, such excesses were classified as an unidentifiable intangible asset subject to continuing amortization under SFAS No. 142. As a result of SFAS No. 147, entities are required to reclassify and restate both the goodwill asset and amortization expense as of the date SFAS No. 142 was adopted. In addition, SFAS No. 147 amends SFAS No. 144 to include in its scope long-term customer-relationship intangible assets of financial institutions such as depositor- and borrower-relationship intangible assets. As a result, those intangible assets are subject to the same undiscounted cash flow recoverability test and impairment loss recognition and measurement provisions that SFAS No. 144 requires for other long-lived assets that are held and used by a company. SFAS No. 147 is effective October 1, 2002 and is not expected to have a material impact on the Corporation's financial statements.
ACCOUNTING FOR STOCK-BASED COMPENSATION--TRANSITION AND DISCLOSURE - In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation--Transition and
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Disclosure. This statement amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this statement amends the disclosure requirements of SFAS No. 123 to require disclosures in both annual and interim financial statements regarding the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Corporation does not have any outstanding stock options or stock option plans at December 31, 2002 and 2001.
GUARANTOR'S ACCOUNTING FOR GUARANTEES--In December 2002, the FASB issued Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. Interpretation No. 45 requires that at the time a company issues a guarantee, the company must recognize an initial liability for the fair value, or market value, of the obligations it assumes under that guarantee. This interpretation is applicable on a prospective basis to guarantees issued or modified after December 31, 2002. While the Corporation has various guarantees included in contracts in the normal course of business, primarily in the form of indemnities, these guarantees would only result in immaterial increases in future costs, but do not represent significant commitments or contingent liabilities of the indebtedness of others.
CONSOLIDATION OF VARIABLE INTEREST ENTITIES--In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities. Interpretation No. 46 requires companies with a variable interest in a variable interest entity to apply this guidance to that entity after June 15, 2003 for existing interests and immediately for new interests. The Corporation does not have any variable interest entities. Management has determined that adoption will not have a material impact on the Corporation's financial statements.
RECLASSIFICATIONS--The Corporation has reclassified certain prior year amounts to conform to the 2002 presentation.
2. SECURITIES
The following tables provide information related to securities available for sale as of December 31, (in thousands):
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The book value and approximate fair value of securities at December 31, 2002 by contractual maturity, are shown below (in thousands). Actual maturities may differ from contractual maturities when there exists a right to call or prepay obligations.
Management reviews the securities portfolio on a quarterly basis to determine whether any securities have been impaired. As of December 31, 2002 and 2001, the securities portfolio did not include any securities with other-than-temporary impairments.
The Corporation did not sell any securities in 2002 or 2001. The Corporation recognized gross gains of $2,000 and gross losses of $1,000 from the sale of securities in 2000.
At December 31, 2002 and 2001, securities with amortized cost of approximately $17,197,000 and $21,136,000, respectively, were pledged to secure public deposits and for other purposes as required or permitted by law.
3. LOANS
Loans at December 31, 2002 and 2001 were as follows (in thousands):
At December 31, 2002 and 2001, the recorded investment in loans considered to be impaired was approximately $4,031,000 and $4,133,000, of which $476,000 and $383,000 were on a nonaccrual basis, respectively. Specific reserves for credit losses allocated to these loans were $664,000 and $235,000 at December 31, 2002 and 2001, respectively. The average investment in impaired loans for 2002, 2001, and 2000 was $2,132,000, $2,625,000, and $2,094,000, respectively. Interest income recognized from cash payments on impaired loans was $11,000, $133,000, and $122,000 for 2002, 2001, and 2000, respectively.
Total loans serviced by the Bank for the benefit of others at December 31, 2002 and 2001 were approximately $6,103,000 and $3,217,000, respectively.
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4. ALLOWANCE FOR LOAN LOSSES
Activity in the allowance for loan losses was as follows (in thousands):
5. BANK PREMISES AND EQUIPMENT
Bank premises and equipment at December 31, 2002 and 2001 consisted of the following (in thousands):
Depreciation expense was $659,000, $633,000, and $486,000 for the years ended December 31, 2002, 2001, and 2000, respectively.
6. DEPOSITS
Major classifications of deposits are categorized as follows (in thousands):
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Maturities of certificates of deposit for each of the next five years are as follows (in thousands):
AMOUNT
2003 $ 94,520 2004 19,550 2005 16,451 2006 231 2007 12 -------- Total $130,764 ========
7. FHLB BORROWINGS
All stock in the Federal Home Loan Bank ("FHLB") with a carrying value of $2,027,000 and first mortgage residential loans with an unpaid principal balance of $43,837,000, which equals at least 135% of the amount borrowed, are pledged as collateral on FHLB borrowings. Maturities and interest rates at December 31, 2002 are as follows (in thousands):
INTEREST MATURITY RATE AMOUNT
April 10, 2008 5.39 % $ 1,000 September 25, 2008 4.78 % 3,000 March 15, 2010 6.26 % 3,000 September 1, 2011 5.23 % 470 January 9, 2012 4.64 % 10,000 ------- Total $17,470 =======
The interest rate on the advances maturing on April 10, 2008, September 25, 2008, and March 15, 2010 are fixed for three years. On a quarterly basis, the FHLB may convert, at its option, the fixed rate to one that varies with the three month LIBOR. This advance may be prepaid at anytime, subject to the terms of the agreement.
In addition to the FHLB borrowings, the Corporation has an outstanding standby letter of credit available with the FHLB totaling $15,000,000 at December 31, 2002 and 2001.
8. FEDERAL INCOME TAXES
Federal income taxes consisted of the following (in thousands):
2002 2001 2000
Currently payable $ 2,292 $ 1,959 $ 1,916 Deferred provision (benefit) (129) (7) 48 ------- ------- ------- Total $ 2,163 $ 1,952 $ 1,964 ======= ======= =======
A reconciliation of the Corporation's statutory income tax rate to the effective rate at December 31 follows:
2002 2001 2000
Statutory tax rate 34.0 % 34.0 % 34.0 % Decrease from tax-exempt interest (4.1)% (2.3)% (2.5)% Other, net 1.3 % (1.0)% 0.3 % ------ ------ ------ Effective tax rate 31.2 % 30.7 % 31.8 % ====== ====== ======
Deferred income taxes are provided for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases (primarily the allowance for loan losses and unrealized gains/losses on securities available for sale).
The tax effects of significant items comprising the Corporation's deferred tax assets (liabilities) at December 31, are as follows (in thousands):
2002 2001 Unrealized gains on securities available for sale $(482) $(271) Allowance for loan losses 624 574 Other, net (31) (166) ----- -----
Net deferred tax asset $ 111 $ 137 ===== =====
9. EMPLOYEE BENEFIT PLANS
The Corporation provides defined pension benefits to substantially all eligible employees. Benefits are based on years of service and earnings in the highest five consecutive calendar years preceding retirement or a monthly amount if employed less than five years. The Plan is funded in accordance with the minimum funding requirements of the Employee Retirement Income Security Act of 1974.
The details of net periodic pension cost included in personnel expense in the accompanying consolidated statements of income for the years ended December 31, 2002, 2001 and 2000 are as follows (in thousands):
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2002 2001 2000 Economic assumptions: Discount rate 6.50 % 7.50 % 7.50 % Return on assets 7.50 % 7.50 % 7.50 % Salary increases 4.00 % 4.00 % 4.00 %
Service cost $ 111 $ 107 $ 96 Interest cost on projected benefit obligation 100 105 93 Expected return on plan assets (73) (98) (95) Net amortization and deferral 7 (4) (4) ----- ----- ----- Net periodic pension cost $ 145 $ 110 $ 90 ===== ===== =====
A summary of the Plan's funded status at December 31 is as follows (in thousands):
2002 2001
Projected benefit obligation at beginning of year $ 1,306 $ 1,429 Service cost 111 107 Interest cost 100 105 Actuarial (gain)/loss 367 (24) Benefits paid during year (1) (311) ------- ------- Projected benefit obligation at end of year 1,883 1,306 ------- -------
Fair value of plan assets at beginning of year 1,004 1,323 Actual return on assets (185) (145) Employer contributions 168 137 Benefits paid (1) (311) ------- ------- Fair value of plan assets at end of year 986 1,004 ------- ------- Funded status - underfunded 897 302 Unrecognized transition obligation 15 17 Unrecognized prior service cost 16 17 Minimum pension liability 162 Unrecognized net gain (loss) (908) (292) ------- ------- Accrued pension cost $ 182 $ 44 ======= =======
The above accrued pension cost is included in "Accrued interest, taxes and other liabilities" in the accompanying consolidated balance sheets. Unrecognized prior service cost and net gain (loss) is amortized over the average future service lives of plan participants (18 years).
For the Corporation's defined benefit plan, with an accumulated benefit obligation exceeding assets, the total projected benefit obligation, accumulated benefit obligation and fair value of plan assets were approximately $1,883,000, $1,169,000, and $986,000, respectively as of December 31, 2002, and $1,306,000, $757,000, and $1,004,000, respectively as of December 31, 2001. At
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December 31, 2002, an additional minimum pension liability was recorded as a reduction to shareholders' equity in an amount of $108,000, net of $58,000 of tax benefit.
The Corporation has entered into supplemental deferred compensation agreements with certain executives of the Corporation under an Executive Investment Plan. Total expense related to this plan was approximately $25,000, $16,000, and $37,000 in 2002, 2001, and 2000, respectively. As of December 31, 2002 and 2001, the amounts payable under this plan were approximately $188,000 and $179,000, respectively.
The Corporation has a defined contribution 401(k) plan covering substantially all eligible employees. The Corporation made contributions of $36,000, $32,000 and $30,000 for 2002, 2001 and 2000, respectively.
10. COMMITMENTS AND CONTINGENT LIABILITIES
In the normal course of business, the Corporation has outstanding various financial instruments with off-balance sheet risk, such as commitments to extend credit and commercial and standby letters of credit. At December 31, 2002 and 2001, the Corporation had approximately $21,864,000 and $17,400,000, respectively, of commitments to extend credit. Commercial and standby letters of credit with customers were $80,000 and $159,000 at December 31, 2002 and 2001, respectively.
Commitments to extend credit are agreements to lend. Commercial and standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. The Corporation's exposure to credit loss in the event of nonperformance by the other party is represented by the contractual amount. No material losses or liquidity demands are anticipated as a result of these commitments.
The Corporation evaluates each customer's creditworthiness on a case-by-case basis in accordance with the Corporation's credit policies. The amount of collateral obtained, if deemed necessary by the Corporation upon extension of credit, is based upon management's credit evaluation of the customer. Collateral held varies, but may include business assets of commercial borrowers as well as personal property and real estate of individual borrowers or guarantors.
The Corporation grants agribusiness, commercial, residential and installment loans to customers in the surrounding areas of its offices in Hillsboro, Greenfield, London, and Washington Court House, Ohio. Although the Bank has a diversified loan portfolio, the borrower's ability to honor their commitments is dependent upon the regional economy. As of December 31, 2002 and 2001, the Corporation had outstanding approximately $41,106,000 and $34,105,000, respectively, in loans for agriculture purposes, or secured by agricultural properties.
11. RELATED PARTY TRANSACTIONS
At December 31, 2002 and 2001, certain directors, executive officers and/or companies in which these individuals had a ten percent or more beneficial ownership were indebted to the Corporation in the aggregate amounts of approximately $1,282,000 and $1,540,000, respectively. A rollforward of the related party activity follows (in thousands):
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] 2002 2001
Balance, January 1, $ 1,540 $ 1,642 Originations 222 1,044 Payments (480) (1,146) ------- ------- Balance, December 31, $ 1,282 $ 1,540 ======= =======
12. FAIR VALUES OF FINANCIAL INSTRUMENTS
The estimated fair value of financial instruments is as follows (in thousands):
The estimated fair value amounts are determined by the Corporation, using available market information and appropriate valuation methodologies. However, considerable judgment is required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Corporation could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.
CASH AND CASH EQUIVALENTS, FEDERAL RESERVE BANK AND FHLB STOCK--The carrying amounts of these items are a reasonable estimate of their fair value.
SECURITIES AVAILABLE FOR SALE--Fair values are based on quoted market prices and dealer quotes.
LOANS RECEIVABLE--The fair value of loans receivable is estimated by discounting future cash flows at market rates for loans of similar terms and maturities, taking into consideration repricing characteristics and prepayment risk.
DEPOSITS--The fair value of demand deposits and savings deposits is the amount payable on demand at the reporting date. The fair value of fixed-rate certificates of deposits is estimated by discounting the future cash flows using rates offered on the reporting date for deposits of similar remaining maturities.
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FHLB BORROWINGS-- The fair value of FHLB borrowings is estimated by discounting the future cash flows using rates offered on the reporting date for borrowings of similar remaining maturities.
REPURCHASE AGREEMENTS--The carrying amounts of these items are a reasonable estimate of their fair value.
COMMITMENTS--The estimated fair value of commitments to originate fixed-rate loans is determined based on the fees currently charged to enter into similar agreements and the difference between current levels of interest rates and the committed rates. Based on the analysis, the estimated fair value of such commitments is a reasonable estimate of the loan commitments at par.
The fair value estimates presented herein are based on information available to management as of December 31, 2002 and 2001. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since that date, and therefore, current estimates of fair value may differ significantly from the amounts presented herein.
13. REGULATORY MATTERS
The Corporation is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Corporations' financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation must meet specific capital guidelines that involve quantitative measures of the Corporation's assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Corporation's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Corporation to maintain minimum amounts and ratios (set forth in the table below, in thousands) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 2002, that the Corporation meets all capital adequacy requirements to which it is subject.
As of December 31, 2002, the most recent notification from the Office of the Comptroller of the Currency categorized the Corporation as well capitalized under the regulatory framework for prompt corrective action. To be categorized as adequately capitalized the Corporation must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the institutions' categories.
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DIVIDEND RESTRICTIONS--National banking laws restrict the maximum amount of dividends that a bank may pay in any calendar year. Dividends are limited to the Bank's retained profits (as defined by the Comptroller of the Currency) for that year and the two preceding years. The amount of retained earnings available for cash dividends payable by the Bank to the Corporation was approximately $8,267,000 and $7,765,000 as of December 31, 2002 and 2001, respectively.
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14. PARENT COMPANY FINANCIAL STATEMENTS
Condensed Balance Sheets (in thousands):
2002 2001 ASSETS
Due from banks $ 288 $ 949 Securities available for sale 3,996 4,516 Loans, net 2,166 652 Subordinated note receivable from subsidiary 8,000 Other assets 53 55 Investment in subsidiary 19,449 24,398 ------- ------- TOTAL $33,952 $30,570 ======= =======
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES: Other liabilities $ 444 $ 338 ------- ------- Total liabilities 444 338 ------- ------- SHAREHOLDERS' EQUITY 33,508 30,232 ------- ------- TOTAL $33,952 $30,570 ======= =======
Condensed Statements of Income for the year ended December 31 (in thousands):
2002 2001 2000
INCOME: Dividends from subsidiary bank $1,800 $1,560 $1,350 Other income 265 314 309 ------ ------ ------ Total income 2,065 1,874 1,659 ------ ------ ------
EXPENSES: Other expenses 19 28 6 ------ ------ ------
INCOME BEFORE INCOME TAXES 2,046 1,846 1,653 ------ ------ ------
Income tax expense 78 89 91 ------ ------ ------
Income before equity in undistributed income of bank subsidiary 1,968 1,757 1,562 ------ ------ ------
Equity in undistributed income of bank subsidiary 2,804 2,648 2,643 ------ ------ ------
NET INCOME $4,772 $4,405 $4,205 ====== ====== ======
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Condensed Statements of Cash Flows for the year ended December 31 (in thousands):
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10-K EXHIBIT INDEX
EXHIBIT NO. DESCRIPTION
EX-99.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002