ITEM 1. BUSINESS - -----------------
Forward-Looking Information
This Annual Report on Form 10-K includes forward-looking information which is subject to the "safe harbor" created by Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements (which involve the Company's plans, beliefs and goals, refer to estimates or use similar terms) involve certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Such risks and uncertainties include, but are not limited to, the following factors: competitive pressure in the banking industry; changes in the interest rate environment; the declining health of the economy, either nationally or regionally; the deterioration of credit quality, which could cause an increase in the provision for possible loan and lease losses; changes in the regulatory environment; changes in business conditions, particularly in Santa Clara County real estate and high tech industries; certain operational risks involving data processing systems or fraud; volatility of rate sensitive deposits; asset/liability matching risks and liquidity risks; risks associated with the Year 2000 which could cause disruptions in the Company's operations; and changes in the securities markets. The Company undertakes no obligation to revise or publicly release the results of any revision to these forward-looking statements. See also the section included herein entitled "Year 2000 Problem" and "Certain Additional Business Risks" and other risk factors discussed elsewhere in this Report.
General
SJNB Financial Corp. (the "Company") is a bank holding company registered under the Bank Holding Company Act of 1956, as amended (the "BHCA"). The Company was incorporated under the laws of the State of California on April 18, 1983. Its principal office is located at One North Market Street, San Jose, California 95113, and its telephone number is (408) 947-7562.
The Company owns 100% of the issued and outstanding common shares of San Jose National Bank (referred to herein as "SJNB" or "the Bank"). The Bank was incorporated on November 23, 1981 and commenced business in San Jose, California, on June 10, 1982. The Company acquired Business Bancorp ("BB") and its wholly-owned subsidiary, California Business Bank ("CBB"), on October 1, 1994. Operations of the Company and BB were consolidated into a single location at One North Market Street, San Jose, California 95113. SJNB engages in the general commercial banking business with special emphasis on the banking needs of the business and professional communities in San Jose and the surrounding areas.
On January 2, 1996, the Bank acquired Astra Financial Corp. for approximately $760,000. Its business was merged into the Bank's Financial Services Division, by adding approximately $1.9 million of factored receivables. Astra Financial Corp. was liquidated on January 5, 1996, and its assets were transferred to the Bank. The Bank's Financial Services Division is located at 95 South Market Street, San Jose, California 95113.
On May 22, 1998, SJNB acquired all of the stock of a private company, Epic Funding Corporation ("Epic"), pursuant to a definitive agreement dated April 13, 1998. In connection with the acquisition, which was structured as a tax-free reorganization, SJNB issued 12,223 shares of its common stock and paid $110,000 to Epic's sole shareholder in exchange for all of Epic's outstanding stock. The total purchase price for Epic was $611,000, while Epic's net equity was $28,000. Goodwill amounted to $759,000, including certain expenses of the transaction. Epic provides direct and vendor lease programs and accounts receivable financing to manufacturers and equipment users throughout California and across parts of the United States. Epic is now a wholly-owned subsidiary of the Bank. Epic's office is located in Danville, California, together with a small de novo branch of the Bank at the same facility which opened July 1, 1998.
SJNB accepts checking and savings deposits, offers money market deposit accounts and certificates of deposit, makes secured and unsecured commercial and other installment and term loans and offers other customary banking services. SJNB offers banking services generally, but it places primary emphasis on lending for real estate purposes and specialized lending to businesses and professionals. Loans for real estate purposes include term financing for commercial facilities and real estate construction loans mainly for residential and commercial properties. Loans to businesses and professionals include accounts receivable financing, equipment financing, commercial loans, SBA loans and letters of credit. The Company provides commercial banking, factoring and leasing services principally through the Bank, the Bank's Financial Services Division and Epic. Although the Bank has neither a trust nor an international banking department, it has arranged to provide these services through its correspondent banks. As a bank holding company, the Company is authorized to engage in the activities permitted under the BHCA and regulations thereunder.
Year 2000 Problem - -----------------
The "Year 2000 issue" relates to the fact that many computer programs and other technology utilizing microprocessors use only two digits to represent a year, such as "98" to represent "1998." In the year 2000 ("Y2K"), such programs/processors could incorrectly treat the year 2000 as the year 1900. The Company's business is dependent on technology and data processing. As a result, it has created a Year 2000 team whose members are familiar with the Company's business and operations. This issue has grown in importance as the use of computers and microprocessors has become more pervasive throughout the economy, and interdependencies between systems has multiplied. The issue must be recognized as a business problem, rather than simply a computer problem, because of the way its effects could ripple through the economy. The Company could be affected either directly or indirectly by the Year 2000 issue. This could happen if any of its critical computer systems or equipment containing embedded logic fail, if the local infrastructure (electric power, communications, or water system) fails, if its significant vendors are adversely impacted, or if its borrowers or depositors are significantly impacted by their internal systems or those of their customers or suppliers.
The Company does not rely on its own data processing software for its mission-critical needs. Rather, it uses outside vendors to license software and/or data processing services for its critical applications such as data and item processing and customer statements. The Company is also dependent on an IBM AS/400 computer and OS/400 operating system, as well as personal computers connected on a local area network. The foregoing systems are classified by the Company as mission-critical information technology ("IT") systems.
The Company's business also involves non-IT products and services, some of which have embedded technology which might not be Year 2000 compliant. Some non-IT products and services involve various infrastructure issues such as power, communications and water, as well as elevators, ventilation and air conditioning equipment. The Company classifies power and communications as non-IT mission-critical systems.
The Company's application software, data processing vendors, computer operating systems, local area network and the power and communication infrastructure provide critical support to substantially all of its business and operations. Failure to successfully complete renovation, validation and implementation of its mission-critical IT systems could have a material adverse effect on the operations and financial performance of the Company. Moreover, Year 2000 problems experienced by significant vendors or customers of the Company or power or communications systems could negatively impact the business and operations of the Company even if its own critical IT systems are capable of functioning satisfactorily. Due to the numerous issues and problems which might arise and the lack of guarantees concerning Year 2000 readiness from non-IT service providers such as power and communication systems vendors, the Company cannot quantify the potential cost of problems if the Company's renovation and implementation efforts or the efforts of significant vendors or customers are not successful.
State of Readiness
The Company has conducted a comprehensive review of its IT systems to identify systems that present Year 2000 issues. The Company has developed a plan which it believes should satisfactorily resolve Year 2000 problems related to its mission-critical IT systems. The Company's Y2K team has also utilized external resources provided by its outside vendors and a consultant hired to assist the Company. Management initially anticipated that renovation and validation (testing) of its critical IT systems would be completed by December 31, 1998.
While this process has taken somewhat longer than anticipated, initial testing and validation of mission-critical systems was substantially completed as of February 26, 1999.
The Company converted to a new core processing system (which handles accounting for loans, deposit accounts and general ledger) in November 1997. The conversion to this system was not based on Year 2000 issues; however, the vendor of this system represented to the Company that the system was Y2K compliant. Vendors of the Company's other critical IT systems have also informed the Company that their products/systems are Y2K compliant. Based on information provided by outside service providers and its testing process the Company believes that its mission-critical IT systems are substantially Y2K compliant. The Company intends to work with its vendors to resolve any other issues discovered during the testing process. The Company plans to complete secondary testing, where it is deemed appropriate, by June 30, 1999.
The Company ran tests on its core processing system at a remote disaster recovery site during October 1998 with technical assistance from the vendor and an outside consultant. Actual data from a prior period was used to conduct future date tests. The Company is also monitoring the Y2K readiness of its outside item processing and operating system vendors.
By February 28, 1999, the Company had also tested 95% of its critical network applications and 83% of its non-critical network applications. The Company's target for completion of non-critical IT application testing is March 31, 1999. The Company cannot test for Y2K readiness of its power and telecommunication vendors, although the Company is monitoring their readiness. Additionally, at the date of this Report management of the Company had not identified any serious problems with any of its mission-critical systems.
Costs
The Company is expensing all period costs associated with the Year 2000 problem. Through December 31, 1998, the amount of such expenses had been approximately $120,000. Management estimates that the Company will incur approximately an additional $85,000 in Year 2000 related expenses in fiscal 1999. There can be no assurance that these expenses will not increase as further testing and assessment of vendor and customer readiness and contingency planning for the Year 2000 continues. The above cost estimates include costs for consultants, running tests and technical assistance from vendors, as well as development of contingency plans and costs of communicating with customers concerning Year 2000 issues. These costs exclude the cost of the Company's internal staff time and systems or products which were replaced for other business reasons.
Risks
It is inherently difficult to predict the future outcome of most events. The Y2K issue is no exception due to the complexity of technology, the numerous variables and the inability to assess the impact of the Year 2000 problem on the local, national and international economy. Management has identified a long-range, most reasonably likely, worst-case scenario. This scenario suggests that the Y2K problem might negatively impact some significant customers and non-IT vendors/products through the failure of the customer and /or vendor to be prepared or the impact on them of the failure of their own vendors and customers. Management believes that this scenario could occur in conjunction with an economic recession arising from the Y2K problem. The Bank's asset quality and earnings could be adversely impacted in that event. It is not possible to predict the effect of this Y2K scenario on the economic viability of the Bank's customers and the related adverse impact it may have on Company's the financial position and results of operations, including the level of the Bank's provision for possible loan losses in future periods. Further, there can be no assurance that other possible adverse scenarios will not occur.
The Company presently believes that, based upon its Year 2000 testing program and assuming representations of Year 2000 readiness from significant vendors and customers are accurate, the Year 2000 issue should not pose significant operational risks for the Company's IT systems. However, other significant risks relating to the Year 2000 problem are that of the unknown impact of this problem on the operations of the Bank's customers and vendors, the impact of infrastructure failures such as power, communications and water on the Company's IT systems, the economy and future actions which banking or securities regulators may take.
The Company is making efforts to ensure that its customer base is aware of the Year 2000 problem. In addition to seminars for and mailings to its customer base, the Bank has amended its credit policy and credit authorization documentation to include consideration regarding the Year 2000 problem.
Significant customer relationships have been identified, and such customers are being contacted by the Bank's account officers to determine whether they are aware of Year 2000 risks and whether they are taking preparatory actions. An initial assessment of these customers was substantially completed in late 1998. The Company is taking follow-up action in 1999 based on the results of this assessment.
The Company has also attempted to contact major vendors and suppliers of non-software products and services (including those where products utilize embedded technology) to determine the Year 2000 readiness of such organizations and/or the products and services which the Company purchases from such organizations. The Company is monitoring reports provided by such vendors regarding their preparations for Year 2000. This is an ongoing process, and the Company intends to continue to monitor information provided by such vendors through the century date change.
Federal banking regulators have responsibility for supervision and examination of banks to determine whether they have an effective plan for identifying, renovating, testing and implementing solutions for Year 2000 processing and coordinating Year 2000 processing capabilities with their customers, vendors and payment system partners. Examiners are also required to assess the soundness of an institution's internal controls and to identify whether further corrective action may be necessary to ensure an appropriate level of attention to Year 2000 processing capabilities. Management believes it is currently in compliance with the federal bank regulatory guidelines and timetables.
Contingency Plans
The Company had developed contingency plans for its mission-critical software systems, in the event they do not successfully pass the Company's Year 2000 testing. Generally this has involved the identification of an alternate vendor or other actions the Company could take, as well as the establishment of a trigger date to implement the contingency plan. The Company is currently working to develop further contingency plans to address potential business disruptions which might result from Year 2000 issues. This will involve, among other things, procedures to be followed in the event of a power failure, communications failure, or system failure which occurs despite the testing which has been performed. Management intends to have an independent party review the feasibility of its business resumption plan. This process is not expected to be completed until on or about June 30, 1999.
Service Area - ------------
The principal service area of SJNB includes the County of Santa Clara and its contiguous counties, including San Mateo, Alameda, Contra Costa, Santa Cruz and San Benito.
Employees - ---------
At December 31, 1998, SJNB had 85 full-time officers and employees and 23 part-time employees for a total of 99 employees on a full-time equivalent basis. Certain of the Bank's officers are also officers of the Company. None of the Bank's employees are represented by a union. Management believes that employee relations are good.
Supervision and Regulation - --------------------------
The Effect of Government Policy on Banking
The earnings and growth of the Company are affected not only by local market area factors and general economic conditions, but also by government monetary and fiscal policies. For example, the Board of Governors of the Federal Reserve System ("FRB") influences the supply of money through its open market operations in U.S. Government securities and adjustments to the discount rates applicable to borrowings by depository institutions and others. Such actions influence the growth of loans, investments and deposits and also affect interest rates charged on loans and paid on deposits. The nature and impact of future changes in such policies on the business and earnings of the Company cannot be predicted. Additionally, state and federal tax policies can impact banking organizations.
As a consequence of the extensive regulation of commercial banking activities in the United States, the business of the Company is particularly susceptible to being affected by the enactment of federal and state legislation which may have the effect of increasing or decreasing the cost of doing business, modifying permissible activities or enhancing the competitive position of other financial institutions. Any change in applicable laws or regulations may have a material adverse effect on the business and prospects of the Company.
Regulation and Supervision of Bank Holding Companies
The Company is a bank holding company subject to the Bank Holding Company Act of 1956, as amended ("BHCA"). The Company reports to, registers with, and may be examined by, the FRB. The FRB also has the authority to examine the Company's subsidiaries. The costs of any examination by the FRB are payable by the Company.
The Company is a bank holding company within the meaning of Section 3700 of the California Financial Code. As such, the Company and the Bank are subject to examination by, and may be required to file reports with, the California Commissioner of Financial Institutions (the "Commissioner").
The FRB has significant supervisory and regulatory authority over the Company and its affiliates. The FRB requires the Company to maintain certain levels of capital. See "Capital Standards." The FRB also has the authority to take enforcement action against any bank holding company that commits any unsafe or unsound practice, or violates certain laws, regulations or conditions imposed in writing by the FRB. See "Prompt Corrective Action and Other Enforcement Mechanisms."
Under the BHCA, a company generally must obtain the prior approval of the FRB before it exercises a controlling influence over a bank, or acquires directly or indirectly, more than 5% of the voting shares or substantially all of the assets of any bank or bank holding company. Thus, the Company is required to obtain the prior approval of the FRB before it acquires, merges or consolidates with any bank or bank holding company; any company seeking to acquire, merge or consolidate with the Company also would be required to obtain the prior approval of the FRB.
The Company is generally prohibited under the BHCA from acquiring ownership or control of more than 5% of the voting shares of any company that is not a bank or bank holding company and from engaging directly or indirectly in activities other than banking, managing banks, or providing services to affiliates of the holding company. However, a bank holding company, with the approval of the FRB, may engage, or acquire the voting shares of companies engaged, in activities that the FRB has determined to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. A bank holding company must demonstrate that the benefits to the public of the proposed activity will outweigh the possible adverse effects associated with such activity.
A bank holding company may acquire banks in states other than its home state without regard to the permissibility of such acquisitions under state law, but subject to any state requirement that the bank has been organized and operating for a minimum period of time, not to exceed five years, and the requirement that the bank holding company, prior to or following the proposed acquisition, controls no more than 10% of the total amount of deposits of insured depository institutions in the United States and no more than 30% of such deposits in that state (or such lesser or greater amount set by state law). Banks may also merge across states lines, therefore creating interstate branches. Furthermore, a bank is now able to open new branches in a state in which it does not already have banking operations, if the laws of such state permit such de novo branching.
Under California law, (a) out-of-state banks that wish to establish a California branch office to conduct core banking business must first acquire an existing five year old California bank or industrial loan company by merger or purchase; (b) California state-chartered banks are empowered to conduct various authorized branch-like activities on an agency basis through affiliated and unaffiliated insured depository institutions in California and other states and (c) the Commissioner is authorized to approve an interstate acquisition or merger which would result in a deposit concentration exceeding 30% if the Commissioner finds that the transaction is consistent with public convenience and advantage. However, a state bank chartered in a state other than California may not enter California by purchasing a California branch office of a California bank or industrial loan company without purchasing the entire entity or by establishing a de novo California bank.
The FRB generally prohibits a bank holding company from declaring or paying a cash dividend which would impose undue pressure on the capital of subsidiary banks or would be funded only through borrowing or other arrangements that might adversely affect a bank holding company's financial position. The FRB's policy is that a bank holding company should not continue its existing rate of cash dividends on its common stock unless its net income is sufficient to fully fund each dividend and its prospective rate of earnings retention appears consistent with its capital needs, asset quality and overall financial condition. See the section entitled "Restrictions on Dividends and Other Distributions" for additional restrictions on the ability on the Company and the Bank to pay dividends.
Transactions between the Company and the Bank are subject to a number of other restrictions. FRB policies forbid the payment by bank subsidiaries of management fees which are unreasonable in amount or exceed the fair market value of the services rendered (or, if no market exists, actual costs plus a reasonable profit). Subject to certain limitations, depository institution subsidiaries of bank holding companies may extend credit to, invest in the securities of, purchase assets from, or issue a guarantee, acceptance, or letter of credit on behalf of, an affiliate, provided that the aggregate of such transactions with affiliates may not exceed 10% of the capital stock and surplus of the institution, and the aggregate of such transactions with all affiliates may not exceed 20% of the capital stock and surplus of such institution. The Company may only borrow from depository institution subsidiaries if the loan is secured by marketable obligations with a value of a designated amount in excess of the loan. Further, the Company may not sell a low-quality asset to a depository institution subsidiary.
Comprehensive amendments to Regulation Y became effective in 1997, and are intended to improve the competitiveness of bank holding companies by, among other things: (i) expanding the list of permissible nonbanking activities in which well-run bank holding companies may engage without prior FRB approval, (ii) streamlining the procedures for well-run bank holding companies to obtain approval to engage in other nonbanking activities and (iii) eliminating most of the anti-tying restrictions imposed upon bank holding companies and their nonbank subsidiaries. Amended Regulation Y also provides for a streamlined and expedited review process for bank acquisition proposals submitted by well-run bank holding companies and eliminates certain duplicative reporting requirements when there has been a further change in bank control or in bank directors or officers after an earlier approved change. These changes to Regulation Y are subject to numerous qualifications, limitations and restrictions. In order for a bank holding company to qualify as "well-run," both it and the insured depository institutions that it controls must meet the "well-capitalized" and "well-managed" criteria set forth in Regulation Y.
To qualify as "well-capitalized," the bank holding company must, on a consolidated basis: (i) maintain a total risk-based capital ratio of 10% or greater; (ii) maintain a Tier 1 risk-based capital ratio of 6% or greater; and (iii) not be subject to any order by the FRB to meet a specified capital level. Its lead insured depository institution must be well-capitalized as that term is defined in the capital adequacy regulations of the applicable bank regulator, 80% of the total risk-weighted assets held by its insured depository institutions must be held by institutions that are well-capitalized, and none of its insured depository institutions may be undercapitalized.
To qualify as "well-managed": (i) each of the bank holding company, its lead depository institution and its depository institutions holding 80% of the total risk-weighted assets of all its depository institutions at their most recent examination or review must have received a composite rating, rating for management and rating for compliance which were at least satisfactory; (ii) none of the bank holding company's depository institutions may have received one of the two lowest composite ratings; and (iii) neither the bank holding company nor any of its depository institutions during the previous 12 months may have been subject to a formal enforcement order or action.
Bank Regulation and Supervision
As a national bank, the Bank is regulated, supervised and regularly examined by the Office of the Comptroller of the Currency ("OCC"). Deposit accounts at the Bank are insured by Bank Insurance Fund ("BIF"), as administered by the Federal Deposit Insurance Corporation ("FDIC"), to the maximum amount permitted by law. The Bank is also subject to applicable provisions of California law, insofar as such provisions are not in conflict with or preempted by federal banking law. The Bank is a member of the Federal Reserve System, and is also subject to certain regulations of the FRB dealing primarily with check clearing activities, establishment of banking reserves, Truth-in-Lending (Regulation Z), Truth-in-Savings (Regulation DD), and Equal Credit Opportunity (Regulation B).
The OCC may approve, on a case-by-case basis, the entry of bank operating subsidiaries into a business incidental to banking, including activities in which the parent bank is not permitted to engage. A national bank is permitted
to engage in activities approved for a bank holding company through a bank operating subsidiary, such as acting as an investment or financial advisor, leasing personal property and providing financial advice to customers. In general, these activities are permitted only for well-capitalized or adequately capitalized national banks.
Capital Standards
The federal banking agencies have risk-based capital adequacy guidelines intended to provide a measure of capital adequacy that reflects the degree of risk associated with a banking organization's operations for both transactions reported on the balance sheet as assets and transactions, such as letters of credit and recourse arrangements, which are recorded as off balance sheet items. Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as certain U.S. government securities, to 100% for assets with relatively higher credit risk, such as certain loans.
In determining the capital level the Bank is required to maintain, the federal banking agencies do not, in all respects, follow generally accepted accounting principles ("GAAP") and has special rules which have the effect of reducing the amount of capital it will recognize for purposes of determining the capital adequacy of the Bank.
A banking organization's risk-based capital ratios are obtained by dividing its qualifying capital by its total risk-adjusted assets and off balance sheet items. The regulators measure risk-adjusted assets and off balance sheet items against both total qualifying capital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) and Tier 1 capital. Tier 1 capital consists of common stock, retained earnings, noncumulative perpetual preferred stock, other types of qualifying preferred stock and minority interests in certain subsidiaries, less most other intangible assets and other adjustments. Net unrealized losses on available-for-sale equity securities with readily determinable fair value must be deducted in determining Tier 1 capital. For Tier 1 capital purposes, deferred tax assets that can only be realized if an institution earns sufficient taxable income in the future are limited to the amount that the institution is expected to realize within one year, or ten percent of Tier 1 capital, whichever is less. Tier 2 capital may consist of a limited amount of the allowance for possible loan and lease losses, term preferred stock and other types of preferred stock not qualifying as Tier 1 capital, term subordinated debt and certain other instruments with some characteristics of equity. The inclusion of elements of Tier 2 capital are subject to certain other requirements and limitations of the federal banking agencies. The federal banking agencies require a minimum ratio of qualifying total capital to risk-adjusted assets and off balance sheet items of 8%, and a minimum ratio of Tier 1 capital to adjusted average risk-adjusted assets and off balance sheet items of 4%.
On October 1, 1998, the FDIC adopted two rules governing minimum capital levels that FDIC-supervised banks must maintain against the risks to which they are exposed. The first rule makes risk-based capital standards consistent for two types of credit enhancements (i.e., recourse arrangements and direct credit substitutes) and requires different amounts of capital for different risk positions in asset securitization transactions. The second rule permits limited amounts of unrealized gains on debt and equity securities to be recognized for risk-based capital purposes as of September 1, 1998. The FDIC rules also provide that a qualifying institution that sells small business loans and leases with recourse must hold capital only against the amount of recourse retained. In general, a qualifying institution is one that is well-capitalized under the FDIC's prompt corrective action rules. The amount of recourse that can receive the preferential capital treatment cannot exceed 15% of the institution's total risk-based capital.
In addition to the risked-based guidelines, the federal banking agencies require banking organizations to maintain a minimum amount of Tier 1 capital to adjusted average total assets, referred to as the leverage capital ratio. For a banking organization rated in the highest of the five categories used to rate banking organizations, the minimum leverage ratio of Tier 1 capital to total assets must be 3%. It is improbable, however, that an institution with a 3% leverage ratio would receive the highest rating since a strong capital position is a significant part of the regulators' rating. For all banking organizations not rated in the highest category, the minimum leverage ratio must be at least 100 to 200 basis points above the 3% minimum. Thus, the effective minimum leverage ratio, for all practical purposes, must be at least 4% or 5%. In addition to these uniform risk-based capital guidelines and leverage ratios that apply across the industry, the regulators have the discretion to set individual minimum capital requirements for specific institutions at rates significantly above the minimum guidelines and ratios.
As of December 31, 1998, the Bank's capital ratios exceeded applicable regulatory requirements. The following tables present the capital ratios for the Company and the Bank, compared to the standards for well-capitalized depository
institutions, as of December 31, 1998 (amounts in thousands except percentage amounts).
The federal banking agencies must take into consideration concentrations of credit risk and risks from non-traditional activities, as well as an institution's ability to manage those risks, when determining the adequacy of an institution's capital. This evaluation will be made as a part of the institution's regular safety and soundness examination. The federal banking agencies must also consider interest rate risk (when the interest rate sensitivity of an institution's assets does not match the sensitivity of its liabilities or its off-balance-sheet position) in evaluation of a bank's capital adequacy.
Prompt Corrective Action and Other Enforcement Mechanisms
The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") requires each federal banking agency to take prompt corrective action to resolve the problems of insured depository institutions, including but not limited to those that fall below one or more prescribed minimum capital ratios. The law required each federal banking agency to promulgate regulations defining the following five categories in which an insured depository institution will be placed, based on the level of its capital ratios: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized.
Under the prompt corrective action provisions of FDICIA, an insured depository institution generally will be classified in the following categories based on the capital measures indicated below:
"Well capitalized" "Adequately capitalized" ------------------ ------------------------ Total risk-based capital of 10%; Total risk-based capital of 8%; Tier 1 risk-based capital of 6%; and Tier 1 risk-based capital of 4%; Leverage ratio of 5%. and Leverage ratio of 4%.
"Undercapitalized" "Significantly undercapitalized" ------------------ -------------------------------- Total risk-based capital less than 8%; Total risk-based capital less than Tier 1 risk-based capital less than 4%; 6%; Tier 1 risk-based capital less or Leverage ratio less than 4%. than 3%; or Leverage ratio less than 3%.
"Critically undercapitalized" ----------------------------- Tangible equity to total assets less than 2%.
An institution that, based upon its capital levels, is classified as "well capitalized," "adequately capitalized" or "undercapitalized" may be treated as though it were in the next lower capital category if the appropriate federal banking agency, after notice and opportunity for hearing, determines that an unsafe or unsound condition or an unsafe or unsound practice warrants such treatment. At each successive lower capital category, an insured depository institution is subject to more restrictions.
In addition to measures taken under the prompt corrective action provisions, commercial banking organizations may be subject to potential enforcement actions by the federal banking agencies for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency.
Enforcement actions may include the imposition of a conservator or receiver, the issuance of a cease-and-desist order that can be judicially enforced, the termination of insurance of deposits (in the case of a depository institution), the imposition of civil money penalties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the issuance of removal and prohibition orders against institution-affiliated parties and the enforcement of such actions through injunctions or restraining orders based upon a judicial determination that the agency would be harmed if such equitable relief was not granted. Additionally, a holding company's inability to serve as a source of strength to its subsidiary banking organizations could serve as an additional basis for a regulatory action against the holding company.
Safety and Soundness Standards
FDICIA also implemented certain specific restrictions on transactions and required federal banking regulators to adopt overall safety and soundness standards for depository institutions related to internal control, loan underwriting and documentation and asset growth. Among other things, FDICIA limits the interest rates paid on deposits by undercapitalized institutions, restricts the use of brokered deposits, limits the aggregate extensions of credit by a depository institution to an executive officer, director, principal shareholder or related interest, and reduces deposit insurance coverage for deposits offered by undercapitalized institutions for deposits by certain employee benefits accounts.
The federal banking agencies may require an institution to submit to an acceptable compliance plan as well as the flexibility to pursue other more appropriate or effective courses of action given the specific circumstances and severity of an institution's noncompliance with one or more standards.
Restrictions on Dividends and Other Distributions
The power of the board of directors of an insured depository institution to declare a cash dividend or other distribution with respect to capital is subject to statutory and regulatory restrictions which limit the amount available for such distribution depending upon the earnings, financial condition and cash needs of the institution, as well as general business conditions. FDICIA prohibits insured depository institutions from paying management fees to any controlling persons or, with certain limited exceptions, making capital distributions, including dividends, if, after such transaction, the institution would be undercapitalized.
The Federal Banking agencies also have authority to prohibit a depository institution from engaging in business practices which are considered to be unsafe or unsound, possibly including payment of dividends or other payments under certain circumstances even if such payments are not expressly prohibited by statute.
The payment of dividends by a national bank is further restricted by additional provisions of federal law, which prohibit a national bank from declaring a dividend on its shares of common stock unless its surplus fund exceeds the amount of its common capital (total outstanding common shares times the par value per share). Additionally, if losses have at any time been sustained equal to or exceeding a bank's undivided profits then on hand, no dividend shall be paid. Moreover, even if a bank's surplus exceeded its common capital and its undivided profits exceed its losses, the approval of the OCC is required for the payment of dividends if the total of all dividends declared by a national bank in any calendar year would exceed the total of its net profits of that year combined with its retained net profits of the two preceding years, less any required transfers to surplus or a fund for the retirement of any preferred stock. A national bank must consider other business factors in determining the payment of dividends. The payment of dividends by the Bank is governed by the Bank's ability to maintain minimum required capital levels and an adequate allowance for loan losses. Regulators also have authority to prohibit a depository institution from engaging in business practices which are considered to be unsafe or unsound, possibly including payment of dividends or other payments under certain circumstances even if such payment are not expressly prohibited by statute.
Premiums for Deposit Insurance and Assessments for Examinations
FDICIA established several mechanisms to increase funds to protect deposits insured by the Bank Insurance Fund ("BIF") administered by the FDIC. The FDIC is authorized to borrow up to $30 billion from the United States Treasury; up to 90% of the fair market value of assets of institutions acquired by the FDIC as receiver from the Federal Financing Bank; and from depository institutions that are members of the BIF. Any borrowings not repaid by asset sales are to be
repaid through insurance premiums assessed to member institutions. Such premiums must be sufficient to repay any borrowed funds within 15 years and provide insurance fund reserves of $1.25 for each $100 of insured deposits. FDICIA also provides authority for special assessments against insured deposits. No assurance can be given at this time as to what the future level of premiums will be.
Community Reinvestment Act and Fair Lending Developments
The Bank is subject to certain fair lending requirements and reporting obligations involving home mortgage lending operations and Community Reinvestment Act ("CRA") activities. The CRA generally requires the federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of their local communities, including low and moderate income neighborhoods. In addition to substantive penalties and corrective measures that may be required for a violation of certain fair lending laws, the federal banking agencies may take compliance with such laws and CRA into account when regulating and supervising other activities.
Recently Enacted Legislation
During 1996, new federal legislation amended the Comprehensive Environmental Response, Compensation, and Liability Act ("CERCLA") and the underground storage tank provisions of the Resource Conversation and Recovery Act to provide lenders and fiduciaries with greater protections from environmental liability. In June 1997, the U.S. Environmental Protection Agency ("EPA") issued its official policy with regard to the liability of lenders under CERCLA as a result of the enactment of the Asset Conservation, Lender Liability and Deposit Insurance Protection Act of 1996.
California law provides that, subject to numerous exceptions, a lender acting in the capacity of a lender shall not be liable under any state or local statute, regulation or ordinance, other than the California Hazardous Waste Control Law, to undertake a cleanup, pay damages, penalties or fines, or forfeit property as a result of the release of hazardous materials at or from the property.
In 1997, California adopted the Environmental Responsibility Acceptance Act (Cal. Civil Code ss.ss. 850-855) to facilitate (i) the notification of government agencies and potentially responsible parties (e.g., for cleanup) of the existence of contamination and (ii) the cleanup or other remediation of contamination by the potentially responsible parties. The Act requires, among other things, that owners of sites who have actual awareness of a release of a hazardous material that exceeds a specified notification threshold to take all reasonable steps to identify the potentially responsible parties and to send a notice of potential liability to the parties and the appropriate oversight agency.
The Company cannot be certain of the effect of the foregoing recently enacted legislation on its business.
Pending Legislation and Regulations
There are pending legislative proposals to reform the Glass-Steagall Act to allow affiliations between banks and other firms engaged in "financial activities," including insurance companies and securities firms.
Certain other pending legislative proposals include bills to let banks pay interest on business checking accounts, to require "know your customer" policies, to cap consumer liability for stolen debit cards, and to give judges the authority to force high-income borrowers to repay their debts rather than cancel them through bankruptcy.
Competition
In the past, an independent bank's principal competitors for deposits and loans have been other banks (particularly major banks), savings and loan associations and credit unions. To a lesser extent, competition was also provided by thrift and loans, mortgage brokerage companies and insurance companies. Other institutions, such as brokerage houses, mutual fund companies, credit card companies, and even retail establishments have offered new investment vehicles which also compete with banks for deposit business. The direction of federal legislation in recent years seems to favor competition between different types of financial institutions and to foster new entrants into the financial services market, and it is anticipated that this trend will continue.
The enactment of the Interstate Banking and Branching Act in 1994 and the California Interstate Banking and Branching Act of 1995 have increased competition within California. Regulatory reform, as well as other changes in federal and California law will also affect competition. While the impact of these changes, and of other proposed changes, cannot be predicted with certainty, it is clear that the business of banking in California will remain highly competitive.
At present there are approximately 368 banking offices in the geographic area served by SJNB, including offices of major chain banks and other independent banks. There are also approximately 173 offices of savings banks. Of these there are 216 offices of commercial banks (and 106 offices of savings banks) in Santa Clara County, which is the principal market area for the San Jose office. In addition, there are 152 offices of commercial banks (and 67 offices of savings banks) in the Danville office's primary market area. Total deposits of the combined area are approximately $43 billion as of June 30, 1998, of which the Bank has approximately a 0.7% share. In the San Jose's office market area, the Bank's market share is approximately 1.9% of the deposits in that market.
Presently, there are approximately seven other independent banks in Santa Clara County. Three of the independent banks--Heritage Bank of Commerce, Cupertino National Bank, and Silicon Valley Bank--emphasize commercial banking services and, therefore, create direct competition for the services that SJNB offers to the business and professional communities in its market area.
The Bank's Financial Services Division and Epic also compete with many of the major and independent banks within their respective marketing areas. The Bank and Epic also compete with companies solely in the factoring or leasing business. Such companies may offer products and services which traditionally are not offered by banking institutions.
Certain Additional Business Risks - ---------------------------------
The Company's business, financial condition, operating results and prospects can be impacted by a number of factors, including, but not limited to, those set forth in the paragraphs below. Any one of these stated risks could cause the Company's actual results in the future to vary from the Company's anticipated future results.
Shares of Company Common Stock eligible for future sale could have a dilutive effect on the market for Company Common Stock and could adversely affect the market price of the Common Stock. The Articles of Incorporation of the Company authorize the issuance of 20,000,000 shares of Common Stock, of which approximately 2,449,791 shares were outstanding at December 31, 1998. Pursuant to its stock option plans, the Company had outstanding options to purchase an aggregate of 425,650 shares of Company Common Stock at December 31, 1998. As of the same date, 158,755 shares of Company Common Stock remained available for option grants under the Company's stock option plans.
The Company has previously announced its intention to pursue acquisitions of other financial services companies from time to time when such acquisitions are believed by the Company to enhance shareholder value or satisfy other strategic objectives of the Company. Other acquisitions, if any, could be accomplished by the issuance of additional shares of Company Common Stock or other securities convertible into or exercisable for such Common Stock. Sales of substantial amounts of Company Common Stock in the public market or due to acquisitions could adversely affect the market price of the Common Stock.
The loan and lease portfolio of the Company is dependent on real estate. At December 31, 1998, real estate served as the principal source of collateral with respect to approximately 55% of the Company's loan and lease portfolio. A worsening of current economic conditions or rising interest rates could have an adverse effect on the demand for new loans, the ability of borrowers to repay outstanding loans, the value of real estate and other collateral securing loans and the value of the available for sale investment portfolio, as well as the Company's financial condition and results of operations in general and the market value of the Company's Common Stock. Acts of nature, including earthquakes and floods, which may cause uninsured damage and other loss of value to real estate that secures these loans, may also negatively impact the Company's financial condition.
The Bank is subject to certain operational risks including, but not limited to, data processing system failures and errors and customer or employee fraud. The Bank maintains a system of internal controls to mitigate such occurrences and maintains insurance coverage for such risks. Should such an event occur that was not prevented or detected by the Bank's internal controls or that was uninsured or in excess of the applicable insurance limits, it could have a significant negative impact on the Company's financial condition or results of operations.
The risks associated with the "Year 2000" problem involve both operational issues relating to the Bank's data processing systems and the impact of this problem on the operations of the Bank's customers. Both of these issues could have a significant negative impact on the Company's financial condition or results of operations, including the level of the Bank's provision for possible loan and lease losses in future periods. See "Year 2000 Problem."
Statistical Data - ----------------
Certain consolidated statistical information concerning the business of the Company appears on page 15, under the caption "Selected Financial Data;" on pages 16 through 33, under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operation;" on page 34, under the caption "Quantitative and Qualitative Disclosures about Market Risk;" and on pages 35 through 60, in the Company's Consolidated Financial Statements. Ratios relating to the Company's Return on Equity and Assets appear on page 15. The section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operation" should be read in conjunction with the information in Item 1 herein and the Company's Consolidated Financial Statements.
ITEM 2:
ITEM 2: PROPERTIES - -------------------
The Company shares common quarters with SJNB's main branch at One North Market Street, San Jose, California, 95113. The building was purchased by the Bank in 1985 and consists of approximately 24,000 square feet of basement, ground floor and second floor space. It is constructed and equipped to meet prescribed security requirements.
In addition, the Bank assumed BB's lease for approximately 12,000 square feet located at 95 South Market Street, San Jose, California when the Company acquired BB in October 1994. Approximately 9,000 square feet of space at this location is currently being occupied by two third-party tenants under subleases which expire in September 2004 upon termination of the original BB lease. The remaining space at this location is being occupied by the Bank's Financial Services Division.
The Bank and its subsidiary, Epic, share 3,000 square feet of leased facilities in Danville, California. The monthly lease expense is $6,000 with annual increases in 1999 and 2000. The lease expires July 2001.
In the opinion of management, adequate insurance is being maintained on these properties.
ITEM 3:
ITEM 3: LEGAL PROCEEDINGS - --------------------------
Other than as set forth below, neither the Company nor the Bank is a party to any material pending legal proceeding, nor is their property the subject of any material pending legal proceeding, except ordinary routine legal proceedings arising in the ordinary course of the Bank's business and incidental to its business, none of which are expected to have a material adverse impact upon the Company's or the Bank's business, financial position or results of operations.
During 1995, the Bank (along with Comerica Bank-California, Santa Clara Land Title and three principals of Century Loan Corporation) was served with a civil complaint in a class action lawsuit filed in the Superior Court of Santa Clara County, California. The lawsuit stemmed from the failure of Century Loan, a real estate investment company now in bankruptcy, which borrowed approximately $750,000 from the Bank during 1994. Plaintiffs were persons who invested in deeds of trust sold by Century Loan. Their complaint alleged that they were defrauded by Century Loan and its principals and that the Bank and other defendants aided and abetted a fraudulent Ponzi scheme by the principals of Century Loan.
The Court granted class certification to the Plaintiffs in December 1995, permitting them to proceed on behalf of all Century Loan investors. On November 26, 1996, the Court granted summary judgment in favor of the Bank on all of the Plaintiff's claims against it. The Court found no evidence that the Bank had participated in any conspiracy with, or aided and abetted, Century Loan. On December 4, 1996, the Court entered judgment in favor of the Bank, dismissing the Plaintiffs' claims. Plaintiff's motion for a new trial was denied on January 27, 1997 and has subsequently been appealed. Plaintiffs have filed their opening brief on appeal. Counsel for the Bank has filed a responsive brief. The California Bankers Association has filed an amicus (friend-of-the-court) brief arguing in favor of the Bank's position. Oral argument has not yet been scheduled. On February 11, 1999, the Court of Appeals requested from all parties involved supplemental briefs on several issues. The briefs were submitted March 15, 1999, and oral arguments are scheduled for April 28, 1999.
ITEM 4:
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------------------------------------------------------------
No matter was submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this Report.
PART II -------
ITEM 5:
ITEM 5: MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS - ------------------------------------------------------------------------------
As of March 18, 1999, the Company had 2,348,531 shares of Common Stock outstanding, held by approximately 1,800 beneficial shareholders. The Company's Common Stock is listed on the NASDAQ National Market System under the symbol "SJNB." Market makers of the Company's Common Stock include: Hoefer & Arnett, Inc., Wedbush Morgan Securities, Inc., Sandler O'Neill & Partners, Keefe Bruyette & Woods, Inc., Knight Securities L.P., and Torrey Pines Securities Inc.
Stock Price - -----------
The following sets forth the high and low sales prices for the Company's Common Stock during the periods indicated, as reported by NASDAQ, and the per share cash dividends declared on the Common Stock during such periods.
QUARTERLY COMMON STOCK PRICE - ------------------------------------------------------------------------------- Price of Common Stock Cash High Low Dividends - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- First Quarter $26.00 $18.75 ----- Second Quarter 26.00 22.50 $.21 Third Quarter 32.25 24.75 ----- Fourth Quarter 42.00 30.75 .24 - ------------------------------------------------------------------------------- .45 - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- First Quarter 37.00 33.50 .14 Second Quarter 43.25 35.00 .14 Third Quarter 43.25 26.00 .14 Fourth Quarter 29.00 26.00 .14 - ------------------------------------------------------------------------------- .56 - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- First quarter (through March 12, 1999)28.50 26.00 .14*
*Declared by the Board of Directors on January 27, 1999 and payable on March 1, 1999 to shareholders of record on February 8, 1999.
The Company's Board of Directors considers the advisability and amount of proposed dividends each year. Future dividends will be determined after consideration of the Company's earnings, financial condition, future capital funds, regulatory requirements and such other factors as the Board of Directors may deem relevant. The Company's primary source of funds for payment of dividends to its shareholders will be receipt of dividends and management fees from the Bank. The payment of dividends by a bank is subject to various legal and regulatory restrictions. See "Business - Supervision and Regulation - Restrictions on Dividends and Other Distributions."
From 1993 through 1997, the Company maintained a policy of paying semi-annual dividends to its shareholders. Effective with the first quarter of 1998, the Company adopted a policy to pay quarterly cash dividends to its shareholders. It is the intention of the Company to continue the payment of dividends, subject to financial results and other factors which could limit or restrict dividends as more fully discussed elsewhere herein.
ITEM 6:
ITEM 6: SELECTED FINANCIAL DATA - --------------------------------
The following presents selected financial data and ratios for the five years ended December 31, 1998:
ITEM 7:
ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ------------------------------------------------------------------------ RESULTS OF OPERATION - --------------------
This Annual Report on Form 10-K includes forward-looking information within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are subject to the "safe harbor" created by those sections. These forward-looking statements (which involve the Company's plans, beliefs and goals, refer to estimates or use similar terms) involve certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Such risks and uncertainties include, but are not limited to, the following factors: competitive pressure in the banking industry; changes in the interest rate environment; the declining health of the economy, either nationally or regionally; the deterioration of credit quality, which could cause an increase in the provision for possible loan and lease losses; changes in the regulatory environment; changes in business conditions, particularly in Santa Clara County real estate and high tech industries; certain operational risks involving data processing systems or fraud; volatility of rate sensitive deposits; asset/liability matching risks and liquidity risks; risks associated with the Year 2000 which could cause disruptions in the Company's operations; and changes in the securities markets. The Company undertakes no obligation to revise or publicly release the results of any revision to these forward-looking statements. See also the sections included herein entitled "Business - Year 2000 Problem" and "Business - Certain Additional Business Risks" and other risk factors discussed elsewhere in this Report.
The purpose of the following discussion is to provide information pertaining to the financial condition and results of operations of the Company that may not be apparent from a review of the consolidated financial statements and related notes. It also incorporates certain statistical information that is required by Industry Guide 3 promulgated by the Securities and Exchange Commission. The discussion should be read in conjunction with the aforementioned consolidated financial statements, as found on pages 35 through 60. The interest earned and yields on nontaxable securities have been adjusted to a fully-taxable equivalent basis for all financial information presented in this Item 7.
Dollars are in thousands in the text for Item 7, except per share amounts or as otherwise noted.
Financial Review - ----------------
Earnings Summary
For the year ended December 31, 1998, the Company reported net income of $5.5 million or $2.11 per diluted share as compared to net income of $5.1 million or $1.94 per diluted share in December 31, 1997 (a 8% increase). Net income for the year increased over that of the previous year primarily due to an increase of $1.7 million in net interest income and a decrease in the loan and lease loss provision, partially offset by an increase in non-interest expense.
For the year ended December 31, 1997, the Company reported net income of $5.1 million or $1.94 per diluted share as compared to net income of $4.3 million or $1.64 per diluted share in December 31, 1996 (a 19% increase). Net income for the year increased substantially over that of the previous year primarily due to the increase of $2.0 million in net interest income offset by increases in the loan and lease loss provision and non-interest expense.
As of December 31, 1998, consolidated assets were $350 million, gross loans and leases were $261 million, and deposits were $302 million. Total consolidated assets increased $25 million from $325 million, and deposits grew $32 million from $270 million the previous year, representing an 8% and 12% increase, respectively. Loan and lease and deposit growth was generated by marketing and business development efforts of the Bank, in addition to the generating of a $10 million, ten year callable, floating rate (30 day LIBOR plus 5 basis points) certificate of deposit in December 1998.
Net Interest Income and Margin
Net interest income is the principal source of the Company's operating earnings. Significant factors affecting net interest income are rates, volumes and mix of the loan, investment and deposit portfolios.
The following table shows the composition of average earning assets and average funding sources, average yields and rates and the net interest margin for the three years ended December 31, 1998.
The following table shows the effect on the interest differential of volume and rate changes for the years ended December 31, 1998 and 1997:
Consolidated net interest income (on a fully taxable equivalent basis) was $20.4 million in 1998, as compared to $18.6 million in 1997. The increase of $1.8 million in net interest income during 1998 was primarily a result of an increase in volume of $27 million in earning assets which amounted to approximately $2.2 million of net interest income and an increase of approximately $295 in loan fees. Late in 1998, the Federal Open Market Committee ("FOMC") decreased the interbank borrowing rate by 75 basis points and the Discount Rate by 50 basis points which resulted in a decrease in the Bank's prime rate from 8 1/2% to 7 3/4%. The Bank's average prime was 8.38% in 1998, as compared to 8.44% in 1997. In a declining rate environment, the Company must generally increase its earning assets in order to maintain net interest income growth.
Consolidated net interest income (on a fully taxable equivalent basis) was $18.6 million in 1997, as compared to $16.6 million in 1996. The $2.0 million increase in net interest income during 1997 was due primarily to an increase in the volume of earning assets. The Bank's net interest margin for 1997 was 6.48%, as compared to 6.59% in 1996. The decrease in the net interest margin was primarily due to the impact of the competitive market and the resulting pressure on loan interest rates and imputed financing cost of leases.
Loan fees contributed 5.3% of loan and lease portfolio interest during 1998, 4.5% in 1997 and 5.0% in 1996. This increase in the proportion of loan fees to total loan and lease interest in 1998 was due mainly to the impact of the increased activity in real estate construction. In prior years the declining ratio was primarily due to an increase in the competitive atmosphere relating to loan pricing, the overall level of interest rates and the higher proportion of SBA loans included in the loan portfolio (SBA loans generally have had lower origination fees).
Interest expense in 1998 was $9.1 million as compared to $8.7 million in 1997. The difference was due primarily to the increase in volume offset by the decrease in overall interest rate paid. Actual interest expense rates declined from 4.11% to 3.95%. This compares to a decrease in the yields on earning assets from 9.54% in 1997 to 9.39% in 1998.
Interest expense in 1997 was $8.7 million as compared to $8.1 million in 1996. This was mainly due to the increase in volumes. Actual interest expense rates declined from 4.29% in 1996 to 4.11% in 1997. This compares to a decrease in the yields on earning assets from 9.80% in 1997 to 9.54% in 1996.
During both periods, interest expense proportionately declined at a greater rate than interest income. It is management's opinion that this occurred because of measures taken by the Bank, which management believed to be the most efficient product pricing for deposit products.
A substantial portion of the Bank's deposits (an average of 23% in 1998, and 25% in each of 1997 and 1996) are non interest-bearing and therefore do not reprice when interest rates change. See "Funding." This is somewhat ameliorated by a significant amount of customer corporate account balances which are tied to earnings credits and utilized to offset bank service costs.
Due to the nature of the Company's lending markets, in which loans are generally tied to the Prime Rate, an increase in interest rates should positively affect the Company's future earnings, while a decline in interest rates would have a negative impact. In late 1998, market interest rates declined significantly due to several factors most notable of which were the strengthening of the dollar, the Asia crisis and the collective wisdom that inflation had receded. Should this "market" trend of declining interest rates continue during 1999, management believes the Bank could experience an additional increase in its cost of funds relative to the yields earned on its earning assets. This would produce a decrease in the Bank's net interest margin. According to the management's reasonable estimate on the impact of the changes in interest rates, it is estimated that for each 25 basis point decline in the prime rate, net interest income is negatively impacted by approximately $270.
The Company's net interest margin for the periods presented is high relative to its peer group, mainly due to its high proportion of non interest-bearing deposits and the impact of the Bank's Financial Services Division.
Net interest income also reflects the impact of nonperforming loans. The effect of nonaccrual loans on interest income for the years ended December 31, 1998 through 1994 was as follows:
This table does not reflect the cash basis interest received on several significant loan collections during 1995, as such loans were not classified as nonaccrual as of the end of the year. The impact of such was significant in 1995. Approximately $588 of interest income was recognized in 1995 on collection of certain loans classified nonaccrual, which resulted in a 29 basis point impact on the net interest margin.
Provision for Possible Loan and Lease Losses
The level of the allowance for possible loan and lease losses (and therefore the related provision) reflects the Company's judgment as to the inherent risks associated with the loan and factoring portfolios. Since estimates of the adequacy of the Company's allowance for possible loan and lease losses are based on foreseeable risks, such judgments are subject to change based on changing circumstances. Based on management's current evaluation of such risks, as well as judgments of the Company's regulators, additions of $300, $705 and $190 were made to the allowance for possible loan and lease losses in 1998, 1997 and 1996, respectively. Management's determinations of the provision in 1998, 1997 and
1996 were based on the measurement of the possibility of future estimated loan and lease losses through various objective and subjective criteria and the impact of net chargeoffs. See "Loan and Lease Portfolio" for a detailed discussion of asset quality and the allowance for possible loan and lease losses.
Other Income
The following table sets forth the components of other income and the percentage distribution of such income for the years ended December 31, 1998, 1997 and 1996.
Other income totaled $1.1 million in 1998, $1.0 million in 1997 and $846 in 1996. The reduced levels of other income in 1996 were the result of the recognition of $142 of securities losses in that year.
Other Expense
The components of other expense are set forth in the following table for the years ended December 31, 1998, 1997 and 1996.
Total other expenses increased approximately $1.6 million or 16.2% in 1998 as compared to 1997. The increase is primarily related to the acquisition of Epic Funding Corporation (which accounted for approximately $421 of the increase), salary increases of $328 during the first quarter of 1998, necessary to adjust officers' salaries based on competitive conditions and increased data processing expenses of $213 relating to the acquisition and implementation of a new processing system in November 1997.
In addition to the above, the Bank increased its number of its business development and lending personnel and incurred overall salary increases for the Bank's operating staff. Advertising and marketing costs increased due to effects of greater amounts expended on charitable donations, community support events and client entertainment. Client services paid by the Bank also increased due to the significant increase in services provided for client purposes.
Total other expenses increased approximately $275 or 2.8% in 1997 as compared to 1996. This was primarily due to the increase in salaries and benefits arising from staff growth related to the increased level of Bank's business activity and an increase in the provision for incentive payments for exceeding predefined goals. Business promotion and advertising expenses declined due to costs of promotions incurred in 1996 and none in 1997. In addition, the Bank's data
processing costs declined due to the termination of payments for its previous data processing software. During 1997 the Bank acquired a new processing system for a total cost of approximately $600. This cost will be amortized over a five-year period commencing in November 1997. Amortization of core deposit intangibles is based on a declining balance method, and as such, the amount charged to expense will decline each year. Costs relating to client services increased approximately $100 during 1997 as compared to 1996 mainly due to the addition of significant clients utilizing services purchased by the Bank.
Income Taxes
The effective tax rate was 42% in 1998, 42% in 1997 and 43% in 1996. The lower effective tax rates in 1998 and 1997 were primarily due to the reduction in the amount and proportion of amortization of the nondeductible portion of intangibles to pretax income arising in connection with the purchase of BB and Astra Financial Corp.
Quarterly Income
The unaudited consolidated income statement data of the Company and the Bank, in the opinion of management, includes all normal and recurring adjustments necessary to state fairly the information set forth therein. The results of operations are not necessarily indicative of results for any future period. The following table shows the Company's unaudited quarterly income statement data for the years 1998 and 1997:
The Company reported net income of $1.3 million for the quarter ended December 31, 1998, compared with net income of $1.4 million for the fourth quarter of 1997. The results for the fourth quarter of 1998 as compared to the same quarter a year ago reflect an increase in volume of earning assets ($316 million in 1998 compared to $297 million in 1997) offset by a decline in net interest margins (6.45% in 1998 and 6.48% in 1997). The loan and lease loss provision declined from $310 in 1997 to $150 in 1998. Other expenses increased $519, primarily as a result of increases in salaries, addition of business development and lending staff, the impact of the acquisition of Epic Funding Corporation and the opening of the branch office in Danville, CA. Data processing and telephone cost increases relate to the conversion of the Bank's November 1997 operating system and increased usage of internet and interoffice communication.
Financial Condition and Earning Assets - --------------------------------------
Money Market Investments
Money market investments, which include federal funds sold and other short-term investments, were $22.3 million at December 31, 1998 as compared to $2.7 million at December 31, 1997. This increase relates to the reduction in year-end cash balances to $11.3 million at December 31, 1998 from $22.8 million in 1997 and a reduction in the amount of investment securities to $46.4 million at December 31, 1998 from $62.0 million in 1997.
The average balance of money market investments, which include federal funds sold and liquid money market investments, was $18.5 million in 1998 and $10.8 million in 1997. These balances represented 6% and 4% of average deposits for 1998 and 1997, respectively. They are maintained primarily for the short-term liquidity needs of the Bank. The increase in money market investments relates to the growth of certain volatile deposits. See "Capital and Liquidity."
Securities
The following table shows the book value composition of the securities portfolio at December 31, 1998, 1997 and 1996. At December 31, 1998, there were no issuers of securities for which the aggregate book value of securities of such issuer held by the Bank exceeded 10% of the Company's shareholders' equity.
Investment securities classified as available for sale (which include all mutual funds), are acquired without the intent to hold until maturity. At December 31, 1998, the Bank's weighted average maturity of the available for sale investment portfolio was 2.0 years. It is estimated that for each 1.0% change in interest rates, the value of the Company's securities held to maturity will change by approximately 1.7%.
Any unrealized gain or loss on investment securities available for sale is reflected in the carrying value of the security and reported net of income taxes in the equity section of the condensed consolidated balance sheets. Realized gains and losses are reported in the condensed consolidated statement of income. The net unrealized gain, net of tax, on securities available for sale as of December 31, 1998 was $300.
Investment securities classified as held to maturity include those securities which the Company has the ability and intent to hold to maturity. The Company's policy is to generally acquire "A" rated or better U.S., state and municipal securities. The specific issues are monitored for changes in financial condition. Appropriate action would be taken if significant deterioration was noted.
The pre-tax unrealized gain on investment securities held to maturity was $196 as of December 31, 1998 as compared to $106 as of December 31, 1997. The increase in unrealized gains resulted from the significant decrease in interest rates in 1998. Decreases in interest rates have an inverse effect on the value of securities for which the interest rate is fixed. The Bank's weighted average maturity of the held to maturity investment portfolio as of December 31, 1998 was approximately 3.9 years. It is estimated that for each 1.0% change in interest rates, the value of the Company's securities held to maturity will change by approximately 2.4%. This volatility decreases as the average maturity shortens. Since it is the intention of management to hold these securities to maturity, the unrealized gains will be realized over the life of the securities as above- market interest income is recognized.
Mortgage backed securities ("MBS") are considered to have increased risks associated with them because of the timing of principal repayments. As interest rates decrease, the average maturity of mortgages underlying MBS tend to decline; as rates increase, maturities tend to lengthen. At December 31, 1998, the Company had the following securities which were mortgage-backed or related securities:
Mortgage-Backed and Related Securities December 31, 1998
Fair (dollars in thousands) Cost Value ------------------------------------------------------------------------------ Federal Home Loan Mortgage Corp.(U.S. Agency) $3,643 $3,722 Federal National Mortgage Association (U.S. Agency) 2,148 2,202 Federated ARMs Funds * 1,686 1,621 Overland Variable Rate Government Fund* 952 865
* The assets of these mutual funds are invested mainly in adjustable rate U.S. Treasury or U.S. Government Agency securities.
Loan and Lease Portfolio
The following table shows the Company's consolidated loans and leases by type of loan or borrower and their percentage distribution:
General
The Company's loan and lease portfolio consists primarily of short-term, floating rate loans for business and real estate purposes. At December 31, 1998, approximately 37% of the loan and lease portfolio consisted of commercial loans (including non-real estate SBA loans and factoring), 1% was leasing, 12% was real estate construction, and 39% was in real estate - other. The Bank's legal lending limit for any one borrower was approximately $5.1 million at December 31, 1998.
The commercial loan portfolio primarily consists of loans to small- to medium-sized businesses with gross revenues up to $50 million, as well as loans to local professional businesspersons. SJNB's lending services include revolving credit loans, SBA loans, term loans, accounts receivable financing, factoring,
equipment financing and letters of credit. The commercial loan portfolio includes approximately $16 million of SBA loans which are not made for real estate purposes. These loans carry a 70% to 80% guarantee by the SBA.
Included in commercial loans as of December 31, 1998 were factored accounts receivable of approximately $7.4 million or 2.8% of total loans and leases. As of December 31, 1997, factored accounts receivable were $4.9 million or 2.1% of total loans. The Bank purchases accounts receivable from clients and then receives payment directly from the party obligated for the receivable. In most cases, the Bank's Financial Services Division purchases the receivables subject to recourse from the Bank's factoring client. The factoring business and related purchasing of accounts receivable is subject to a greater degree of risk than normal lending due to the involvement of the third party obligee, the lack of control over the direct receipt of payment, and the potential purchase of fraudulent or inflated receivables. To date, there have been no significant losses relating to the Bank's factoring program.
The real estate construction portfolio (12% of the loan and lease portfolio) consists of 44% residential and 56% commercial. Such loans are made on the basis of the economic viability for the specific project, the cash flow resources of the developer, the developer's equity in the project and the underlying financial strength of the borrower. The Company's policy is to monitor each loan with respect to incurred costs, sales price and sales cycle.
The real estate - other loans include term loans (up to a twenty-five year maturity) on income-producing commercial properties. These loans include SBA real estate type loans.
Consumer loans consist primarily of loans to individuals for personal uses, such as home equity loans, installment purchases, premier lines (unsecured lines of credit) and overdraft protection loans and a variety of other consumer purposes.
Other loans include loans to real estate developers for short-term investment purposes (approximately $1.7 million), loans for real estate investment purposes made to non-developers (approximately $3.0 million) and loans for other investments (approximately $5.0 million).
Concentrations of credit risk arise when a number of customers are engaged in similar business activities, or activities in the same geographic region, or have similar economic features that would cause their ability to meet contractual obligations to be similarly affected by changes in economic conditions. Although the Company has a diversified loan and lease portfolio, a substantial portion of its customers' ability to honor loan and lease terms is reliant upon the economic stability of Santa Clara County, which in some degree relies on the stability of high technology companies in its "Silicon Valley." Loans are made on the basis of a secure repayment source as the first priority. Collateral is generally a secondary source for loan qualification.
Approximately 55% of the loan and lease portfolio is directly related to real estate or real estate interests, when real estate construction loans, real estate - other loans, Prime equity loans (included in consumer loans in the amount of $4.8 million) and certain other loans to real estate developers and other investors for short-term investment purposes (approximately 6% of the loan and lease portfolio) are included. Included in the real estate - other category are approximately $21 million of SBA real estate type loans, of which, 70% to 80% are guaranteed by the SBA. Approximately 37% of the loan and lease portfolio is made up of commercial loans; however, no particular industry represents a significant portion of such loans.
Inherent in any loan and lease portfolio are risks associated with certain types of loans and leases. The Company attempts to limit these risks through conservative loan and lease policies and review procedures that are applied at the time of origination. Included in these policies are specific maximum loan-to-value (LTV) limitations as to various categories of real estate related loans. These ratios are as follows:
Maximum Loan to Value Ratios - ------------------------------------------------------------ Maximum LTV Category of Real Estate Collateral Ratio - --------------------------------------------- -------------- Raw land 50% Land Development 60 Construction: 1-4 Single family residence, Less than $500 80 Greater than $500 80 Other 80 Term loans (construction take-out and commercial) 75 Other improved property 70 Prime equity loans 80
The Company's loan and lease policy provides that any term loans on income-producing properties must have a minimum debt service coverage of at least 1.2 to 1 for non-owner occupied property and at least 1.1 to 1 for owner occupied.
One of the significant risks associated with real estate lending is the risk associated with the possible existence of environmental risks or hazards on or in property affiliated with the loan. The Bank attempts to mitigate such risk through the use of an Environmental Risk Questionnaire for all loans secured by real estate. A Phase I environmental report is required if so indicated by response to the questionnaire or if (for any other reason) it is determined to be appropriate. Other reasons would include the industrial use of environmentally sensitive substances or the proximity to other known environmental problems. A Phase II report is required in certain cases, depending on the outcome of the Phase I report.
Activity
Total loans and leases were $261 million and averaged $237 million as of and for the year ended December 31, 1998. Total loans and leases were $229 million and averaged $213 million as of and for the year ended December 31, 1997. The increase in total loans and leases of $32 million during 1998 relates primarily to the growth in the Bank's real estate portfolio. Both construction lending and real estate term lending showed significant growth during 1998. The growth in the construction portfolio was mainly due to the rapid expansion of housing in the Bank's market area. Demand in the housing market was fueled by low unemployment (less than 4% over the last two years) and increased wealth of employees of Silicon Valley technology firms. The Bank was able to provide financing for several construction projects, and this, together with the low interest rate environment which fuels the refinancing market in which the Bank participated, caused the real estate term loans to increase.
Total loans were $229 million and averaged $213 million as of and for the year ended December 31, 1997. Total loans were $199 million and averaged $183 million as of and for the year ended December 31, 1996. The increase in total loans of $30 million during 1997 relates to the overall growth in the Bank's loan portfolio. The most significant areas of growth were the increase in commercial loans of $15 million. In addition, Real Estate Construction increased $2.4 million, while Real Estate - other increased $16 million, of which $10.9 million was SBA real estate loans.
The economic climate in Northern California has been generally strong in 1998 and 1997. The competitive environment within the Bank's marketplace for additional loan and lease growth has become more aggressive between lenders, resulting in increasingly competitive pricing. To the extent that such competitive activity continues during 1999 and the Bank finds it necessary to meet such competition, the Bank's net interest margins could decline. It is uncertain what impact the current economic crisis currently unfolding in Asia and South America will have on the Silicon Valley and, potentially, the business of the Bank.
Asset Quality
Allowance for Possible Loan and Lease Losses
A consequence of lending activities is the potential for loss. The amount of such losses will vary from time to time depending upon the risk characteristics of the loan and lease portfolio as affected by economic conditions, rising interest rates and the financial experience of borrowers. The allowance for possible loan and lease losses, which provides for the risk of losses inherent in the credit extension process, is increased by the provision for possible loan and lease losses charged to expense and decreased by the amount of charge-offs net of recoveries. There is no precise method of predicting specific losses or amounts that ultimately may be charged off on particular segments of the loan and lease portfolio. Similarly, the adequacy of the allowance for possible loan and lease losses and the level of the related provision for possible loan and lease losses is determined on a judgmental basis by management based on consideration of:
o Economic conditions, o Borrowers' financial condition, o Loan and lease impairment, o Evaluation of industry trends, o Industry and other concentrations, o Loans which are contractually current as to payment terms but demonstrate a higher degree of risk as identified by management, o Continuing evaluation of the performing loan portfolio, o Monthly review and evaluation of problem loans and leases identified as having loss potential, o Quarterly review by the Board of Directors, o Off-balance sheet risks, and o Assessments by regulators and other third parties.
In addition to the internal assessment of the loan and lease portfolio (and off-balance sheet credit risk, such as letters of credit, etc.), the Company also retains a consultant who performs credit reviews on a quarterly basis and then provides an assessment of the adequacy of the allowance for possible loan and lease losses. Examinations of the loan and lease portfolio are also conducted periodically by the federal banking regulators.
The Company utilizes a method of assigning a minimum and maximum loss ratio for each grade of loan or lease within each category of loans (commercial, real estate - other, real estate construction, etc.) Loans and leases are graded on a ranking system based on management's assessment of the loan or lease's credit quality. The assigned loss ratio is based upon the Company's prior experience, industry experience, delinquency trends and the level of nonaccrual loans. In addition, the Company's methodology considers (and assigns a risk factor for) current economic conditions, off-balance sheet risk and concentrations of credit. The methodology provides a systematic approach for the measurement of the possible existence of future loan and lease losses. Management and the Board of Directors evaluate the allowance and determine its desired level considering objective and subjective measures, such as knowledge of the borrowers' business, valuation of collateral, the determination of impaired loans and leases and exposure to potential losses. Based on known information available to it at the date of this Report, management believes that the Company's allowance for possible loan and lease losses, determined as described above, was adequate at December 31, 1998 for foreseeable losses.
The allowance for possible loan and lease losses is a general reserve available against the total loan and lease portfolio and off-balance sheet credit exposure. While management uses available information to recognize losses on loans or leases, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for possible loan and lease losses. Such agencies may require the Bank to provide additions to the allowance based on their judgment of information available to them at the time of their examination.
Finally, there is uncertainty concerning future economic trends. Accordingly, it is not possible to predict the effect future economic trends may have on the level of the provision for possible loan and lease losses in future periods.
The following table summarizes the activity in the allowance for possible loan and lease losses for the five years ended December 31, 1998:
Net chargeoffs were $15 or 0.01% of average loans and leases during 1998. Net chargeoffs were $217 or 0.10% of average loans during 1997. During 1996, the Company experienced net chargeoffs of $82 or 0.04% of average loans.
The allowance for possible loan and lease losses as a percentage of total loans and leases was 1.83%, 1.96%, and 2.02% at December 31, 1998, 1997 and 1996, respectively. The allowance for possible loan and lease losses as a percentage of nonperforming loans was approximately 1,983%, 1,060% and 733% at December 31, 1998, 1997 and 1996, respectively. Nonperforming loans were $241, $424 and $546 at December 31, 1998, 1997 and 1996, respectively. See "Nonperforming Loans and Leases" below.
Based on an evaluation of individual credits, historical credit loss experienced by loan or lease type and economic conditions, management has allocated the allowance for possible loan and lease losses as follows for the past five years:
The allowance for possible loan and lease losses is maintained without any internal allocation to the segments of the loan and lease portfolio and the entire allowance is available to cover loan and lease losses. The allocation is based on subjective estimates that take into account historical loss experience and management's current assessment of the relative risk characteristics of the portfolio as of the reporting date noted above and as described more fully herein.
Nonperforming Loans and Leases
Loans for which the accrual of interest has been suspended, restructured loans and other loans with principal or interest contractually past due 90 days or more are set forth in the following table:
Potential nonperforming loans and leases are identified by management as part of its ongoing evaluation and review of the loan and lease portfolio. Based on such reviews and information known to management at the date of this Report, management has not identified any loans or leases (other than those in the above table) about which it has serious doubts regarding the borrowers' ability to comply with present loan repayment terms, such that the loans or leases might subsequently be classified as nonperforming.
The accrual of interest on loans is discontinued and any accrued and unpaid interest is reversed when, in the opinion of management, there is significant doubt as to the collectibility of interest or principal or when the payment of principal or interest is ninety days past due, unless the amount is well-secured and in the process of collection.
Other Real Estate Owned
At December 31, 1998 and 1997 there were no properties owned by the Bank acquired through the foreclosure process.
Commitments and Lines of Credit
It is the Bank's policy not to issue formal commitments or lines of credit except to well-established and financially responsible local commercial enterprises. Such commitments can be either secured or unsecured and are typically in the form of revolving lines of credit for seasonal working capital needs.
Occasionally, such commitments are in the form of a letter of credit to facilitate the customer's particular business transaction. Commitments and lines of credit typically mature within one year. These commitments involve (to varying degrees) credit risk in excess of the amount recognized as either an asset or liability in the statement of financial position. The Company attempts to control this credit risk through its credit approval process. The same credit policies are used when entering into such commitments.
As of December 31, 1998, the Company had undisbursed loan commitments to extend credit as follows:
UNDISBURSED LOAN COMMITMENTS (dollars in thousands) Loan Category Amount - ------------------------------------------------------------- Commercial $75,004 Real estate construction 30,751 Real estate - other 5,207 Consumer 8,281 Other 19,993 - ------------------------------------------------------------- Total $139,236 =============================================================
In addition, there was approximately $6.3 million available for commitments under unused letters of credit.
Funding - -------
Deposits represent SJNB's principal source of funds. Most of the Bank's deposits are obtained from professionals, small- to medium-sized businesses and individuals within the Bank's market area. SJNB's deposit base consists of non-interest and interest-bearing demand deposits, savings and money market accounts and certificates of deposit. The following table summarizes the composition of deposits as of December 31, 1998, 1997 and 1996:
Deposits increased 12% to $302 million at December 31, 1998 from $270 million at December 31, 1997. Deposits increased 11% to $270 million at December 31, 1997 from $245 million at December 31, 1996. These increases are due to a combination of factors including the development of customers with significant cash balances, utilization of sophisticated cash management systems and aggressive pricing of interest rates. See below for a description of a $10 million synthetic floating rate certificate of deposit which is included in the deposit total for 1998.
The Bank has been able to attract a significant proportion of its deposits in the form of noninterest-bearing deposits. The Bank's primary business is commercially oriented with significant noninterest-bearing deposits maintained by commercial customers. In a high interest rate environment, these funds could be subject to disintermediation (moved for higher interest rate products). To counter such possibilities, the Bank maintains an array of products which it believes would be competitive if such were to occur. In addition, in illiquid economic times (possibly recessions) these deposits could be subject to withdrawal pressures. See "Capital and Liquidity - Liquidity" for a discussion of the Bank's liquidity sources.
The Bank also raises a substantial amount of funds through certificates of deposit of $100 or greater, which were approximately 26% of total deposits. These deposits are usually at interest rates greater than other types of deposits and are more sensitive to interest rate changes. Historically, the Bank's overall cost of funds has been less than that of its peer group. However, as these certificates of deposit are usually more interest rate sensitive, their repricing in an increasing interest rate environment could increase the Bank's cost of funds and negatively impact the Bank's net interest margin. See "Capital and Liquidity."
On December 4, 1998 the Bank obtained $10 million through the placement of a ten year synthetic floating rate certificate of deposit. The instrument consists of two linked transactions, a callable interest rate swap and callable fixed rate certificate of deposit. Under the swap agreement, the Bank pays LIBOR plus 5 basis points and receives 6% for a period of ten years. The swap is callable after one year by a major U.S. domestic bank. Simultaneously, the Bank issued a callable 6% fixed rate certificate of deposit. The certificate of deposit does not have any early redemption clauses, other than by death of the holder. Effectively, the Bank's rate of interest on the combined transaction is LIBOR plus five basis points.
The Bank utilizes short-term borrowings in its balance sheet management. The short-term borrowings (securities sold under agreements to repurchase) are used for short-term liquidity needs. The average cost of the borrowings during 1998 was 5.59%, the average amount outstanding was $3.8 million and the maximum at any month end was $12 million.
Asset/Liability Management - --------------------------
The Company defines interest rate sensitivity as the measurement of the mismatch in repricing characteristics of assets, liabilities and off-balance sheet instruments at a specified point in time. This mismatch (known as interest rate sensitivity gap) represents the potential mismatch in the change in the rate of interest revenue accrual and interest expense that would result from a change in interest rates. Mismatches in interest rate repricing among assets and liabilities arise primarily from the interaction of various customer businesses (i.e., types of loans and leases versus the types of deposits maintained) and from management's discretionary investment and funds gathering activities. The Company attempts to manage its exposure to interest rate sensitivity. However, due to its size and direct competition from the major banks, the Company must offer products which are competitive in the market place, even if less than optimum with respect to its interest rate exposure.
The Company's balance sheet position at December 31, 1998 was asset-sensitive, based upon the significant amount of variable rate loans and the repricing characteristics of its deposit accounts. This position provides a hedge against rising interest rates, but has a detrimental effect during times of interest rate decreases. Net interest revenues are negatively impacted by a decline in interest rates. The interest rate gap is a measure of interest rate exposure and is based upon the known repricing dates of certain assets and liabilities and assumed repricing dates of others. See "Financial Review - Net Interest Income and Margin."
The following table quantifies the Company's interest rate exposure at December 31, 1998 based upon the known repricing dates of certain assets and liabilities and the assumed repricing dates of others. At December 31, 1998, the Company was asset-sensitive in the near term, as noted above.
In evaluating the Company's exposure to interest rate risk, certain shortcomings inherent in the method of analysis presented in the foregoing table must be considered. For example, although certain assets and liabilities may have similar maturities or periods to reprice, they may react in different degrees to changes in market interest rates. Additionally, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market interest rates. Further, certain earning assets have features which restrict changes in interest rates on a short-term basis and over the life of the asset. The Company considers the anticipated effects of these various factors in implementing its interest rate risk management activities, including the utilization of certain interest rate hedges.
A large proportion of the Bank's deposits are non interest-bearing demand deposits and are not included in the above table as they tend not to be interest rate sensitive. The average balance of these deposits was $68 million in 1998. In addition, the Bank's total tangible capital of approximately $31 million is not included as a funding source in the above table.
To counter its asset-sensitive interest rate position, the Bank has entered into interest rate "floors" as follows:
INTEREST RATE FLOORS At December 31, 1998 - ------------------------------------------------------------------------------- Notional amount $10,000,000 $10,000,000 Floor rate 7.00% 8.50% Remaining life (months) 4 11 Carrying amount $2,000 $98,000 Fair market value ----- $82,000 Expiration date May 10, 1999 December 11, 1999
The Bank has paid a fixed premium for which it will receive the amount of interest based on the notional amount and the difference between the floor rate and the current Prime when Prime is less than the floor rate. This will protect the Bank against decreases in its net income when Prime decreases. Settlement is done quarterly, and the Bank records the impact of this hedge on an accrual basis.
The maturities and yields of the investment portfolio at December 31, 1998 are shown below:
The following table shows the maturity and interest rate sensitivity of commercial, real estate construction and real estate - other loans at December 31, 1998. Approximately 81% of the commercial and real estate loan portfolio is priced with floating interest rates, which limit the exposure to interest rate risk on long-term loans.
The above table does not take into account the possibility that a loan may be renewed at the time of maturity. In most circumstances, the Company treats a renewal request in substantially the same manner in which it considers the request for an initial extension of credit. The Company does not have a policy to automatically renew loans.
Capital and Liquidity - ---------------------
Capital
The Company's book value per share was $14.48, $13.30 and $12.14 as of December 31, 1998, 1997 and 1996, respectively. Tangible book value per share was $12.84, $11.80 and $10.40 at December 31, 1998, 1997 and 1996, respectively, adjusted for goodwill and core deposit intangibles. Shareholders' equity was $35 million, $33 million and $31 million as of December 31, 1998, 1997 and 1996, respectively. Tangible shareholders' equity was $31 million, $30 million and $27 million as of December 31, 1998, 1997 and 1996, respectively. During 1998 and 1997 the Company repurchased 102 shares for $2.5 million and 91 shares for $3.5
million, respectively. See Notes to Consolidated Financial Statements and "Business - Supervision and Regulation" for a discussion of the Company's capital requirements.
Liquidity
Management strives to maintain a level of liquidity sufficient to meet customer requirements for loan and lease funding and deposit withdrawals. Liquidity requirements are evaluated by taking into consideration factors such as deposit concentrations, seasonality and maturities, loan and lease demand, capital expenditures and prevailing and anticipated economic conditions. SJNB's business is generated primarily through customer referrals and employee business development efforts. The Bank utilizes brokered deposits on a limited basis to satisfy temporary liquidity needs.
The Bank's sources of liquidity consist of its deposits with other banks, overnight funds sold to correspondent banks and short-term, marketable investments net of short-term borrowings. On December 31, 1998, consolidated liquid assets totaled $70 million or 20% of consolidated total assets, as compared to $62 million or 19% of consolidated total assets on December 31, 1997. In addition to the liquid asset portfolio, SJNB also has $17.5 million in informal lines of credit available with three major commercial banks, approximately $3.6 million of credit available at the Federal Reserve Discount Window and $18 million in SBA guaranteed loans which are available for sale and could likely be sold within a 30-day period.
SJNB is primarily a business and professional bank and, as such, its deposit base is more susceptible to economic fluctuations. Accordingly, management strives to maintain a balanced position of liquid assets to volatile and cyclical deposits. In their normal course of business, commercial clients maintain balances in large certificates of deposit. The stability of these balances hinges upon, among other factors, market conditions and each business' seasonality. Large certificates of deposit amounted to 26% of total deposits on December 31, 1998, as compared to 18% for 1997. This increase was due to the $10 million callable variable rate certificate discussed above and several significant deposits by existing customers.
Liquidity is also affected by investment securities and loan and lease maturities and the effect of interest rate fluctuations on the marketability of both assets and liabilities. The loan and lease portfolio consists primarily of floating rate, short-term loans. On December 31, 1998, approximately 41% of total consolidated assets had maturities under one year and 78% of total consolidated loans and leases had floating rates tied to the prime rate or similar indexes. The short-term nature of the loan and lease portfolio, and loan agreements which generally require monthly interest payments, provide the Company with an additional secondary source of liquidity.
The Company's liquidity is maintained by cash flows stemming from dividends and management fees from the Bank and the exercise of stock options issued to the Bank's employees and directors. The amount of dividends from the Bank is subject to certain regulatory restrictions as discussed in Note 17 of the Notes to the Consolidated Financial Statements and elsewhere within this Report. Subject to said restrictions, at December 31, 1998, up to $8.9 million could have been paid to the parent Company by the Bank without regulatory approval. The Company's parent-only financial statements are presented in Note 16 of the Notes to Consolidated Financial Statements. Dividends of $4.5 million and $2.6 million were paid to the parent company during 1998 and 1997, respectively.
There are no material commitments for capital expenditures in 1999 or beyond.
Effects of Inflation - --------------------
The most direct effect of inflation on the Company is higher interest rates. Because a significant portion of the Bank's deposits are represented by non interest-bearing demand accounts, changes in interest rates have a direct impact on the financial results of the Bank. See "Asset/Liability Management." Another effect of inflation is the upward pressure on the Company's operating expenses. Inflation did not have a material effect on the Bank's operations in 1998, 1997 or 1996.
ITEM 7A:
ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK - --------------------------------------------------------------------
The Company defines interest rate sensitivity as the measurement of the mismatch in repricing characteristics of assets, liabilities and off-balance sheet instruments at a specified point in time. This mismatch (known as interest rate sensitivity gap) represents the potential mismatch in the change in the rate of interest income and interest expense that would result from a change in interest rates. Mismatches in interest rate repricing among assets and liabilities arise primarily from the interaction of various customer businesses (i.e., types of loans and leases versus the types of deposits maintained) and from management's discretionary investment and funds gathering activities. The Company attempts to manage its exposure to interest rate sensitivity. However, due to its size and direct competition from the major banks, the Company must offer products which are competitive in the market place, even if less than optimum with respect to its interest rate exposure.
The Company's balance sheet position at December 31, 1998 was asset-sensitive, based upon the significant amount of variable rate loans and the repricing characteristics of its deposit accounts. This position provides a hedge against rising interest rates, but has a detrimental effect during times of interest rate decreases. Net interest revenues are negatively impacted by a decline in interest rates. The interest rate gap is a measure of interest rate exposure and is based upon the known repricing dates of certain assets and liabilities and assumed repricing dates of others. See "Financial Review - Net Interest Income and Margin."
In evaluating the Company's exposure to interest rate risk, certain shortcomings inherent in the method of analysis presented in the following table must be considered. For example, although certain assets and liabilities may have similar maturities or periods to reprice, they may react in different degrees to changes in market interest rates. Additionally, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market interest rates. Further, certain earning assets have features which restrict changes in interest rates on a short-term basis and over the life of the asset. The Company considers the anticipated effects of these various factors when implementing its interest rate risk management activities, including the utilization of certain interest rate hedges.
ITEM 8:
ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ----------------------------------------------------
The following section includes the Company's Consolidated Financial Statements:
Independent Auditors' Report
Consolidated Balance Sheets - December 31, 1998 and 1997
Consolidated Statements of Income for the Years Ended December 31, 1998, 1997 and 1996
Consolidated Statements of Shareholders' Equity and Comprehensive Income for the Years Ended December 31, 1998, 1997 and 1996
Consolidated Statements of Cash Flows for the Years Ended December 31, 1998, 1997 and 1996
Notes to Consolidated Financial Statements
Independent Auditors' Report
The Board of Directors SJNB Financial Corp.:
We have audited the accompanying consolidated balance sheets of SJNB Financial Corp. and subsidiary (the Company) as of December 31, 1998 and 1997, and the related consolidated statements of income, shareholders' equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 1998. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. 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, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of SJNB Financial Corp. and subsidiary as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1998, in conformity with generally accepted accounting principles.
KPMG LLP
Mountain View, California January 14, 1999
Notes to Consolidated Financial Statements December 31, 1998, 1997 and 1996
NOTE 1 - Summary of Significant Accounting Policies
SJNB Financial Corp. ("Company") is a bank holding company registered under the Bank Holding Company Act of 1956, as amended. The Company was incorporated under the laws of the State of California on April 18, 1983. Its principal office is located at One North Market Street, San Jose, California, 95113.
The Company owns 100% of the issued and outstanding common shares of San Jose National Bank (referred to herein as "SJNB" or "the Bank"). The Bank was incorporated on November 23, 1981 and commenced business in San Jose, California on June 10, 1982. Its main office is located at One North Market Street, San Jose, California. SJNB engages in the general commercial banking business with special emphasis on the banking needs of the business and professional communities in San Jose and the surrounding areas. The Financial Services Division is located at 95 South Market, San Jose, California, where it engages in the factoring of accounts receivable.
The accounting policies of SJNB Financial Corp. and San Jose National Bank (collectively, the "Company") are in accordance with generally accepted accounting principles and conform to general practices within the banking industry.
a. Consolidation
The consolidated financial statements include the accounts of SJNB. All material intercompany accounts and transactions have been eliminated in the consolidated financial statements.
b. Investment Securities
The Company accounts for its investment securities as follows:
Available for sale-Investment securities that are acquired without the intent to hold until maturity are classified as available for sale. Such securities are valued at market value. Market value adjustments are reported as a separate component of shareholders' equity until realized.
Held to maturity-Investment securities purchased with the intent and ability to hold them until maturity are classified as held to maturity. Such securities are carried at cost, adjusted for accretion of discounts and amortization of premiums.
Investment securities purchased are recorded as of their trade date. Accretion of discounts and amortization of premiums arising at acquisition are included in income using methods approximating the interest method. Gains or losses on sales of securities, if any, are determined based on the specific identification method.
c. Loans and Leases and Allowance for Possible Loan and Lease Losses
Loans and leases generally are stated at the principal amount outstanding. Interest on loans is credited to income on a simple interest basis. Unearned revenue on direct financing leases is accreted over the lives of the leases in decreasing amounts to provide a constant rate of return on the net investment in the leases. Loan origination fees and direct origination costs, including initial direct cost of lease origination are deferred and amortized to income by a method approximating the level yield method over the estimated lives of the underlying loans. The accrual of interest on loans and leases is discontinued and any accrued and unpaid interest is reversed when, in the opinion of management, there is significant doubt as to the collectibility of interest or principal or when the payment of principal or interest is ninety days past due, unless the amount is well-secured and in the process of collection.
The allowance for possible loan and leases losses is a valuation allowance maintained to provide for future loan losses through charges to current operating expense. The allowance is based upon a continuing review of loans by management which includes consideration of changes in the character of the loan portfolio, current and anticipated economic conditions, past lending experience and such other factors which, in management's judgment, deserve recognition in
estimating potential loan losses. In addition, regulatory examiners may require the Company to recognize additions to the allowance based on their judgments about information available to them at the time of their examinations.
Impaired loans are those in which, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement, including scheduled interest payments. The Company measures such loans based on the present value of future cash flows discounted at the loan's effective interest rate, or at the loan's market value or the fair value of the collateral if the loan is secured. If the measurement of the impaired loan is less than the recorded investment in the loan, impairment is recognized by creating or adjusting an existing allocation of the allowance for loan losses. Recognition of interest income on impaired loans is as stated in the first paragraph above of this footnote 1(c).
d. Premises and Equipment
Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization are charged to expense over the estimated useful lives of the assets on a straight-line basis as follows:
Buildings 30 years Furniture and equipment 3-10 years Improvements 7-15 years
e. Intangibles
Goodwill is amortized using the straight-line method over 15 years. Core deposit intangibles are amortized using an accelerated method over ten years.
On a periodic basis, the Company reviews its intangible assets for events or changes in circumstances that may indicate that the carrying amount of the assets may not be recoverable. Should such a change indicate that the value of such intangibles may be impaired, an evaluation of the recoverability would be performed, using undiscounted cash flows, prior to any writedown of the assets.
f. Interest Rate Instruments
Interest rate instruments are entered into in conjunction with the Bank's asset/liability management. As these contracts are entered into only after meeting the accounting criteria for a hedge, and as long as they continue to meet such criteria, changes in market value are deferred and the net settlements are accrued as adjustments to interest income. The Bank currently has outstanding an interest rate floor arrangement which does not meet the accounting criteria for a hedge and which therefore is accounted for on a mark to market basis.
g. Income Taxes
The Company accounts for income taxes using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences of differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
Under the asset and liability method, deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carryforwards, and then a valuation allowance is established to reduce that deferred tax asset if it is "more likely than not" that the related tax benefits will not be realized.
h. Stock-based Compensation
The Company applies Accounting Principles Board ("APB") Opinion No. 25 and related Interpretations in accounting for its stock options. Accordingly, no compensation cost has been recognized.
i. Net Income Per Share
In December 1997, the Company implemented Statement of Financial Accounting Standards (SFAS) No. 128, Earnings Per Share. SFAS No. 128 establishes standards for computing and reporting earnings per share (EPS) and applies to entities with publicly held common stock. This statement supersedes APB Opinion No. 15.
Basic net income per share is computed by dividing net income by the weighted average number of shares of common stock outstanding during the year. Diluted net income per share is computed by dividing net income by the weighted average number of shares of common stock outstanding during the year plus shares issuable assuming exercise of all employee stock options, except where anti-dilutive.
j. Comprehensive income
Effective January 1, 1998, the Company adopted SFAS No. 130, Reporting Comprehensive Income, which establishes new rules for the reporting and display of comprehensive income and its components. The adoption of this statement had no impact on net income or shareholders' equity. SFAS No. 130 requires the Company's net unurealized gains or losses on available-for-sale securities to be included in other comprehensive income. Comprehensive income is included in the statement of shareholders' equity for the periods presented.
k. Statement of Cash Flows
For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, fed funds sold and money market investments.
l. Use of Estimates
Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent asset and liabilities to prepare these financial statement in conformity with generally accepted accounting principles. Actual results could differ from those estimates.
m. Impairment of Long-lived Assets
Long-lived assets and certain identifiable intangibles held and used by an entity are reviewed for impairment whenever events or changes indicate that the carrying amount of an asset may not be recoverable. The Company has not identified any long-lived assets or identifiable intangibles which were impaired.
n. Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities
SFAS No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities based on consistent application of a financial-components approach that focuses on control. It distinguishes transfers of financial assets that are sales from transfers that are secured borrowings. Under this approach, after a transfer of financial assets, an entity recognizes all financial and servicing assets it controls and liabilities it has incurred and derecognizes financial assets it no longer controls and liabilities that have been extinguished. The Company did not have any significant transactions in which this Statement had any impact on its consolidated financial statements.
o. Segments of an Enterprise and Related Information
SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, requires certain information about the operating segments of the Company. The objective of requiring disclosures about segments of an enterprise and related information is to provide information about the different types of business activities in which an enterprise engages and the different economic environments in which it operates to help users of financial statements better understand its performance; better assess its prospects for future cash flows
and make more informed judgments about the enterprise as a whole. The Company has determined it has three segments, general commercial banking, leases, and factoring/asset based financing. Neither leasing nor factoring and asset based financing meet the required thresholds for disagregation and therefore the disclosures and related information about such segments has not been included in the consolidated financial statements. At such time these segments meet the required thresholds, such disclosures and other information will be included. It is expected they will meet the thresholds in 1999.
p. Derivative Instruments and Hedging Activities
In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. This Statement requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The Statement is effective for fiscal quarters of fiscal years beginning after June 15, 1999. The Company expects to adopt this Statement on January 1, 2000. Currently, management believes the Statement would not have a significant effect on the Company's consolidated financial position or its consolidated statement of operations.
q. Reclassification
Certain 1997 and 1996 amounts have been reclassified to conform with the 1998 presentation.
NOTE 2 - Acquisitions
On January 2, 1996 the Company acquired Astra Financial Inc. (Astra) which was accounted for as a purchase transaction. Astra was an asset-based lending company based in San Jose, California. Its outstanding factoring receivables were approximately $2.2 million as of December 31, 1995. The purchase price of Astra was approximately $760.
On May 22, 1998 SJNB acquired all of the stock of a private company, Epic Funding Corporation (Epic), pursuant to a definitive agreement dated April 13, 1998. In connection with the acquisition, which was structured as a tax-free reorganization and accounted for as a purchase transaction for accounting purposes, SJNB issued 12,223 shares of its common stock and paid $110 to Epic's shareholder in exchange for all of Epic's outstanding stock. Total purchase price was $611, while Epic's fair value of net assets was $28; goodwill amounted to $759 including certain expenses of the transaction. Epic provides direct and vendor lease programs and accounts receivable financing to manufacturers and equipment users throughout California and across parts of the United States. Epic is a wholly-owned subsidiary of the Bank. Epic's office is located in Danville, California; together with a small de novo branch at the same facility which was opened on July 1, 1998.
NOTE 3 - Cash and Due from Banks
The Federal Reserve requires the Bank to maintain average reserve balances for certain deposit balances. Such required reserves were none as of December 31, 1998 and approximately $6.0 million as of December 31, 1997.
NOTE 4 - Investment Securities
Investment securities as of December 31, 1998 and 1997 are summarized as follows:
As of December 31, 1998 and 1997 investment securities with carrying values of approximately $18.6 million and $39 million, respectively, were pledged as collateral for deposits of public funds and other purposes. Investment in Federal Reserve Bank stock is carried at cost, which is approximately equal to its market value.
The following tables provide the scheduled maturities of the Company's investment securities portfolio as of December 31, 1998:
Mutual funds consist of several funds invested in U. S. Government securities and government issued adjustable rate mortgages (ARMS).
Interest income earned on U. S. Treasury, U. S. Government agencies and state and municipal securities for the years ended December 31, 1998, 1997 and 1996 are as follows:
NOTE 5 - Loans
A summary of loans as of December 31, 1998, 1997 and 1996 is as follows:
Concentrations of credit risk arise when a number of customers are engaged in similar business activities, or activities in the same geographic region, or have similar features that would cause their ability to meet contractual obligations to be similarly affected by changes in economic conditions. Although the Company has a diversified loan portfolio, a substantial portion of its customers' ability to honor contracts is reliant upon the economic stability of the Santa Clara Valley, which in some degree relies on the stability of high technology companies in its "Silicon Valley." Loans are generally made on the basis of a secure repayment source, which is based on a detailed cash flow analysis; however, collateral is generally a secondary source for loan qualification.
Approximately 39% of the Company's loan portfolio is made up of real estate - -other loans. This category of real estate loans includes loans on income-bearing commercial properties. In addition, 12% of the loan portfolio is made up of real estate construction loans. These loans consist of approximately 44% residential and 56% commercial. Included in Consumer loans are Prime equity loans of $4.9 million or approximately 2% of the total loan portfolio. Included in the category "Other" are loans to real estate developers for short-term investment purposes and loans to nondevelopers for real estate investment purposes that amount to approximately 2% of the total loan portfolio. This amounts to approximately 55% of the loan portfolio directly related to real estate or real estate interests. Approximately 37% of the total loan portfolio is commercial loans; however, no particular industry represents a significant portion of such loans.
The following is an analysis of the allowance for possible loan losses for the years ended December 31, 1998, 1997 and 1996:
At December 31, 1998, impaired loans totaled $403 with a corresponding valuation allowance of $27. For the year ended December 31, 1998, the average recorded investment in impaired loans was approximately $733. The Company recognized $60 of interest on impaired loans (during the portion of the year they were impaired), of which $8 related to impaired loans for which interest income is recognized on the cash basis.
The balance of nonaccrual loans as of December 31, 1998 and 1997 was approximately $197 and $360, respectively. The effect on interest income had these loans been performing in accordance with contractual terms was $22 in 1998, $61 in 1997 and $35 in 1996. Income actually recognized on these loans was $21 in 1998, $32 in 1997 and $29 in 1996.
The Company has made loans to executive officers, directors and their affiliates in the ordinary course of business. An analysis of activity with respect to such loans during the years ended December 31, 1997, 1996 and 1995 is as follows:
As of December 31, 1998, loans of approximately $12 million were pledged as collateral for the Federal Reserve Discount Window.
NOTE 6 - Premises and Equipment
A summary of premises and equipment as of December 31, 1998 and 1997 is as follows:
NOTE 7 - Time Deposits
As of December 31, 1998 and 1997, the Bank had $78 million and $48 million, respectively, in time deposits in denominations of $100 or more. Interest expense for these deposits was $3.3 million and $3.0 million in 1998 and 1997, respectively. Time deposits in denominations of $100 or more which mature in greater than one year was $13.3 million as of December 31, 1998.
On December 4, 1998 the Bank raised $10 million through the placement of a ten year synthetic floating rate certificate of deposit. The instrument consists of two linked transactions, a callable interest rate swap and callable fixed rate certificate of deposit. Under the swap agreement the Bank pays LIBOR plus 5 basis points and receives 6% for a period of ten years. The swap is callable after one year by the issuer. Simultaneously, the Bank issued a callable 6% fixed rate 10 year certificate of deposit. The certificate of deposit does not have any early redemption clauses, other then by death of the holder. Effectively, the Bank's rate of interest on the combined transaction is LIBOR plus five basis points.
NOTE 8 - Other Short-term Borrowings
Other short-term borrowings include federal funds purchased and securities sold under agreements to repurchase and information relating to these borrowings are summarized below:
Any securities used under securities sold under agreements to repurchase are under the control of the Bank.
The Company's bank subsidiary has informal arrangements with various correspondents providing short-term credit for liquidity requirements; such informal lines aggregated $17.5 million at December 31, 1998.
NOTE 9 - Accumulated other Comprehensive Income
Accumulated other comprehensive income is as follows for the years ended December 31, 1998, 1997, and 1996:
NOTE 10 - Earnings per Share
The reconciliation of the numerators and denominators of the basic and diluted earnings per share (EPS) computations are as follows:
NOTE 11 - Income Taxes
Income tax expense for the years ended December 31, 1998, 1997 and 1996 consists of the following:
Total income tax expense differed from the amount computed by applying the U. S. federal income tax rates in years ended December 31, 1998, 1997 and 1996 of 34% to income before income taxes as a result of the following:
The tax effects of temporary differences that gave rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1998 and 1997, are presented below:
Amounts for the current year are based upon estimates and assumptions as of the date of this report and could vary significantly from amounts shown on the tax returns as filed. Accordingly, the variances from the amounts previously reported for 1997 are primarily as a result of adjustments to conform to tax returns as filed.
Deferred tax assets related to purchase accounting adjustments include the tax effect of fair market value adjustments of the assets and liabilities of businesses acquired. The Company believes that the net deferred tax asset is realizable through sufficient taxable income within the carryback periods and the current year's taxable income.
NOTE 12 - Detail of Other Expense
Other expense for the years ended December 31, 1998, 1997 and 1996 consists of the following:
NOTE 13 - Stock Option Plan
During 1996 the shareholders of the Company approved the 1996 Stock Option Plan (the "Plan"), which replaced the then existing two stock option plans. The 1996 Stock Option Plan is described below. In accordance with APB 15, no compensation cost has been recognized for the Plan. Had compensation cost for the Plan been determined consistent with SFAS No. 123, the Company's net income and earnings per share would have been adjusted to the pro forma amounts for options granted for the years 1998, 1997 and 1996 indicated below:
The above amounts include the impact on net income and net income per share for options granted during the years 1995 through 1998; such amounts would have been substantially different if options granted prior to 1995 had been included in the computation.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in the following years:
The 1996 Stock Option Plan provides that either incentive stock options or nonstatutory stock options may be granted to certain key employees or directors to purchase authorized, but unissued, Common Stock of the Company. Shares may be purchased at a price not less than the fair market value of such stock on the date of the grant. Generally, stock options become exercisable 40% one year after the date of grant and 20% in each of the following three years. They expire no later than ten years after the date of the grant. The Plan provides that outside directors will automatically receive a nonstatutory option covering 5,000 shares annually at an exercise price equal to 100% of the market price of the Common Stock on the date of grant. The 1996 Stock Option Plan replaced the previous two plans which had similar provisions. If options granted under the prior plans expire without being exercised, the corresponding common shares shall become available for awards under the Plan. During 1998, 3,490 shares became available under this provision. The number of shares available for future grants of options under the 1996 Stock Option Plan was 158,755 as of December 31, 1998.
Activity under the stock plans is as follows:
The weighted-average fair value of options granted during 1998, 1997 and 1996 was $14.38, $13.28 and $6.22 respectively.
The following table summarizes options outstanding and exercisable at December 31, 1998:
NOTE 14 - Commitments and Contingent Liabilities
In the normal course of business, there are outstanding commitments, such as commitments to extend credit, which are not reflected in the consolidated financial statements. These commitments involve, to varying degrees, credit risk in excess of the amount recognized as either an asset or liability in the consolidated balance sheet. The Company controls the credit risk through its credit approval process. The same credit policies are used when entering into such commitments. Management does not anticipate any loss from such commitments. As of December 31, 1998, amounts committed to extend credit under normal lending agreements aggregated approximately $139 million for undisbursed variable loan commitments and approximately $6.3 million for commitments under unused standby letters of credit and other guarantees.
The Bank utilizes various financial instruments with off-balance sheet risk to reduce its exposure to fluctuations in interest rates. These financial
instruments involve, to varying degrees, credit and interest rate risk in excess of the amount recognized as either an asset or liability in the statement of financial position.
The credit risk is the possibility that a loss may occur because a party to a transaction fails to perform according to the terms of the contract. Interest rate risk is the possibility that future changes in market prices will cause a financial instrument to be less valuable or more onerous. The Bank attempts to control the credit risk arising from these instruments through its credit approval process and through the use of risk control limits and monitoring procedures. Interest rate risk is managed by various asset and liability methods including the utilization of interest rate hedging vehicles.
Also at December 31, 1998, the Bank had outstanding interest rate floors as follows:
Notional amount $10,000 $10,000 Floor rate 7.00% 8.50% Remaining life (months) 4 11 Carrying amount $3 $98 Fair market value ------ $82 Expiration date May 10, 1999 December 11, 1999
The Bank has paid a fixed premium for which it will receive the amount of interest based on the notional amount and the difference between the floor rate and the current Prime when Prime is less than floor rate. This will protect the Bank against decreases in its net income when Prime decreases.
The Company is obligated under its lease agreement for 95 South Market Street under a noncancelable operating lease through September 2004. The lease is subject to periodic adjustment based on changes in the CPI. The following table shows future minimum payments under the lease as of December 31, 1998:
- ------------------------------------------------------------ Years Ending December 31, (in thousands) 1999 $311 2000 314 2001 276 2002 237 2003 237 Thereafter 178 Total minimum lease payments $1,553 ============================================================
Total minimum lease payments to be received under noncancelable operating subleases at December 31, 1998 are approximately $1.1 million; these payments are not reflected in the above table.
There is ordinary routine litigation incidental to the business pending against the Company but, in the opinion of management, liabilities (if any) arising from such claims will not have a material effect upon the consolidated financial statements of the Company.
NOTE 15 - Fair Value of Financial Instruments
SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," requires disclosure of estimated fair values for the Company's financial instruments. Fair value estimates, methods and assumptions, set forth below for the Company's financial instruments, are made solely to comply with the requirements of SFAS No. 107 and should be read in conjunction with the consolidated financial statements and notes thereto in this Annual Report.
Fair values are based on estimates or calculations at the transaction level using present value techniques in instances where quoted market prices are not available. Because broadly traded markets do not exist for most of the Company's financial instruments, the fair value calculations attempt to incorporate the effect of current market conditions at a specific time. Fair valuations are management's estimates of the values, and they are often calculated based on
current pricing policy, the economic and competitive environment, the characteristics of the financial instruments, and other such factors. These calculations are subjective in nature, involve uncertainties and matters of significant judgment and do not include tax ramifications; therefore, the results cannot be determined with precision, substantiated by comparison to independent markets and may not be realized in an actual sale or immediate settlement of the instruments. The fair valuations have not been updated since year end; therefore, the valuations may have changed significantly since that point in time.
The Company has not included certain material items in its disclosure, such as the value of the long-term relationships with the Company's deposit customers, since these intangibles are not financial instruments. There may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results. For all these reasons, the aggregation of the fair value calculations presented herein do not represent, and should not be construed to represent, the underlying value of the Company.
The following table presents a summary of the Company's financial instruments, as defined by SFAS No. 107 as of December 31, 1998 and 1997:
The methodology and assumptions utilized to estimate the fair value of the Company's financial instruments, not previously discussed above, are described below:
Financial instruments with fair value approximate to carrying value - The carrying value of cash and due from banks, money market investments, accrued interest receivable, noninterest-bearing demand accounts, interest-bearing checking, money market and savings deposit accounts, accrued interest receivable and expense approximates fair value due to the short-term nature of these financial instruments.
Investment securities - The estimated fair values of securities by type are based on quoted market prices when available.
Loans and leases - The carrying amount of loans and leases is net of unearned fee income and the reserve for possible loan and lease losses. The fair valuation calculation process differentiates loans and leases based on their financial characteristics, such as product classification, loan category, pricing features and remaining maturity. Prepayment estimates are evaluated by product and respective interest rate. Discount rates presented in the paragraphs below have a wide range due to the Company's mix of fixed and variable rate products.
The fair value of loans and leases is calculated by discounting contractual cash flows using discount rates that reflect the Company's current pricing for loans and leases with similar characteristics and remaining maturity. Most of the discount rates applied to these loans were between 7.7% and 10.9% at December 31, 1998.
Additionally, the allowance for loan and lease losses was applied against the estimated fair value of loans and leases to recognize future defaults of contractual cash flows.
Fair value for nonperforming loans and leases is based on discounting estimated cash flows using a rate commensurate with the risk associated with the estimated cash flows, or underlying collateral values, where appropriate.
Deposits - The fair value of certificates of deposit and other time deposits is calculated based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for like deposits with similar remaining maturities.
Other short-term borrowings - A reasonable estimate of the fair value of federal funds sold is the carrying amount because of the relatively short period of time between the origination of the instrument and its expected maturity.
The fair value of the Company's securities sold under repurchase agreements is calculated based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for such instruments with similar remaining maturities.
Commitment to extend credit - The majority of the Company's commitments to extend credit carry variable and current market interest rates if converted to loans or leases. Because these commitments are generally unassignable by either the Company or the borrower, they only have value to the Company and the borrower. The estimated fair value approximates the recorded deferred fee amounts and is excluded from the table.
Derivative financial instruments - The fair value of the interest rate floor generally reflects the estimated amounts the Company would receive based upon dealer quotes, to terminate such agreements at the reporting date.
NOTE 16 - SJNB Financial Corp. (Parent Company Only)
The following are the financial statements of SJNB Financial Corp. (parent company only):
NOTE 17- Regulatory Matters
The Federal Reserve Board, the Comptroller of the Currency and the FDIC have issued substantially similar risk-based and leverage capital guidelines applicable to United States banking organizations. In addition, those regulatory agencies may from time to time require that a banking organization maintain capital above the minimum levels, whether because of its financial condition or actual or anticipated growth.
The Federal Reserve Board risk-based guidelines define a two-tier capital framework. Tier 1 capital consists of common and qualifying preferred shareholders' equity, less certain intangibles and other adjustments. Tier 2 capital consists of subordinated and other qualifying debt, and the allowance for possible loan and lease losses up to 1.25% of risk weighted assets. The total of Tier 1 and Tier 2 capital, less investments in unconsolidated subsidiaries, represents qualifying total capital, at least 50% of which must consist of Tier 1 capital. Risk-based capital ratios are calculated by dividing Tier 1 and total capital by risk-weighted assets. Assets and off-balance sheet exposures are assigned to one of four categories of risk-weights, based primarily on relative credit risk. The minimum tier 1 risk-based capital ratio is 4% and the minimum total risk-based capital ratio is 8%. The leverage capital ratio is determined by dividing Tier 1 capital by adjusted average total assets. Although the stated minimum leverage capital ratio is 3%, most banking organizations are required to maintain leveraged capital ratios of at least 100 to 200 basis points above the 3%.
The table below summarizes the Tier 1 and total risk-based capital ratios and leverage capital ratios of the Company and the Bank as of the dates indicated:
The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), among other things, identifies five capital categories for insured depository institutions, (well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized) and requires the respective Federal regulatory agencies to implement systems for "prompt corrective action" for insured depository institutions that do not meet minimum capital requirements within such categories. FDICIA imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the category in which an institution is classified. Failure to meet the capital guidelines could also subject a banking institution to capital raising requirements. An "undercapitalized" bank must develop a capital restoration plan and its parent holding company must guarantee the bank's compliance with the plan. The liability of the parent holding company under any such guarantee is limited to the lesser of 5% of the bank's assets at the time it became "undercapitalized" or the amount needed to comply with the plan. Furthermore, in the event of the bankruptcy of the parent holding company, such guarantee would take priority over the parent's general unsecured creditors.
The various regulatory agencies have adopted substantially similar regulations that define the five capital categories identified by FDICIA, using the total risk-based capital, Tier 1 risk-based capital and leverage capital ratios as the relevant capital measures. Such regulations establish various degrees of corrective action to be taken when an institution is considered undercapitalized. Under the regulations, a "well capitalized" institution must have a Tier 1 capital ratio of at least 6%, a total capital ratio of at least 10% and a leverage ratio of at least 5% and not be subject to a capital directive order. An "adequately capitalized" institution must have a Tier 1 capital ratio of at least 4%, or 3% in some cases. Under these guidelines, the Company and the Bank were considered well capitalized at December 31, 1998 and 1997.
Banking agencies have recently adopted final regulations which mandate that regulators take into consideration concentrations of credit risk and risks from non-traditional activities, as well as an institution's ability to manage those risks, when determining the adequacy of an institution's capital. This evaluation will be made as part of the institution's regular safety and soundness examination. Banking agencies also have recently adopted final regulations requiring regulators to consider interest rate risk (when the interest rate sensitivity of an institution's assets does not match the sensitivity of its liabilities or its off-balance-sheet position) in evaluation of a bank's capital adequacy. Concurrently, banking agencies have proposed a methodology for evaluating interest rate risk. After gaining experience with the proposed measurement process, those banking agencies intend to propose further regulations to establish an explicit risk-based capital charge for interest rate risk.
The ability of the Company to pay dividends largely depends upon the dividends paid to it by the Bank. There are legal limitations on the ability of the Bank to provide funds to the Company in the form of loans, advances or dividends. Under national banking law, without the prior approval of the Comptroller of the Currency, the Bank may not declare dividends in any calendar year that exceed the Bank's net profits for that year, as defined by statute, combined with its net retained profits, as defined, for the preceding two years. As of December 31, 1998, the Bank may initiate dividend payments without prior regulatory approval of up to $8.9 million.
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 - ------------------------------------------------------------
Information concerning directors, executive officers, promoters and control persons and compliance with Section 16(a) of the Exchange Act is incorporated by reference to the text under the captions "Election of Directors," "Executive Compensation and Transactions with Directors and Officers" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Registrant's Proxy Statement for its 1999 Annual Meeting of Shareholders.
ITEM 11:
ITEM 11: EXECUTIVE COMPENSATION - --------------------------------
Information concerning executive compensation is incorporated by reference to the text under the caption "Executive Compensation and Transactions with Directors and Officers" in the Registrant's Proxy Statement for its 1999 Annual Meeting of Shareholders.
ITEM 12:
ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ------------------------------------------------------------------------
Information concerning security ownership of certain beneficial owners and management is incorporated by reference to the text under the captions "Security Ownership of Directors and Management" and "Security Ownership of Certain Beneficial Owners in the Registrant's Proxy Statement for its 1999 Annual Meeting of Shareholders.
ITEM 13:
ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - --------------------------------------------------------
Information concerning certain relationships and related transactions is incorporated by reference to the text under the caption "Executive Compensation and Transactions with Directors and Officers" of the Registrant's Proxy Statement for its 1999 Annual Meeting of Shareholders.
PART IV -------
ITEM 14:
ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K - -------------------------------------------------------------------------
(a) 1. All Financial Statements
See Index to Financial Statements on page 35 hereof.
(a) 2. Financial statements schedules required. None. (Information included in Financial Statements).
(a) 3. Exhibits
The following exhibits are filed as part of this report:
Exhibit Number
(3) (i). The Registrant's restated Articles of Incorporation are hereby incorporated by reference to Exhibit (3) a. of the Registrant's Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1998.
(3) (ii). The Registrant's restated Bylaws as of July 23, 1998 are hereby incorporated by reference to Exhibit (3) b. of the Registrant's Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1998.
*(10) a. The Registrant's 1992 Employee Stock Option Plan is hereby incorporated by reference from Exhibit 4.1 of the Registrant's Registration Statement on Form S-8, as filed on September 4, 1992, under Registration No. 33-51740.
*(10) b. Amendment No. 1 to the 1992 Employee Stock Option Plan.
*(10) c. The form of Incentive Stock Option Agreement being utilized under the 1992 Employee Stock Option Plan is hereby incorporated by reference from Exhibit 4.2 of the Registrant's Registration Statement on Form S-8, as filed on September 4, 1992, under Registration No. 33-51740.
*(10) d. The form of Stock Option Agreement being utilized under the 1992 Employee Stock Option Plan is hereby incorporated by reference from Exhibit 4.3 of the Registrant's Registration Statement on Form S-8, as filed on September 4, 1992, under Registration No. 33-51740.
*(10) e. The Registrant's Amended 1996 Stock Option Plan is incorporated by reference to exhibit 99.1 of the Registrant's Form S-8 filed July 1, 1998.
*(10) f. The form of Nonstatutory Stock Option Agreement for Outside Directors being utilized under the Amended 1996 Stock Option Plan.
*(10) g. The form of Nonstatutory Stock Option Agreement for Employees being utilized under the Amended 1996 Stock Option Plan.
*(10) h. The form of Incentive Stock Option Agreement being utilized under the Amended 1996 Stock Option Plan.
*(10) i. Agreement between James R. Kenny and SJNB Financial Corp. and San Jose National Bank dated March 27, 1996 is hereby incorporated by reference to Exhibit (10) m. of the Registrant's Quarterly Report on Form 10-QSB for the quarterly period ended March 31, 1996.
*(10) j. Agreement between Eugene E. Blakeslee and SJNB Financial Corp. and San Jose National Bank dated March 27, 1996 is hereby incorporated by reference to Exhibit (10) n. of the Registrant's Quarterly Report on Form 10-QSB for the quarterly period ended March 31, 1996.
(10) k. Sublease dated April 5, 1982, for premises at 95 South Market Street, San Jose, CA is hereby incorporated by reference to Exhibit (10) n. of the Registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1994.
(10) l. Sublease by and between McWhorter's Stationary and San Jose National Bank, dated July 6, 1995, and as amended August 11, 1995 and September 21, 1995, for premises at 95 South Market Street, San Jose CA is hereby incorporated by reference to Exhibit (10) o. of the Registrant's Quarterly Report on Form 10-QSB for the quarterly period ended September 30, 1995.
(22) Subsidiary of Registrant.
(23) Consent of KPMG LLP.
(27) Financial Data Schedule.
* Indicates management contract or compensation plan or arrangement.
(b) Reports on Form 8-K
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: March 18, 1999 SJNB Financial Corp.
By: S/J.R. Kenny By: S/E.E. Blakeslee ------------------------------ ------------------------------ James R. Kenny Eugene E. Blakeslee President and Chief Executive Vice President & Executive Officer Chief Financial Officer
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.
S/J.R. Kenny S/F.J. Gorry ------------------------------ ------------------------------ James R. Kenny F. Jack Gorry, Director President, Chief Executive Officer March 18, 1999 and Director (Principal Executive Officer) March 18, 1999
S/E.E. Blakeslee S/A.K. Lund ------------------------------ ------------------------------ Eugene E. Blakeslee Arthur K. Lund, Director Executive Vice President and March 18, 1999 Chief Financial Officer and Chief Accounting Officer (Principal Financial Officer and Principal Accounting Officer March 18, 1999
S/R.S. Akamine S/L. Oneal ------------------------------ ------------------------------ Ray S. Akamine, Director Louis Oneal, Directo March 18, 1999 March 18, 1999
S/R.A. Archer S/D. Rubino ------------------------------ ------------------------------ Robert A. Archer Diane Rubino, Director Chairman and Director March 18, 1999 March 18, 1999
S/A.B. Bruno S/D.L. Shen ------------------------------ ------------------------------ Albert V. Bruno, Director Douglas L. Shen, Director March 18, 1999 March 18, 1999
S/R. Diridon S/G.S. Vandeweghe ------------------------------ ------------------------------ Rod Diridon, Director Gary S. Vandeweghe, Director March 18, 1999 March 18, 1999
SJNB Financial Corp.
Form 10-K
Exhibits
December 31, 1998
The following exhibits are filed as part of this report: