ITEM 1. BUSINESS
General
First Capital, Inc. (the “Company” or
“First Capital”) was incorporated under Indiana law on September 11, 1998. On December 31, 1998, the Company became
the holding company for First Federal Bank, A Federal Savings Bank (the “Bank”) upon the Bank’s reorganization
as a wholly owned subsidiary of the Company resulting from the conversion of First Capital, Inc., M.H.C. (the “MHC”),
from a federal mutual holding company to a stock holding company. On January 12, 2000, the Company completed a merger of equals
with HCB Bancorp, the former holding company for Harrison County Bank, and the Bank changed its name to First Harrison Bank. On
March 20, 2003, the Company acquired Hometown Bancshares, Inc. (“Hometown”), a bank holding company located in New
Albany, Indiana. On December 4, 2015, the Company acquired Peoples Bancorp, Inc. of Bullitt County and its wholly-owned bank subsidiary,
Peoples Bank of Bullitt County (“Peoples”), headquartered in Shepherdsville, Kentucky.
The Company’s primary business activity is
the ownership of the outstanding common stock of the Bank. Management of the Company and the Bank are substantially similar and
the Company neither owns nor leases any property, but instead uses the premises, equipment and furniture of the Bank in accordance
with applicable regulations.
The Bank is regulated by the Office of the Comptroller
of the Currency (the “OCC”) and the Federal Deposit Insurance Corporation (the “FDIC”). The Bank’s
deposits are federally insured by the FDIC under the Deposit Insurance Fund. The Bank is a member of the Federal Home Loan Bank
(“FHLB”) System.
Availability of Information
The Company’s Annual Report on Form 10-K,
Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to such reports filed or furnished pursuant to
Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are made available free of charge on the Company’s Internet
website, www.firstharrison.com, as soon as practicable after the Company electronically files such material with, or furnishes
it to, the Securities and Exchange Commission. The contents of the Company’s website shall not be incorporated by reference
into this Form 10-K or into any reports the Company files with or furnishes to the Securities and Exchange Commission.
Market Area and Competition
The Bank considers Harrison, Floyd, Clark and Washington
counties in Indiana and Bullitt County in Kentucky its primary market area. All of its offices are located in these five counties,
which results in most of the Bank’s loans being made in these five counties. The main office of the Bank is located in Corydon,
Indiana, 35 miles west of Louisville, Kentucky. The Bank aggressively competes for business with local banks, as well as large
regional banks. Its most direct competition for deposit and loan business comes from the commercial banks operating in these five
counties. Based on data published by the FDIC, the Bank is the leader among FDIC-insured institutions in deposit market share in
Harrison County, Indiana, which includes the Bank’s main office, and in Bullitt County, Kentucky, where Peoples was headquartered.
Lending Activities
General.
Over the last few years,
the Bank has continued to transform the composition of its balance sheet from that of a traditional thrift institution to that
of a commercial bank. On the asset side, this is being accomplished in part by selling in the secondary market the newly-originated
qualified fixed-rate residential mortgage loans while retaining variable rate residential mortgage loans in the portfolio. This
transformation is also enhanced by an expanded commercial lending staff dedicated to growing commercial real estate and commercial
business loans. The Bank also continues to originate consumer loans and residential construction loans for the loan portfolio.
The Bank does not offer, and has not offered, Alt-A, sub-prime or no-document mortgage loans.
Loan Portfolio Analysis.
The following
table presents the composition of the Bank’s loan portfolio by type of loan at the dates indicated.
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At December 31,
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2015
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2014
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2013
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2012
|
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2011
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Amount
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Percent of Total
|
|
Amount
|
|
Percent of Total
|
|
Amount
|
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Percent of
Total
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|
Amount
|
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Percent of Total
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Amount
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Percent of Total
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(Dollars in thousands)
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Mortgage Loans:
|
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|
|
|
|
|
|
|
|
|
|
|
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|
|
|
|
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|
|
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|
|
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Residential
(1)
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|
$
|
147,933
|
|
|
|
40.32
|
%
|
|
$
|
106,679
|
|
|
|
34.61
|
%
|
|
$
|
107,029
|
|
|
|
35.65
|
%
|
|
$
|
108,097
|
|
|
|
37.37
|
%
|
|
$
|
116,338
|
|
|
|
40.84
|
%
|
Land
|
|
|
12,962
|
|
|
|
3.53
|
|
|
|
11,028
|
|
|
|
3.58
|
|
|
|
10,309
|
|
|
|
3.43
|
|
|
|
9,607
|
|
|
|
3.32
|
|
|
|
9,910
|
|
|
|
3.48
|
|
Commercial real estate
|
|
|
84,493
|
|
|
|
23.03
|
|
|
|
78,314
|
|
|
|
25.40
|
|
|
|
76,496
|
|
|
|
25.48
|
|
|
|
68,731
|
|
|
|
23.76
|
|
|
|
57,680
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|
|
|
20.25
|
|
Residential construction
(2)
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|
|
16,391
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|
|
|
4.47
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|
|
|
10,347
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|
|
|
3.36
|
|
|
|
14,423
|
|
|
|
4.80
|
|
|
|
12,753
|
|
|
|
4.41
|
|
|
|
10,988
|
|
|
|
3.86
|
|
Commercial real estate construction
|
|
|
1,090
|
|
|
|
0.30
|
|
|
|
1,422
|
|
|
|
0.46
|
|
|
|
1,715
|
|
|
|
0.57
|
|
|
|
3,299
|
|
|
|
1.14
|
|
|
|
743
|
|
|
|
0.26
|
|
Total mortgage loans
|
|
|
262,869
|
|
|
|
71.65
|
|
|
|
207,790
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|
|
|
67.41
|
|
|
|
209,972
|
|
|
|
69.93
|
|
|
|
202,487
|
|
|
|
70.00
|
|
|
|
195,659
|
|
|
|
68.69
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
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|
|
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|
|
|
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|
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Consumer Loans:
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|
|
|
|
|
|
|
|
|
|
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Home equity and second
mortgage loans
|
|
|
38,476
|
|
|
|
10.49
|
|
|
|
37,513
|
|
|
|
12.17
|
|
|
|
34,815
|
|
|
|
11.60
|
|
|
|
36,962
|
|
|
|
12.78
|
|
|
|
38,641
|
|
|
|
13.57
|
|
Automobile loans
|
|
|
28,828
|
|
|
|
7.86
|
|
|
|
25,274
|
|
|
|
8.20
|
|
|
|
23,983
|
|
|
|
7.99
|
|
|
|
21,922
|
|
|
|
7.58
|
|
|
|
20,627
|
|
|
|
7.24
|
|
Loans secured by savings accounts
|
|
|
2,096
|
|
|
|
0.57
|
|
|
|
1,018
|
|
|
|
0.33
|
|
|
|
1,138
|
|
|
|
0.38
|
|
|
|
770
|
|
|
|
0.27
|
|
|
|
767
|
|
|
|
0.27
|
|
Unsecured loans
|
|
|
4,350
|
|
|
|
1.18
|
|
|
|
3,316
|
|
|
|
1.07
|
|
|
|
3,541
|
|
|
|
1.18
|
|
|
|
3,191
|
|
|
|
1.10
|
|
|
|
3,126
|
|
|
|
1.10
|
|
Other
(3)
|
|
|
7,210
|
|
|
|
1.96
|
|
|
|
5,075
|
|
|
|
1.65
|
|
|
|
4,824
|
|
|
|
1.61
|
|
|
|
5,303
|
|
|
|
1.84
|
|
|
|
5,312
|
|
|
|
1.86
|
|
Total consumer loans
|
|
|
80,960
|
|
|
|
22.06
|
|
|
|
72,196
|
|
|
|
23.42
|
|
|
|
68,301
|
|
|
|
22.76
|
|
|
|
68,148
|
|
|
|
23.57
|
|
|
|
68,473
|
|
|
|
24.04
|
|
|
|
|
|
|
|
|
|
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|
|
|
|
|
|
|
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|
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Commercial business loans
|
|
|
23,095
|
|
|
|
6.29
|
|
|
|
28,282
|
|
|
|
9.17
|
|
|
|
21,956
|
|
|
|
7.31
|
|
|
|
18,612
|
|
|
|
6.43
|
|
|
|
20,722
|
|
|
|
7.27
|
|
Total gross loans
|
|
|
366,924
|
|
|
|
100.00
|
%
|
|
|
308,268
|
|
|
|
100.00
|
%
|
|
|
300,229
|
|
|
|
100.00
|
%
|
|
|
289,247
|
|
|
|
100.00
|
%
|
|
|
284,854
|
|
|
|
100.00
|
%
|
Less:
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|
|
|
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|
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|
|
|
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|
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|
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|
|
|
|
|
|
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|
|
|
|
|
|
|
|
Due to borrowers on loans in process
|
|
|
4,926
|
|
|
|
|
|
|
|
3,325
|
|
|
|
|
|
|
|
7,142
|
|
|
|
|
|
|
|
4,306
|
|
|
|
|
|
|
|
4,768
|
|
|
|
|
|
Deferred loan fees net of direct costs
|
|
|
(583
|
)
|
|
|
|
|
|
|
(506
|
)
|
|
|
|
|
|
|
(341
|
)
|
|
|
|
|
|
|
(202
|
)
|
|
|
|
|
|
|
(143
|
)
|
|
|
|
|
Allowance for loan losses
|
|
|
3,415
|
|
|
|
|
|
|
|
4,846
|
|
|
|
|
|
|
|
4,922
|
|
|
|
|
|
|
|
4,736
|
|
|
|
|
|
|
|
4,182
|
|
|
|
|
|
Total loans, net
|
|
$
|
359,166
|
|
|
|
|
|
|
$
|
300,603
|
|
|
|
|
|
|
$
|
288,506
|
|
|
|
|
|
|
$
|
280,407
|
|
|
|
|
|
|
$
|
276,047
|
|
|
|
|
|
____________
|
(1)
|
Includes conventional one- to four-family and multi-family residential loans.
|
|
(2)
|
Includes construction loans for which the Bank has committed to provide permanent financing.
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|
(3)
|
Includes loans secured by lawn and farm equipment, mobile homes and other personal property.
|
Residential Loans.
The Bank’s
lending activities have concentrated on the origination of residential mortgages, both for sale in the secondary market and for
retention in the Bank’s loan portfolio. Residential mortgages secured by multi-family properties totaled $25.7 million, or
17.4% of the residential loan portfolio at December 31, 2015. Substantially all residential mortgages are collateralized by properties
within the Bank’s market area.
The Bank offers both fixed-rate mortgage loans and
adjustable rate mortgage (“ARM”) loans typically with terms of 15 to 30 years. The Bank uses loan documents approved
by the Federal National Mortgage Corporation (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie
Mac”) whether the loan is originated for investment or sale in the secondary market.
Historically, the Bank has retained its residential
loan originations in its portfolio. Retaining fixed-rate loans in its portfolio subjects the Bank to a higher degree of interest
rate risk. See “
Item 1A. Risk Factors–Above Average Interest Rate Risk Associated with Fixed-Rate Loans
”
for a further discussion of certain risks of rising interest rates. Beginning in 2004, one of the Bank’s strategic goals
was to expand its mortgage business by originating mortgage loans for sale, while offering a full line of mortgage products to
current and prospective customers. This practice increases the Bank’s lending capacity and allows the Bank to more effectively
manage its profitability since it is not required to predict the prepayment, credit or interest rate risks associated with retaining
either the loan or the servicing asset. For the year ended December 31, 2015, the Bank originated and funded $31.5 million of residential
mortgage loans for sale in the secondary market. For a further discussion of the Bank’s mortgage banking operations, see
“
Item 1. Business–Mortgage Banking Activities
.”
ARM loans originated have interest rates that adjust
at regular intervals of one to five years, with up to 2.0% caps per adjustment period and 6.0% lifetime caps, based upon changes
in the prevailing interest rates on United States Treasury Bills. The Bank also originates “hybrid” ARM loans, which
are fixed for an initial period three or five years and adjust annually thereafter. The Bank may occasionally use below market
interest rates and other marketing inducements to attract ARM loan borrowers. The majority of ARM loans provide that the amount
of any increase or decrease in the interest rate is limited to 2.0% (upward or downward) per adjustment period and generally contains
minimum and maximum interest rates. Borrower demand for ARMs versus fixed-rate mortgage loans is a function of the level of interest
rates, the expectations of changes in the level of interest rates and the difference between the interest rates and loan fees offered
for fixed-rate mortgage loans and interest rates and loan fees for ARM loans. The relative amount of fixed-rate and ARM loans that
can be originated at any time is largely determined by the demand for each in a competitive environment.
The Bank’s lending policies generally limit
the maximum loan-to-value ratio on fixed-rate and ARM loans to 80% of the lesser of the appraised value or purchase price of the
underlying residential property unless private mortgage insurance to cover the excess over 80% is obtained, in which case the mortgage
is limited to 95% (or 97% under a Freddie Mac program) of the lesser of appraised value or purchase price. The loan-to-value ratio,
maturity and other provisions of the loans made by the Bank are generally reflected in the policy of making less than the maximum
loan permissible under federal regulations, in accordance with established lending practices, market conditions and underwriting
standards maintained by the Bank. The Bank requires title, fire and extended insurance coverage on all mortgage loans originated.
All of the Bank’s real estate loans contain due on sale clauses. The Bank generally obtains appraisals on all its real estate
loans from outside appraisers.
Construction Loans.
The Bank originates
construction loans for residential properties and, to a lesser extent, commercial properties. Although the Bank originates construction
loans that are repaid with the proceeds of a limited number of mortgage loans obtained by the borrower from another lender, the
majority of the construction loans that the Bank originates are permanently financed in the secondary market by the Bank. Construction
loans originated without a commitment by the Bank to provide permanent financing are generally originated for a term of six to
12 months and at a fixed interest rate based on the prime rate.
The Bank originates speculative construction loans
to a limited number of builders operating and based in the Bank’s primary market area and with whom the Bank has well-established
business relationships. At December 31, 2015, the Bank had approved speculative construction loans, a construction loan for which
there is not a commitment for permanent financing in place at the time the construction loan was originated, with total commitments
of $12.0 million and outstanding balances of $8.2 million. The Bank limits the number of speculative construction loans outstanding
to any one builder based on the Bank’s assessment of the builder’s capacity to service the debt.
Most construction loans are originated with a loan-to-value
ratio not to exceed 80% of the appraised estimated value of the completed property. The construction loan documents require the
disbursement of the loan proceeds in increments as construction progresses. Disbursements are based on periodic on-site inspections
by an independent appraiser.
Construction lending is inherently riskier than
residential mortgage lending. Construction loans, on average, generally have higher loan balances than residential mortgage loans.
In addition, the potential for cost overruns because of the inherent difficulties in estimating construction costs and, therefore,
collateral values and the difficulties and costs associated with monitoring construction progress, among other things, are major
contributing factors to this greater credit risk. Speculative construction loans have the added risk that there is not an identified
buyer for the completed home when the loan is originated, with the risk that the builder will have to service the construction
loan debt and finance the other carrying costs of the completed home for an extended time period until a buyer is identified. Furthermore,
the demand for construction loans and the ability of construction loan borrowers to service their debt depends highly on the state
of the general economy, including market interest rate levels and the state of the economy of the Bank’s primary market area.
A material downturn in economic conditions could be expected to have a material adverse effect on the credit quality of the construction
loan portfolio.
Commercial Real Estate Loans.
Commercial
real estate loans are generally secured by small retail stores, professional office space and, in certain instances, farm properties.
Commercial real estate loans are generally originated with a loan-to-value ratio not to exceed 75% of the appraised value of the
property. Property appraisals are performed by independent appraisers approved by the Bank’s board of directors. The Bank
seeks to originate commercial real estate loans at variable interest rates based on the prime lending rate or the United States
Treasury Bill rate for terms ranging from ten to 15 years and with interest rate adjustment intervals of five years. The Bank also
originates fixed-rate balloon loans with a short maturity, but a longer amortization schedule.
Commercial real estate lending affords the Bank
an opportunity to receive interest at rates higher than those generally available from residential mortgage lending. However, loans
secured by such properties usually are greater in amount, more difficult to evaluate and monitor and, therefore, involve a greater
degree of risk than residential mortgage loans. Because payments on loans secured by multi-family and commercial properties are
often dependent on the successful operation and management of the properties, repayment of such loans may be affected by adverse
conditions in the real estate market or the economy. The Bank seeks to minimize these risks by limiting the maximum loan-to-value
ratio to 75% and strictly scrutinizing the financial condition of the borrower, the quality of the collateral and the management
of the property securing the loan. The Bank also obtains loan guarantees from financially capable parties based on a review of
personal financial statements.
Commercial Business Loans.
Commercial
business loans are generally secured by inventory, accounts receivable, and business equipment such as trucks and tractors. Many
commercial business loans also have real estate as collateral. The Bank generally requires a personal guaranty of payment by the
principals of a corporate borrower, and reviews the personal financial statements and income tax returns of the guarantors. Commercial
business loans are generally originated with loan-to-value ratios not exceeding 75%.
Aside from lines of credit, commercial business
loans are generally originated for terms not to exceed seven years with variable interest rates based on the prime lending rate.
Approved credit lines totaled $38.7 million at December 31, 2015, of which $15.7 million was outstanding. Lines of credit are originated
at fixed and variable interest rates for one-year renewable terms.
A director of the Company and the Bank
is
a shareholder of a farm implement dealership that contracts with the Bank to provide sales financing to the dealership’s
customers. The Bank does not grant preferential credit under this arrangement. During the year ended December 31, 2015, the Bank
granted approximately $862,000 of credit to customers of the dealership and all loans purchased from the dealership had an aggregate
outstanding balance of $1.3 million at December 31, 2015. At December 31, 2015, five loans purchased from the dealership were delinquent
30 days or more with an aggregate outstanding balance of $23,000. Under the terms of the agreement between Bank and the dealership,
any losses from contracts purchased from the dealership are split evenly between the Bank and the dealership. No losses were recognized
on contracts purchased from the dealership in 2015 or 2014.
Commercial business lending generally involves greater
risk than residential mortgage lending and involves risks that are different from those associated with residential and commercial
real estate lending. Real estate lending is generally considered to be collateral-based lending with loan amounts based on predetermined
loan-to-collateral values and liquidation of the underlying real estate collateral is viewed as the primary source of repayment
in the event of borrower default. Although commercial business loans are often collateralized by equipment, inventory, accounts
receivable or other business assets, the liquidation of collateral in the event of a borrower default is often an insufficient
source of repayment because accounts receivable may be uncollectible and inventories and equipment may be obsolete or of limited
use, among other things. Accordingly, the repayment of a commercial business loan depends primarily on the creditworthiness of
the borrower (and any guarantors); while liquidation of collateral is a secondary, and often insufficient, source of repayment.
The Bank has seven commercial lenders and two commercial credit analysts committed to growing commercial business loans to facilitate
the changes desired in the Bank’s balance sheet. The Bank also uses an outside loan review company to review selected commercial
credits on an annual basis.
Consumer Loans.
The Bank offers a
variety of secured or guaranteed consumer loans, including automobile and truck loans, home equity loans, home improvement loans,
boat loans, mobile home loans and loans secured by savings deposits. In addition, the Bank offers unsecured consumer loans. Consumer
loans are generally originated at fixed interest rates and for terms not to exceed seven years. The largest portion of the Bank’s
consumer loan portfolio consists of home equity and second mortgage loans followed by automobile and truck loans. Automobile and
truck loans are originated on both new and used vehicles. Such loans are generally originated at fixed interest rates for terms
up to five years and at loan-to-value ratios up to
90% of the blue book value in the case of used vehicles and 90% of the
purchase price in the case of new vehicles.
The Bank originates variable-rate home equity and
fixed-rate second mortgage loans generally for terms not to exceed five years. The loan-to-value ratio on such loans is limited
to 80%, taking into account the outstanding balance on the first mortgage loan.
The Bank’s underwriting procedures for consumer
loans includes an assessment of the applicant’s payment history on other debts and ability to meet existing obligations and
payments on the proposed loans. Although the applicant’s creditworthiness is a primary consideration, the underwriting process
also includes a comparison of the value of the security, if any, to the proposed loan amount. The Bank underwrites and originates
the majority of its consumer loans internally, which management believes limits exposure to credit risks relating to loans underwritten
or purchased from brokers or other outside sources.
Consumer loans generally entail greater risk than
do residential mortgage loans, particularly in the case of consumer loans which are unsecured or secured by assets that depreciate
rapidly, such as automobiles. In the latter case, repossessed collateral for a defaulted consumer loan may not provide an adequate
source of repayment for the outstanding loan and the remaining deficiency often does not warrant further substantial collection
efforts against the borrower. In addition, consumer loan collections depend on the borrower’s continuing financial stability,
and, therefore, are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the
application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount
which can be recovered on such loans. Such loans may also give rise to claims and defenses by the borrower against the Bank as
the holder of the loan, and a borrower may be able to assert claims and defenses that it has against the seller of the underlying
collateral.
Loan Maturity and Repricing
The following table sets forth certain information
at December 31, 2015 regarding the dollar amount of loans maturing in the Bank’s portfolio based on their contractual terms
to maturity, but does not include potential prepayments. Demand loans, which are loans having neither a stated schedule of repayments
nor a stated maturity, and overdrafts are reported as due in one year or less. Loan balances do not include undisbursed loan proceeds,
unearned income and allowance for loan losses.
|
|
Within
One Year
|
|
After
One Year
Through
3 Years
|
|
After
3 Years
Through
5 Years
|
|
After
5 Years
Through
10 Years
|
|
After
10 Years
Through
15 Years
|
|
After
15 Years
|
|
Total
|
|
|
(Dollars in thousands)
|
Mortgage loans:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Residential
|
|
$
|
15,796
|
|
|
$
|
21,158
|
|
|
$
|
28,644
|
|
|
$
|
34,101
|
|
|
$
|
22,714
|
|
|
$
|
25,520
|
|
|
$
|
147,933
|
|
Commercial real estate and land loans
(1)
|
|
|
19,939
|
|
|
|
16,484
|
|
|
|
19,196
|
|
|
|
21,291
|
|
|
|
15,206
|
|
|
|
6,429
|
|
|
|
98,545
|
|
Residential construction
(2)
|
|
|
16,391
|
|
|
|
0
|
|
|
|
0
|
|
|
|
0
|
|
|
|
0
|
|
|
|
0
|
|
|
|
16,391
|
|
Consumer loans
|
|
|
19,931
|
|
|
|
21,848
|
|
|
|
8,755
|
|
|
|
14,167
|
|
|
|
13,149
|
|
|
|
3,110
|
|
|
|
80,960
|
|
Commercial business
|
|
|
11,792
|
|
|
|
6,170
|
|
|
|
2,623
|
|
|
|
1,644
|
|
|
|
792
|
|
|
|
74
|
|
|
|
23,095
|
|
Total gross loans
|
|
$
|
83,849
|
|
|
$
|
65,660
|
|
|
$
|
59,218
|
|
|
$
|
71,203
|
|
|
$
|
51,861
|
|
|
$
|
35,133
|
|
|
$
|
366,924
|
|
____________
(1)
|
|
Includes commercial real estate construction loans.
|
(2)
|
|
Includes construction loans for which the bank has committed to provide permanent
financing.
|
The following table sets forth the dollar amount
of all loans due after December 31, 2016, which have fixed interest rates and floating or adjustable interest rates.
|
|
Fixed Rates
|
|
Floating or
Adjustable Rates
|
|
|
(Dollars in thousands)
|
Mortgage loans:
|
|
|
|
|
|
|
|
|
Residential
|
|
$
|
88,501
|
|
|
$
|
43,636
|
|
Commercial real estate and land loans
|
|
|
22,997
|
|
|
|
55,609
|
|
Residential construction
|
|
|
0
|
|
|
|
0
|
|
Consumer loans
|
|
|
30,687
|
|
|
|
30,342
|
|
Commercial business
|
|
|
5,391
|
|
|
|
5,912
|
|
Total gross loans
|
|
$
|
147,576
|
|
|
$
|
135,499
|
|
Loan Solicitation and Processing.
A majority of the Bank’s loan originations are made to existing customers. Walk-ins and customer referrals are also a source
of loan originations. Upon receipt of a loan application, a credit report is ordered to verify specific information relating to
the loan applicant’s employment, income and credit standing. A loan applicant’s income is verified through the applicant’s
employer or from the applicant’s tax returns. In the case of a real estate loan, an appraisal of the real estate intended
to secure the proposed loan is undertaken, generally by an independent appraiser approved by the Bank. The mortgage loan documents
used by the Bank conform to secondary market standards.
The Bank requires that borrowers obtain certain
types of insurance to protect its interest in the collateral securing the loan. The Bank requires either a title insurance policy
insuring that the Bank has a valid first lien on the mortgaged real estate or an opinion by an attorney regarding the validity
of title. Fire and casualty insurance is also required on collateral for loans.
Loan Commitments and Letters of Credit.
The Bank issues commitments to originate fixed- and adjustable-rate single-family residential mortgage loans and commercial loans
conditioned upon the occurrence of certain events. Such commitments are made in writing on specified terms and conditions and are
honored for up to 60 days from the date of application, depending on the type of transaction. The Bank had outstanding loan commitments
of approximately $7.9 million at December 31, 2015.
As an accommodation to its commercial business loan
borrowers, the Bank issues standby letters of credit or performance bonds usually in favor of municipalities for whom its borrowers
are performing services. At December 31, 2015, the Bank had outstanding letters of credit of $1.3 million.
Loan Origination and Other Fees.
Loan
fees and points are a percentage of the principal amount of the mortgage loan that is charged to the borrower for funding the loan.
The Bank usually charges a fixed origination fee on residential real estate loans and long-term commercial real estate loans. Current
accounting standards require loan origination fees and certain direct costs of underwriting and closing loans to be deferred and
amortized into interest income over the contractual life of the loan. Deferred fees and costs associated with loans that are sold
are recognized as income at the time of sale. The Bank had $583,000 of net deferred loan costs at December 31, 2015.
Mortgage Banking Activities.
Mortgage
loans originated and funded by the Bank and intended for sale in the secondary market are carried at the lower of aggregate cost
or market value. Aggregate market value is determined based on the quoted prices under a “best efforts” sales agreement
with a third party. Net unrealized losses are recognized through a valuation allowance by charges to income. Realized gains on
sales of mortgage loans are included in noninterest income.
Commitments to originate and fund mortgage loans
for sale in the secondary market are considered derivative financial instruments to be accounted for at fair value. The Bank’s
mortgage loan commitments subject to derivative accounting are fixed rate mortgage commitments at market rates when initiated.
At December 31, 2015, the Bank had commitments to originate $589,000 in fixed-rate mortgage loans intended for sale in the secondary
market after the loans are closed. Fair value is estimated based on fees that would be charged on commitments with similar terms.
Delinquencies.
The Bank’s collection
procedures provide for a series of contacts with delinquent borrowers. A late charge is assessed and a late charge notice is sent
to the borrower after the 15th day of delinquency. After 20 days, the collector places a phone call to the borrower. When a payment
becomes 60 days past due, the collector issues a default letter. If a loan continues in a delinquent status for 90 days or more,
the Bank generally initiates foreclosure or other litigation proceedings.
Nonperforming Assets.
Loans are reviewed
regularly and when loans become 90 days delinquent, the loan is placed on nonaccrual status and the previously accrued interest
income is reversed unless, in the opinion of management, the outstanding interest remains collectible. Typically, payments received
on a nonaccrual loan are applied to the outstanding principal and interest as determined at the time of collection of the loan
when the likelihood of further loss on the loan is remote. Otherwise, the Bank applies the cost recovery method and applies all
payments as a reduction of the unpaid principal balance.
The following table sets forth information with
respect to the Bank’s nonperforming assets for the dates indicated. Nonperforming assets include nonaccrual loans, accruing
loans that are 90 days or more past due, and foreclosed real estate.
|
|
At December 31,
|
|
|
2015
|
|
2014
|
|
2013
|
|
2012
|
|
2011
|
|
|
(Dollars in thousands)
|
|
|
|
|
|
|
|
|
|
|
|
Loans accounted for on a nonaccrual basis:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Residential real estate
(1)
|
|
$
|
1,648
|
|
|
$
|
919
|
|
|
$
|
1,533
|
|
|
$
|
2,773
|
|
|
$
|
2,528
|
|
Commercial real estate
(2)
|
|
|
2,291
|
|
|
|
449
|
|
|
|
1,576
|
|
|
|
2,961
|
|
|
|
2,858
|
|
Commercial business
|
|
|
167
|
|
|
|
1,642
|
|
|
|
1,898
|
|
|
|
1,776
|
|
|
|
1,928
|
|
Consumer
|
|
|
116
|
|
|
|
129
|
|
|
|
252
|
|
|
|
73
|
|
|
|
87
|
|
Total
|
|
|
4,222
|
|
|
|
3,139
|
|
|
|
5,259
|
|
|
|
7,583
|
|
|
|
7,401
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Accruing loans past due 90 days or more:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Residential real estate
(1)
|
|
|
271
|
|
|
|
68
|
|
|
|
180
|
|
|
|
215
|
|
|
|
143
|
|
Commercial real estate
(2)
|
|
|
75
|
|
|
|
0
|
|
|
|
0
|
|
|
|
0
|
|
|
|
38
|
|
Commercial business
|
|
|
0
|
|
|
|
0
|
|
|
|
0
|
|
|
|
0
|
|
|
|
0
|
|
Consumer
|
|
|
9
|
|
|
|
17
|
|
|
|
47
|
|
|
|
74
|
|
|
|
182
|
|
Total
|
|
|
355
|
|
|
|
85
|
|
|
|
227
|
|
|
|
289
|
|
|
|
363
|
|
Total nonperforming loans
|
|
|
4,577
|
|
|
|
3,224
|
|
|
|
5,486
|
|
|
|
7,872
|
|
|
|
7,764
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Foreclosed real estate, net
|
|
|
4,890
|
|
|
|
78
|
|
|
|
466
|
|
|
|
295
|
|
|
|
661
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total nonperforming assets
|
|
$
|
9,467
|
|
|
$
|
3,302
|
|
|
$
|
5,952
|
|
|
$
|
8,167
|
|
|
$
|
8,425
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total nonperforming loans to net loans
|
|
|
1.27
|
%
|
|
|
1.07
|
%
|
|
|
1.90
|
%
|
|
|
2.81
|
%
|
|
|
2.81
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total nonperforming loans to total assets
|
|
|
0.64
|
%
|
|
|
0.68
|
%
|
|
|
1.23
|
%
|
|
|
1.71
|
%
|
|
|
1.77
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total nonperforming assets to total assets
|
|
|
1.32
|
%
|
|
|
0.70
|
%
|
|
|
1.34
|
%
|
|
|
1.78
|
%
|
|
|
1.92
|
%
|
____________
(1)
|
|
Includes residential construction loans.
|
(2)
|
|
Includes commercial real estate construction and land loans.
|
The increase in nonperforming assets from December
31, 2014 to December 31, 2015 is primarily due to the acquisition of Peoples in December 2015. At December 31, 2015, nonperforming
assets acquired from Peoples included nonaccrual loans of $1.7 million, accruing loans past due 90 days or more of $346,000 and
foreclosed real estate of $4.3 million.
The Bank accrues interest on loans over 90 days
past due when, in the opinion of management, the estimated value of collateral and collection efforts are deemed sufficient to
ensure full recovery. The Bank did not recognize any interest income on nonaccrual loans for the fiscal year ended December 31,
2015. The Bank would have recorded interest income of $159,000 for the year ended December 31, 2015 had nonaccrual loans been current
in accordance with their original terms.
Restructured Loans.
Periodically,
the Bank modifies loans to extend the term or make other concessions to help borrowers stay current on their loans and avoid foreclosure.
The Bank does not forgive principal or interest on loans or modify interest rates to rates that are below market rates. These modified
loans are also referred to as “troubled debt restructurings” or “TDRs”.
Restructured loans can involve loans remaining on
nonaccrual, moving to nonaccrual, or continuing on accrual status, depending on the individual facts and circumstances of the borrower.
Generally, a nonaccrual loan that is restructured in a TDR remains on nonaccrual status for a period of at least six months following
the restructuring to ensure that the borrower performs in accordance with the restructured terms including consistent and timely
payments. At December 31, 2015, TDRs totaled $2.3 million with no related allowance for loan losses on TDRs. TDRs on nonaccrual
status totaling $609,000 at December 31, 2015 are included in the nonperforming loans totals above. TDRs performing according to
their restructured terms and on accrual status totaled $1.7 million at December 31, 2015. See Note 5 in the accompanying Notes
to Consolidated Financial Statements, which is incorporated herein by reference, for additional information regarding TDRs.
Classified Assets.
The
OCC has adopted various regulations regarding problem assets of financial institutions. The regulations require that each insured
institution review and classify its assets on a regular basis. In addition, in connection with examinations of insured institutions,
OCC examiners have the authority to identify additional problem assets and, if appropriate, require them to be classified. There
are three classifications for problem assets: substandard, doubtful and loss. “Substandard” assets have one or more
defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the
deficiencies are not corrected. “Doubtful” assets have the weaknesses of substandard assets with the additional characteristic
that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable,
and there is a high possibility of loss. An asset classified as “loss” is considered uncollectible and of such little
value that continuance as an asset of the institution is not warranted. If an asset or portion thereof is classified as loss, the
insured institution charges off an amount equal to 100% of the portion of the asset classified as loss. The regulations also provide
for a “special mention” category, described as assets which do not currently expose the institution to sufficient risk
to warrant adverse classification, but have potential weaknesses that deserve management’s close attention.
At December
31, 2015, the Bank had $5.5 million in doubtful loans and $6.3 million in substandard loans. In addition, the Bank identified $9.1
million in loans as special mention loans at December 31, 2015.
Current
accounting rules require that impaired loans be measured based on the present value of expected future cash flows discounted at
the loan’s effective interest rate, the loan’s observable market price or the fair value of collateral if the loan
is collateral dependent. A loan is classified as “impaired” by management when, based on current information and events,
it is probable that the Bank will be unable to collect all amounts due in accordance with the terms of the loan agreement. If the
fair value, as measured by one of these methods, is less than the recorded investment in the impaired loan, the Bank establishes
a valuation allowance with a provision charged to expense. Management reviews the valuation of impaired loans on a quarterly basis
to consider changes due to the passage of time or revised estimates. At December 31, 2015, all impaired loans were considered to
be collateral dependent for the purposes of determining fair value.
Values for collateral dependent loans are generally
based on appraisals obtained from independent licensed real estate appraisers, with adjustments applied for estimated costs to
sell the property, costs to complete unfinished or repair damaged property and other factors. New appraisals are generally obtained
for all significant properties when a loan is identified as impaired, and a property is considered significant if the value of
the property is estimated to exceed $200,000. Subsequent appraisals are obtained as needed or if management believes there has
been a significant change in the market value of the property. In instances where it is not deemed necessary to obtain a new appraisal,
management bases its impairment and allowance for loan loss analysis on the original appraisal with adjustments for current conditions
based on management’s assessment of market factors and management’s inspection of the property. At December 31, 2015,
discounts from appraised values used to value impaired loans for estimates of changes in market conditions, the condition of the
collateral, and estimated costs to sell the property ranged from 10% to 59%, with a weighted average discount of 16%.
An insured institution is required to establish
and maintain an allowance for loan losses at a level that is adequate to absorb estimated credit losses associated with the loan
portfolio, including binding commitments to lend. General allowances represent loss allowances which have been established to recognize
the inherent risk associated with lending activities. When an insured institution classifies problem assets as “loss,”
it is required either to establish an allowance for losses equal to 100% of the amount of the assets, or charge off the classified
asset. The amount of its valuation allowance is subject to review by the OCC, which can order the establishment of additional general
loss allowances. The Bank regularly reviews the loan portfolio to determine whether any loans require classification in accordance
with applicable regulations.
At December 31, 2015, 2014 and 2013, the aggregate
amounts of the Bank’s classified assets were as follows:
|
|
At December 31,
|
|
|
2014
|
|
2013
|
|
2012
|
|
|
(Dollars in thousands)
|
Classified assets:
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
—
|
|
Doubtful
|
|
|
5,537
|
|
|
|
3,139
|
|
|
|
5,259
|
|
Substandard
|
|
|
6,259
|
|
|
|
6,967
|
|
|
|
5,904
|
|
Special mention
|
|
|
9,082
|
|
|
|
3,937
|
|
|
|
4,066
|
|
The increase in classified assets from December
31, 2014 to December 31, 2015 is primarily due to the acquisition of Peoples in December 2015. At December 31, 2015, classified
assets acquired from Peoples included loans classified as doubtful, substandard and special mention of $3.0 million, $1.9 million
and $4.9 million, respectively.
Loans classified as impaired in accordance with
accounting standards included in the above regulatory classifications and the related allowance for loan losses are summarized
below at the dates indicated:
|
|
At December 31,
|
|
|
2015
|
|
2014
|
|
2013
|
|
|
(Dollars in thousands)
|
|
|
|
|
|
|
|
Impaired loans with related allowance
|
|
$
|
472
|
|
|
$
|
2,034
|
|
|
$
|
3,129
|
|
Impaired loans with no allowance
|
|
|
5,474
|
|
|
|
3,005
|
|
|
|
3,791
|
|
Total impaired loans
|
|
$
|
5,946
|
|
|
$
|
5,039
|
|
|
$
|
6,920
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Allowance for loan losses:
|
|
|
|
|
|
|
|
|
|
|
|
|
Related to impaired loans
|
|
$
|
166
|
|
|
$
|
1,351
|
|
|
$
|
1,529
|
|
Related to other loans
|
|
|
3,249
|
|
|
|
3,495
|
|
|
|
3,393
|
|
See Note 5 in the accompanying Notes to Consolidated
Financial Statements, which is incorporated herein by reference, for additional information regarding impaired loans and the related
allowance for loan losses.
Foreclosed Real Estate.
Foreclosed
real estate held for sale is carried at fair value minus estimated costs to sell. Costs of holding foreclosed real estate are charged
to expense in the current period, except for significant property improvements, which are capitalized. Valuations are periodically
performed by management and an allowance is established by a charge to non-interest expense if the carrying value exceeds the fair
value minus estimated costs to sell. The net income from operations of foreclosed real estate held for sale is reported in non-interest
income. At December 31, 2015, the Bank had foreclosed real estate totaling $4.9 million. See Note 7 in the accompanying Notes to
Consolidated Financial Statements for additional information regarding foreclosed real estate.
Allowance for Loan
Losses.
Loans are the Bank’s largest concentration of assets and continue to represent
the most significant potential risk. In originating loans, the Bank recognizes that losses will be experienced and that the risk
of loss will vary with, among other things, the type of loan made, the creditworthiness of the borrower over the term of the loan,
general economic conditions and, in the case of a secured loan, the quality of the collateral. The Bank maintains an allowance
for loan losses to absorb losses inherent in the loan portfolio. The allowance for loan losses represents management’s estimate
of probable loan losses based on information available as of the date of the financial statements. The allowance for loan losses
is based on management’s evaluation of the loan portfolio, including historical loan loss experience, delinquencies, known
and inherent risks in the nature and volume of the loan portfolio, information about specific borrower situations, estimated collateral
values, and economic conditions.
The loan portfolio is reviewed quarterly
by management to evaluate the adequacy of the allowance for loan losses to determine the amount of any adjustment required after
considering the loan charge-offs and recoveries for the quarter. Management applies a systematic methodology that incorporates
its current judgments about the credit quality of the loan portfolio. In addition, the OCC, as an integral part of its examination
process, periodically reviews the Bank’s allowance for loan losses and may require the Bank to make additional provisions
for estimated losses based on its judgments about information available to it at the time of its examination.
The methodology used in determining the allowance
for loan losses includes segmenting the loan portfolio by identifying risk characteristics common to pools of loans, determining
and measuring impairment of individual loans based on the present value of expected future cash flows or the fair value of collateral,
and determining and measuring impairment for pools of loans with similar characteristics by applying loss factors that consider
the qualitative factors which may affect the loss rates.
Specific allowances related to impaired loans and
other classified loans are established where the present value of the loan’s discounted cash flows, observable market price
or collateral value (for collateral dependent loans) is lower than the carrying value of the loan. The identification of these
loans results from the loan review process that identifies and monitors credits with weaknesses or conditions which call into question
the full collection of the contractual payments due under the terms of the loan agreement. Factors considered by management include,
among others, payment status, collateral value, and the probability of collecting scheduled principal and interest payments when
due. At December 31, 2015, the Company’s specific allowances totaled $166,000.
For loans evaluated on a pool basis, management
applies loss factors to pools of loans with common risk characteristics (e.g., residential mortgage loans, home equity loans, commercial
real estate loans). The loss factors are derived from the Bank’s historical loss experience. Loss factors are adjusted for
significant qualitative factors that, in management’s judgment, affect the collectability of the loan portfolio segment.
The significant qualitative factors include the levels and trends in charge-offs and recoveries, trends in volume and terms of
loans, levels and trends in delinquencies, the effects of changes in underwriting standards and other lending practices or procedures,
the experience and depth of the lending management and staff, effects of changes in credit concentration, changes in industry and
market conditions and national and local economic trends and conditions. Management evaluates these conditions on a quarterly basis
and evaluates and modifies the assumptions used in establishing the loss factors.
At December 31, 2015, management applied
specific qualitative factor adjustments to the residential real estate, construction, commercial real estate, commercial business,
vacant land, and home equity and second mortgage portfolio segments which increased the estimated allowance for loan losses related
to those portfolio segments by approximately $1.4 million. These changes we made to reflect management’s estimates of inherent
losses in these portfolio segments at December 31, 2015.
At December 31, 2015, for each loan portfolio segment
management applied an overall qualitative factor of 1.18 to the Company’s historical loss factors. The overall qualitative
factor is derived from management’s analysis of changes and trends in the following qualitative factors:
|
·
|
Underwriting Standards – Management reviews the findings of periodic internal audit loan
reviews, independent outsourced loan reviews and loan reviews performed by the banking regulators to evaluate the risk associated
with changes in underwriting standards. At December 31, 2015, management assessed the risk associated with this component as neutral,
requiring no adjustment to the historical loss factors.
|
|
·
|
Economic Conditions – Management analyzes trends in housing and unemployment data in the
Louisville, Kentucky metropolitan area to evaluate the risk associated with economic conditions. Due to a decrease in new home
construction and an increase in unemployment in the Company’s primary market area, management assigned a risk factor of 1.20
for this component at December 31, 2015.
|
|
·
|
Past Due Loans – Management analyzes trends in past due loans for the Company to evaluate
the risk associated with delinquent loans. In general, past due loan ratios have remained at elevated levels compared to historical
amounts since 2007, and management assigned a risk factor of 1.20 for this component at December 31, 2015.
|
|
·
|
Other Internal and External Factors – This component includes management’s consideration
of other qualitative factors such as loan portfolio composition. The Company has focused on origination of commercial business
and real estate loans in an effort to convert the Company’s balance sheet from that of a traditional thrift institution to
a commercial bank. In addition, the Company has increased its investment in mortgage loans in which it does not hold a first lien
position. Commercial loans and second mortgage loans generally entail greater credit risk than residential mortgage loans secured
by a first lien. As a result of changes in the loan portfolio composition, management assigned a risk factor of 1.30
for
this component at December 31, 2015.
|
Each of the four factors above was assigned an
equal weight to arrive at an average for the overall qualitative factor of 1.18
at December 31, 2015. The effect of the
overall qualitative factor was to increase
the estimated allowance for loan losses by $457,000 at December 31, 2015.
Management also adjusts the historical loss factors
for loans classified as watch, special mention and substandard that are not individually evaluated for impairment. The adjustments
consider the increased likelihood of loss on classified loans based on the Company’s separate historical loss experience
for classified loans. The effect of these adjustments for classified loans was to increase the estimated allowance for loan losses
by $410,000 at December 31, 2015.
See Notes 1 and 5 in the accompanying Notes to Consolidated
Financial Statements, which are incorporated herein by reference, for additional information regarding management’s methodology
for estimating the allowance for loan losses.
The following table sets forth an analysis of the
Bank’s allowance for loan losses for the periods indicated.
|
|
Year Ended December 31,
|
|
|
2015
|
|
2014
|
|
2013
|
|
2012
|
|
2011
|
|
|
(Dollars in thousands)
|
|
|
|
Allowance at beginning of period
|
|
$
|
4,846
|
|
|
$
|
4,922
|
|
|
$
|
4,736
|
|
|
$
|
4,182
|
|
|
$
|
4,473
|
|
Provision for loan losses
|
|
|
50
|
|
|
|
190
|
|
|
|
725
|
|
|
|
1,525
|
|
|
|
1,825
|
|
|
|
|
4,896
|
|
|
|
5,112
|
|
|
|
5,461
|
|
|
|
5,707
|
|
|
|
6,298
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Recoveries:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Residential real estate
|
|
|
11
|
|
|
|
7
|
|
|
|
60
|
|
|
|
16
|
|
|
|
18
|
|
Commercial real estate and land
|
|
|
34
|
|
|
|
6
|
|
|
|
17
|
|
|
|
1
|
|
|
|
0
|
|
Commercial business
|
|
|
9
|
|
|
|
17
|
|
|
|
74
|
|
|
|
10
|
|
|
|
45
|
|
Consumer
|
|
|
144
|
|
|
|
324
|
|
|
|
202
|
|
|
|
200
|
|
|
|
248
|
|
Total recoveries
|
|
|
198
|
|
|
|
354
|
|
|
|
353
|
|
|
|
227
|
|
|
|
311
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Charge-offs:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Residential real estate
|
|
|
128
|
|
|
|
140
|
|
|
|
353
|
|
|
|
418
|
|
|
|
819
|
|
Commercial real estate and land
|
|
|
0
|
|
|
|
0
|
|
|
|
92
|
|
|
|
108
|
|
|
|
396
|
|
Commercial business
|
|
|
1,205
|
|
|
|
6
|
|
|
|
20
|
|
|
|
17
|
|
|
|
333
|
|
Consumer
|
|
|
346
|
|
|
|
474
|
|
|
|
427
|
|
|
|
655
|
|
|
|
879
|
|
Total charge-offs
|
|
|
1,679
|
|
|
|
620
|
|
|
|
892
|
|
|
|
1,198
|
|
|
|
2,427
|
|
Net (charge-offs) recoveries
|
|
|
(1,481
|
)
|
|
|
(266
|
)
|
|
|
(539
|
)
|
|
|
(971
|
)
|
|
|
(2,116
|
)
|
Balance at end of period
|
|
$
|
3,415
|
|
|
$
|
4,846
|
|
|
$
|
4,922
|
|
|
$
|
4,736
|
|
|
$
|
4,182
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Ratio of allowance to total loans outstanding at the end of the period
|
|
|
0.93
|
%
|
|
|
1.57
|
%
|
|
|
1.64
|
%
|
|
|
1.64
|
%
|
|
|
1.47
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Ratio of net charge-offs to average loans outstanding during the period
|
|
|
0.48
|
%
|
|
|
0.09
|
%
|
|
|
0.19
|
%
|
|
|
0.35
|
%
|
|
|
0.72
|
%
|
The decrease in the ratio of the allowance for loan
losses to total loans outstanding from 2014 to 2015 is primarily due to a $1.2 million charge-off on a commercial loan that had
been fully reserved for in prior periods and the Peoples acquisition. Under accounting principles generally accepted in the United
States of America (“U.S. GAAP”), acquired loans are recorded at their fair value at the date of acquisition including
any discount related to credit risk. As such, loans acquired from Peoples in December 2015 with a fair value of $55.7 million were
initially acquired with no allowance for loan losses.
Allowance for Loan Losses Analysis
The following table sets forth the breakdown of
the allowance for loan losses by loan category at the dates indicated.
|
|
At December 31,
|
|
|
2015
|
|
2014
|
|
2013
|
|
2012
|
|
2011
|
|
|
Amount
|
|
Percent of
Outstanding
Loans
in Category
|
|
Amount
|
|
Percent of
Outstanding
Loans
in Category
|
|
Amount
|
|
Percent of
Outstanding
Loans
in Category
|
|
Amount
|
|
Percent of
Outstanding
Loans
in Category
|
|
Amount
|
|
Percent of
Outstanding
Loans
in Category
|
|
|
(Dollars in thousands)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Residential real estate
(1)
|
|
$
|
574
|
|
|
|
44.79
|
%
|
|
$
|
669
|
|
|
|
37.97
|
%
|
|
$
|
874
|
|
|
|
40.45
|
%
|
|
$
|
922
|
|
|
|
41.78
|
%
|
|
$
|
861
|
|
|
|
44.70
|
%
|
Commercial real estate and land loans
(2)
|
|
|
1,698
|
|
|
|
26.86
|
|
|
|
1,702
|
|
|
|
29.44
|
|
|
|
1,436
|
|
|
|
29.48
|
|
|
|
1,381
|
|
|
|
28.22
|
|
|
|
1,362
|
|
|
|
23.99
|
|
Commercial business
|
|
|
261
|
|
|
|
6.29
|
|
|
|
1,480
|
|
|
|
9.17
|
|
|
|
1,446
|
|
|
|
7.31
|
|
|
|
1,223
|
|
|
|
6.43
|
|
|
|
1,160
|
|
|
|
7.27
|
|
Consumer
|
|
|
882
|
|
|
|
22.06
|
|
|
|
995
|
|
|
|
23.42
|
|
|
|
1,116
|
|
|
|
22.76
|
|
|
|
1,210
|
|
|
|
23.57
|
|
|
|
799
|
|
|
|
24.04
|
|
Total allowance for loan losses
|
|
$
|
3,415
|
|
|
|
100.00
|
%
|
|
$
|
4,846
|
|
|
|
100.00
|
%
|
|
$
|
4,922
|
|
|
|
100.00
|
%
|
|
$
|
4,736
|
|
|
|
100.00
|
%
|
|
$
|
4,182
|
|
|
|
100.00
|
%
|
____________
(1)
|
|
Includes residential construction loans.
|
(2)
|
|
Includes commercial real estate construction loans.
|
Investment Activities
Federally chartered savings institutions have authority
to invest in various types of liquid assets, including United States Treasury obligations, securities of various federal agencies
and of state and municipal governments, deposits at the applicable FHLB, certificates of deposit of federally insured institutions,
certain bankers’ acceptances and federal funds. Subject to various restrictions, such savings institutions may also invest
a portion of their assets in commercial paper, corporate debt securities and mutual funds, the assets of which conform to the investments
that federally chartered savings institutions are otherwise authorized to make directly. Savings institutions are also required
to maintain minimum levels of liquid assets that vary from time to time. The Bank may decide to increase its liquidity above the
required levels depending upon the availability of funds and comparative yields on investments in relation to return on loans.
The Bank is required under federal regulations to
maintain a minimum amount of liquid assets and is also permitted to make certain other securities investments. The balance of the
Bank’s investments in short-term securities in excess of regulatory requirements reflects management’s response to
the significantly increasing percentage of deposits with short maturities. Management intends to hold securities with short maturities
in the Bank’s investment portfolio in order to enable the Bank to match more closely the interest-rate sensitivities of its
assets and liabilities.
The Bank periodically invests in mortgage-backed
securities, including mortgage-backed securities guaranteed or insured by Ginnie Mae, Fannie Mae or Freddie Mac. Mortgage-backed
securities generally increase the quality of the Bank’s assets by virtue of the guarantees that back them, are more liquid
than individual mortgage loans and may be used to collateralize borrowings or other obligations of the Bank. Of the Bank’s
total mortgage-backed securities portfolio at December 31, 2015, securities with a market value of $216,000 have adjustable rates
as of that date.
The Bank also invests in collateralized mortgage
obligations (“CMOs”) issued by Ginnie Mae, Fannie Mae and Freddie Mac, as well as private issuers. CMOs are complex
mortgage-backed securities that restructure the cash flows and risks of the underlying mortgage collateral.
At December 31, 2015, neither the Company nor the
Bank had an investment in securities (other than United States Government and agency securities), which exceeded 10% of the Company’s
consolidated stockholders’ equity at that date.
The following table sets forth the securities portfolio at the dates
indicated.
|
|
At December 31,
|
|
|
2015
|
|
2014
|
|
2013
|
|
|
Fair
Value
|
|
Amortized
Cost
|
|
Percent
of
Portfolio
|
|
Weighted
Average
Yield
(1)
|
|
Fair
Value
|
|
Amortized
Cost
|
|
Percent
of
Portfolio
|
|
Weighted
Average
Yield
(1)
|
|
Fair
Value
|
|
Amortized
Cost
|
|
Percent
of
Portfolio
|
|
Weighted
Average
Yield
(1)
|
|
|
(Dollars in thousands)
|
Securities Held to Maturity
(2)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Mortgage-backed securities
(3)
|
|
$
|
4
|
|
|
$
|
4
|
|
|
|
0.01
|
|
|
|
1.93
|
%
|
|
$
|
6
|
|
|
$
|
6
|
|
|
|
0.01
|
|
|
|
1.86
|
%
|
|
$
|
9
|
|
|
$
|
9
|
|
|
|
0.01
|
|
|
|
1.63
|
%
|
|
|
$
|
4
|
|
|
$
|
4
|
|
|
|
0.01
|
%
|
|
|
|
|
|
$
|
6
|
|
|
$
|
6
|
|
|
|
0.01
|
%
|
|
|
|
|
|
$
|
9
|
|
|
$
|
9
|
|
|
|
0.01
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Securities Available for Sale
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Debt securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
U.S. agency:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Due in one year or less
|
|
$
|
2,018
|
|
|
$
|
2,017
|
|
|
|
1.08
|
%
|
|
|
0.82
|
%
|
|
$
|
0
|
|
|
$
|
0
|
|
|
|
0.00
|
%
|
|
|
0.00
|
%
|
|
$
|
0
|
|
|
$
|
0
|
|
|
|
0.00
|
%
|
|
|
0.00
|
%
|
Due after one year through five years
|
|
|
47,819
|
|
|
|
48,032
|
|
|
|
25.82
|
|
|
|
1.25
|
%
|
|
|
9,626
|
|
|
|
9,629
|
|
|
|
9.73
|
|
|
|
0.98
|
%
|
|
|
7,005
|
|
|
|
7,045
|
|
|
|
6.41
|
|
|
|
0.92
|
%
|
Due after five years through ten years
|
|
|
31,509
|
|
|
|
31,616
|
|
|
|
17.00
|
|
|
|
1.69
|
%
|
|
|
8,494
|
|
|
|
8,507
|
|
|
|
8.59
|
|
|
|
1.17
|
%
|
|
|
16,460
|
|
|
|
16,857
|
|
|
|
15.33
|
|
|
|
1.41
|
%
|
Due after ten years through fifteen years
|
|
|
3,107
|
|
|
|
3,132
|
|
|
|
1.68
|
|
|
|
2.52
|
%
|
|
|
0
|
|
|
|
0
|
|
|
|
0.00
|
|
|
|
0.00
|
%
|
|
|
7,449
|
|
|
|
7,692
|
|
|
|
7.00
|
|
|
|
1.73
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Mortgage-backed securities and CMOs
(3)
|
|
|
51,341
|
|
|
|
51,549
|
|
|
|
27.72
|
|
|
|
1.90
|
%
|
|
|
46,681
|
|
|
|
46,596
|
|
|
|
47.07
|
|
|
|
1.84
|
%
|
|
|
38,610
|
|
|
|
38,894
|
|
|
|
35.38
|
|
|
|
1.85
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Municipal:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Due in one year or less
|
|
|
504
|
|
|
|
504
|
|
|
|
0.27
|
|
|
|
0.42
|
%
|
|
|
121
|
|
|
|
120
|
|
|
|
0.12
|
|
|
|
5.40
|
%
|
|
|
0
|
|
|
|
0
|
|
|
|
0.00
|
|
|
|
0.00
|
%
|
Due after one year through five years
|
|
|
7,885
|
|
|
|
7,769
|
|
|
|
4.18
|
|
|
|
3.33
|
%
|
|
|
6,160
|
|
|
|
6,049
|
|
|
|
6.11
|
|
|
|
3.15
|
%
|
|
|
2,019
|
|
|
|
1,961
|
|
|
|
1.78
|
|
|
|
4.01
|
%
|
Due after five years through ten years
|
|
|
14,708
|
|
|
|
14,322
|
|
|
|
7.70
|
|
|
|
4.50
|
%
|
|
|
12,358
|
|
|
|
11,859
|
|
|
|
11.98
|
|
|
|
4.97
|
%
|
|
|
14,065
|
|
|
|
13,841
|
|
|
|
12.59
|
|
|
|
4.83
|
%
|
Due after ten years
|
|
|
27,742
|
|
|
|
26,932
|
|
|
|
14.48
|
|
|
|
4.39
|
%
|
|
|
14,703
|
|
|
|
14,150
|
|
|
|
14.29
|
|
|
|
4.06
|
%
|
|
|
19,956
|
|
|
|
20,398
|
|
|
|
18.55
|
|
|
|
4.40
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Equity securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Mutual funds
|
|
|
118
|
|
|
|
118
|
|
|
|
0.06
|
|
|
|
N/A
|
|
|
|
2,083
|
|
|
|
2,083
|
|
|
|
2.10
|
|
|
|
N/A
|
|
|
|
3,198
|
|
|
|
3,238
|
|
|
|
2.95
|
|
|
|
N/A
|
|
|
|
$
|
186,751
|
|
|
$
|
185,991
|
|
|
|
99.99
|
%
|
|
|
|
|
|
$
|
100,226
|
|
|
$
|
98,993
|
|
|
|
99.99
|
%
|
|
|
|
|
|
$
|
108,762
|
|
|
$
|
109,926
|
|
|
|
99.99
|
%
|
|
|
|
|
____________
(1)
|
|
Yields are calculated on a fully taxable equivalent basis using a marginal federal
income tax rate of 34%. Weighted average yields are calculated using average prepayment rates for the most recent three-month
period.
|
(2)
|
|
Securities held to maturity are carried at amortized cost.
|
(3)
|
|
The expected maturities of mortgage-backed securities and collateralized mortgage
obligations (CMOs) may differ from contractual maturities because the mortgages underlying the obligations may be prepaid without
penalty.
|
Deposit Activities and Other Sources of Funds
General.
Deposits and loan repayments
are the major source of the Bank’s funds for lending and investment activities and for its general business purposes. Loan
repayments are a relatively stable source of funds, while deposit inflows and outflows and loan prepayments are significantly influenced
by general interest rates and money market conditions. Borrowing may be used on a short-term basis to compensate for reductions
in the availability of funds from other sources or may also be used on a longer-term basis for interest rate risk management.
Deposit Accounts.
Deposits are attracted
from within the Bank’s primary market area through the offering of a broad selection of deposit instruments, including non-interest
bearing checking accounts, negotiable order of withdrawal (“NOW”) accounts, money market accounts, regular savings
accounts, certificates of deposit and retirement savings plans. Deposit account terms vary, according to the minimum balance required,
the time periods the funds must remain on deposit and the interest rate, among other factors. In determining the terms of its deposit
accounts, the Bank considers the rates offered by its competition, profitability to the Bank, matching deposit and loan products
and its customer preferences and concerns. The Bank generally reviews its deposit mix and pricing weekly.
The following table presents the maturity distribution
of time deposits of $100,000 or more as of December 31, 2015.
Maturity Period
|
|
Amount at
December 31, 2015
|
|
|
(Dollars in thousands)
|
Three months or less
|
|
$
|
4,501
|
|
Over three through six months
|
|
|
4,824
|
|
Over six through 12 months
|
|
|
5,622
|
|
Over 12 months
|
|
|
13,409
|
|
Total
|
|
$
|
28,356
|
|
The following table sets forth the balances of deposits
in the various types of accounts offered by the Bank at the dates indicated.
|
|
At December 31,
|
|
|
2015
|
|
2014
|
|
2013
|
|
|
Amount
|
|
Percent
of
Total
|
|
Increase/
(Decrease)
|
|
Amount
|
|
Percent
of
Total
|
|
Increase/
(Decrease)
|
|
Amount
|
|
Percent
of
Total
|
|
Increase/
(Decrease)
|
|
|
(Dollars in thousands)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Non-interest bearing demand
|
|
$
|
125,059
|
|
|
|
19.63
|
%
|
|
$
|
52,017
|
|
|
$
|
73,042
|
|
|
|
17.70
|
%
|
|
$
|
16,606
|
|
|
$
|
56,436
|
|
|
|
15.10
|
%
|
|
$
|
(279
|
)
|
NOW accounts
|
|
|
208,677
|
|
|
|
32.75
|
|
|
|
31,372
|
|
|
|
177,305
|
|
|
|
42.97
|
|
|
|
26,542
|
|
|
|
150,763
|
|
|
|
40.33
|
|
|
|
(3,850
|
)
|
Savings accounts
|
|
|
144,232
|
|
|
|
22.64
|
|
|
|
66,409
|
|
|
|
77,823
|
|
|
|
18.86
|
|
|
|
9,855
|
|
|
|
67,968
|
|
|
|
18.18
|
|
|
|
7,016
|
|
Money market accounts
|
|
|
62,413
|
|
|
|
9.79
|
|
|
|
53,833
|
|
|
|
8,580
|
|
|
|
2.08
|
|
|
|
(2,741
|
)
|
|
|
11,321
|
|
|
|
3.03
|
|
|
|
81
|
|
Fixed rate time deposits which mature:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Within one year
|
|
|
48,826
|
|
|
|
7.66
|
|
|
|
8,122
|
|
|
|
40,704
|
|
|
|
9.86
|
|
|
|
(1,477
|
)
|
|
|
42,181
|
|
|
|
11.28
|
|
|
|
(11,192
|
)
|
After one year, but within three years
|
|
|
37,595
|
|
|
|
5.90
|
|
|
|
11,266
|
|
|
|
26,329
|
|
|
|
6.38
|
|
|
|
(7,613
|
)
|
|
|
33,942
|
|
|
|
9.08
|
|
|
|
(5,194
|
)
|
After three years, but within five years
|
|
|
10,267
|
|
|
|
1.61
|
|
|
|
1,529
|
|
|
|
8,738
|
|
|
|
2.12
|
|
|
|
(2,373
|
)
|
|
|
11,111
|
|
|
|
2.97
|
|
|
|
2,884
|
|
After five years
|
|
|
0
|
|
|
|
0.00
|
|
|
|
0
|
|
|
|
0
|
|
|
|
0.00
|
|
|
|
0
|
|
|
|
0
|
|
|
|
0.00
|
|
|
|
(5
|
)
|
Club accounts
|
|
|
108
|
|
|
|
0.02
|
|
|
|
(7
|
)
|
|
|
115
|
|
|
|
0.03
|
|
|
|
7
|
|
|
|
108
|
|
|
|
0.03
|
|
|
|
26
|
|
Total
|
|
$
|
637,177
|
|
|
|
100.00
|
%
|
|
$
|
224,541
|
|
|
$
|
412,636
|
|
|
|
100.00
|
%
|
|
$
|
38,806
|
|
|
$
|
373,830
|
|
|
|
100.00
|
%
|
|
$
|
(10,513
|
)
|
The following table sets forth the amount and maturities
of time deposits by rates at December 31, 2015.
|
|
Amount Due
|
|
|
|
|
|
|
Less Than
One Year
|
|
1 - 3
Years
|
|
3 - 5
Years
|
|
After 5
Years
|
|
Total
|
|
Percent
of Total
|
|
|
(Dollars in thousands)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
0.00% — 0.99%
|
|
$
|
42,378
|
|
|
$
|
27,393
|
|
|
$
|
5,808
|
|
|
$
|
0
|
|
|
$
|
75,579
|
|
|
|
78.17
|
%
|
1.00% — 1.99%
|
|
|
3,642
|
|
|
|
8,682
|
|
|
|
4,450
|
|
|
|
0
|
|
|
|
16,774
|
|
|
|
17.35
|
|
2.00% — 2.99%
|
|
|
2,798
|
|
|
|
1,515
|
|
|
|
9
|
|
|
|
0
|
|
|
|
4,322
|
|
|
|
4.47
|
|
3.00% — 3.99%
|
|
|
0
|
|
|
|
0
|
|
|
|
0
|
|
|
|
0
|
|
|
|
0
|
|
|
|
0.00
|
|
4.00% — 4.99%
|
|
|
8
|
|
|
|
5
|
|
|
|
0
|
|
|
|
0
|
|
|
|
13
|
|
|
|
0.01
|
|
5.00% — 5.99%
|
|
|
0
|
|
|
|
0
|
|
|
|
0
|
|
|
|
0
|
|
|
|
0
|
|
|
|
0.00
|
|
6.00% — 6.99%
|
|
|
0
|
|
|
|
0
|
|
|
|
0
|
|
|
|
0
|
|
|
|
0
|
|
|
|
0.00
|
|
Total
|
|
$
|
48,826
|
|
|
$
|
37,595
|
|
|
$
|
10,267
|
|
|
$
|
0
|
|
|
$
|
96,688
|
|
|
|
100.00
|
%
|
Borrowings.
The Bank has at times
relied upon advances from the FHLB to supplement its supply of lendable funds and to meet deposit withdrawal requirements. Advances
from the FHLB are secured by certain first mortgage loans. The Bank also uses retail repurchase agreements as a source of borrowings.
The FHLB functions as a central reserve bank providing
credit for savings and loan associations and certain other member financial institutions. As a member, the Bank is required to
own capital stock in the FHLB and is authorized to apply for advances on the security of such stock and certain of its mortgage
loans provided certain standards related to creditworthiness have been met. Advances are made pursuant to several different programs.
Each credit program has its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances
are based either on a fixed percentage of an institution’s net worth or on the FHLB’s assessment of the institution’s
creditworthiness. Under its current credit policies, the FHLB generally limits advances to 20% of a member’s assets, and
short-term borrowing of less than one year may not exceed 10% of the institution’s assets. The FHLB determines specific lines
of credit for each member institution.
The following table sets forth certain information
regarding the Bank’s use of FHLB advances.
|
|
At or For the Years Ended December 31,
|
|
|
2015
|
|
2014
|
|
2013
|
|
|
(Dollars in thousands)
|
Maximum balance at any month end
|
|
$
|
0
|
|
|
$
|
6,500
|
|
|
$
|
5,500
|
|
Average balance
|
|
|
340
|
|
|
|
1,137
|
|
|
|
4,135
|
|
Period end balance
|
|
|
0
|
|
|
|
0
|
|
|
|
5,500
|
|
Weighted average interest rate:
|
|
|
|
|
|
|
|
|
|
|
|
|
At end of period
|
|
|
0.00
|
%
|
|
|
0.00
|
%
|
|
|
0.50
|
%
|
During the period
|
|
|
0.52
|
%
|
|
|
0.44
|
%
|
|
|
3.65
|
%
|
The following table sets forth certain information
regarding the Bank’s use of retail repurchase agreements.
|
|
At or For the Years Ended December 31,
|
|
|
2015
|
|
2014
|
|
2013
|
|
|
(Dollars in thousands)
|
|
|
|
|
|
|
|
Maximum balance at any month end
|
|
$
|
0
|
|
|
$
|
10,617
|
|
|
$
|
13,041
|
|
Average balance
|
|
|
0
|
|
|
|
4,601
|
|
|
|
11,015
|
|
Period end balance
|
|
|
0
|
|
|
|
0
|
|
|
|
9,310
|
|
Weighted average interest rate:
|
|
|
|
|
|
|
|
|
|
|
|
|
At end of period
|
|
|
0.00
|
%
|
|
|
0.00
|
%
|
|
|
0.26
|
%
|
During the period
|
|
|
0.00
|
%
|
|
|
0.26
|
%
|
|
|
0.25
|
%
|
As a result of the Peoples acquisition, the Bank
obtained an unsecured federal funds purchased line of credit through The Bankers Bank of Kentucky with a maximum borrowing amount
of $5.0 million. At December 31, 2015, the Bank had no outstanding federal funds purchased under the line of credit and the Bank
had no borrowings under the federal funds purchased line of credit during 2015.
On July 31, 2015, the Company entered into a $1.0
million revolving line of credit with Stock Yards Bank & Trust Company secured by stock of the Bank held by the Company. The
interest rate charged under the line of credit is the prime rate less 0.25%. The following table sets forth certain information
regarding the Company’s use of the revolving line of credit for the year ended December 31, 2015.
(Dollars in thousands)
|
|
|
|
|
|
Maximum balance at any month end
|
|
$
|
0
|
|
Average balance
|
|
|
62
|
|
Period end balance
|
|
|
0
|
|
Weighted average interest rate:
|
|
|
|
|
At end of period
|
|
|
0.00
|
%
|
During the period
|
|
|
3.18
|
%
|
Subsidiary Activities
The Bank is a subsidiary and is wholly-owned by
the Company. First Harrison Investments, Inc. and First Harrison Holdings, Inc. are wholly-owned Nevada corporate subsidiaries
of the Bank that jointly own First Harrison, LLC, a Nevada limited liability corporation that holds and manages an investment securities
portfolio. First Harrison REIT, Inc. is a wholly-owned subsidiary of First Harrison Holdings, Inc., incorporated to hold a portion
of the Bank's real estate mortgage loan portfolio. Heritage Hill, LLC is a wholly-owned subsidiary of the Bank acquired in connection
with the acquisition of Peoples that holds and operates certain foreclosed real estate properties. On September 23, 2014, the Company
formed FHB Risk Mitigation Services, Inc. (“Captive”). The Captive is a wholly-owned insurance subsidiary of the Company
that provides property and casualty insurance coverage to the Company, the Bank and the Bank’s subsidiaries, and reinsurance
to eight other third party insurance captives, for which insurance may not be currently available or economically feasible in the
insurance marketplace.
Personnel
As of December 31, 2015, the Bank had 167 full-time
employees and 24 part-time employees. A collective bargaining unit does not represent the employees and the Bank considers its
relationship with its employees to be good.
REGULATION AND SUPERVISION
General
As a savings and loan holding company, the Company
is required by federal law to report to, and otherwise comply with the rules and regulations of, the Board of Governors of the
Federal Reserve Board (the “Federal Reserve Board” or “FRB”). The Bank, an insured federal savings association,
is subject to extensive regulation, examination and supervision by the OCC, as its primary federal regulator, and the FDIC, as
the deposit insurer.
The Bank is a member of the FHLB System and, with
respect to deposit insurance, of the Deposit Insurance Fund managed by the FDIC. The Bank must file reports with the OCC and the
FDIC concerning its activities and financial condition and obtain regulatory approvals before entering into certain transactions
such as mergers with, or acquisitions of, other financial institutions. The OCC and/or the FDIC conduct periodic examinations to
test the Bank’s safety and soundness and compliance with various regulatory requirements. This regulation and supervision
establishes a comprehensive framework of activities in which an institution can engage and is intended primarily for the protection
of the insurance fund and depositors. The regulatory structure also gives the regulatory authorities extensive discretion in connection
with their supervisory and enforcement activities and examination policies, including policies with respect to the classification
of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such regulatory requirements
and policies, whether by the OCC, the FDIC or Congress, could have a material adverse impact on the Company, the Bank and their
operations.
The Dodd-Frank Wall Street Reform and Consumer Protection
Act of 2010 (the “Dodd-Frank Act”) made extensive changes to the regulation of the Bank. Under the Dodd-Frank Act,
the Office of Thrift Supervision (the “OTS”) was eliminated and responsibility for the supervision and regulation of
federal savings associations such as the Bank was transferred to the OCC on July 21, 2011. The OCC is the agency that is primarily
responsible for the regulation and supervision of national banks. Additionally, the Dodd-Frank Act created a new Consumer Financial
Protection Bureau as an independent bureau of the FRB. The Consumer Financial Protection Bureau assumed responsibility for the
implementation of the federal financial consumer protection and fair lending laws and regulations and has authority to impose new
requirements. However, institutions of less than $10 billion in assets, such as the Bank, will continue to be examined for
compliance with consumer protection and fair lending laws and regulations by, and be subject to the enforcement authority of, their
prudential regulators.
Certain regulatory requirements applicable to the
Bank and to the Company are referred to below or elsewhere herein. The summary of statutory provisions and regulations applicable
to savings associations and their holding companies set forth below and elsewhere in this document does not purport to be a complete
description of such statutes and regulations and their effects on the Bank and the Company and is qualified in its entirety by
reference to the actual laws and regulations.
BASEL III Capital Rules
In July 2013, the federal banking agencies published
the Basel III Capital Rules establishing a new comprehensive capital framework for U.S. banking organizations. The rules implement
the Basel Committee’s December 2010 framework known as “Basel III” for strengthening international capital standards
as well as certain provisions of the Dodd-Frank Act. The Basel III Capital Rules substantially revise the risk-based capital requirements
applicable to savings and loan holding companies and depository institutions, including the Company and the Bank, compared to the
former U.S. risk-based capital rules. The Basel III Capital Rules define the components of capital and address other issues affecting
the numerator in banking institutions’ regulatory capital ratios. The Basel III Capital Rules also address risk weights and
other issues affecting the denominator in banking institutions’ regulatory capital ratios. The Basel III Capital Rules also
implement the requirements of Section 939A of the Dodd-Frank Act to remove references to credit ratings from the federal banking
agencies’ rules. The Basel III Capital Rules became effective on January 1, 2015 (subject to a phase-in period).
The Basel III Capital Rules, among other things:
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introduce a new capital measure called “Common Equity Tier 1” (“CET1”);
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specify that Tier 1 capital consists of CET1 and “Additional Tier 1 capital” instruments
meeting specified requirements;
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define CET1 narrowly by requiring that most deductions/adjustments to regulatory capital measures
be made to CET1 and not to the other components of capital; and
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expand the scope of the deductions/adjustments as compared to existing regulations.
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When fully phased in on January 1, 2019, the Basel
III Capital Rules will require the Company and the Bank to maintain:
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a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation
buffer” (which is added to the 4.5% CET1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of CET1
to risk-weighted assets of at least 7% upon full implementation);
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a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation
buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1
capital ratio of 8.5% upon full implementation);
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a minimum ratio of Total capital (that is, Tier 1 plus Tier 2) to risk-weighted assets of at least
8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively
resulting in a minimum total capital ratio of 10.5% upon full implementation), and
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a minimum leverage ratio of 4%, calculated as the ratio of Tier 1 capital to average assets (as
compared to a current minimum leverage ratio of 3% for banking organizations that either have the highest supervisory rating or
have implemented the appropriate federal regulatory authority’s risk-adjusted measure for market risk).
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The aforementioned capital conservation buffer is
designed to absorb losses during periods of economic stress. Banking institutions with a ratio of CET1 to risk-weighted assets
above the minimum but below the conservation buffer (or below the combined capital conservation buffer and countercyclical capital
buffer, when the latter is applied) will face constraints on dividends, equity repurchases and compensation based on the amount
of the shortfall.
Under the Basel III Capital Rules, the initial minimum
capital ratios as of January 1, 2015 are as follows:
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4.5% CET1 to risk-weighted assets;
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6.0% Tier 1 capital to risk-weighted assets;
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8.0% Total capital to risk-weighted assets.
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The Basel III Capital Rules provide for a number
of deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing rights, deferred
tax assets arising from temporary differences that could not be realized through net operating loss carrybacks and significant
investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of
CET1 or all such categories in the aggregate exceed 15% of CET1. Under the former capital standards, the effects of accumulated
other comprehensive income items included in capital were excluded for the purposes of determining regulatory capital ratios. Under
the Basel III Capital Rules, the effects of certain accumulated other comprehensive items are not excluded; however, non-advanced
approaches banking organizations, including the Company, may make a one-time permanent election to continue to exclude these items.
The Company and the Bank made this election in order to avoid significant variations in the level of capital depending upon the
impact of interest rate fluctuations on the fair value of the Company’s available-for-sale securities portfolio. The Basel
III Capital Rules also preclude certain hybrid securities, such as trust preferred securities, as Tier 1 capital of bank holding
companies, subject to phase-out. The Company has no trust preferred securities.
Implementation of the deductions and other adjustments
to CET1 began on January 1, 2015 and will be phased-in over a four-year period (beginning at 40% on January 1, 2015 and an additional
20% per year thereafter). The implementation of the capital conservation buffer began on January 1, 2016 at the 0.625% level and
will be phased in over a four-year period (increasing by that amount on each subsequent January 1, until it reaches 2.5% on January
1, 2019).
The Basel III Capital Rules prescribe a standardized approach for
risk weightings that expand the risk-weighting categories from the current four Basel I-derived categories (0%, 20%, 50% and 100%)
to a much larger and more risk-sensitive number of categories, depending on the nature of the assets, generally ranging from 0%
for U.S. government and agency securities, to 600% for certain equity exposures, and resulting in higher risk weights for a variety
of asset categories. Specific changes from the former capital rules impacting the Company’s determination of risk-weighted
assets include, among other things:
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Applying a 150% risk weight instead of a 100% risk weight for certain high volatility commercial
real estate acquisition, development and construction loans;
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Assigning a 150% risk weight to exposures (other than residential mortgage exposures) that are
90 days past due;
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Providing for a 20% credit conversion factor for the unused portion of a commitment with an original
maturity of one year or less that is not unconditionally cancellable (currently set at 0%); and
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Providing for a risk weight, generally not less than 20% with certain exceptions, for securities
lending transactions based on the risk weight category of the underlying collateral securing the transaction.
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Management believes that, as of December 31, 2015,
the Company and the Bank would meet all capital adequacy requirements under the Basel III Capital Rules on a fully phased-in basis
as if such requirements were currently in effect.
Holding Company Regulation
General.
The Company is a unitary
savings and loan holding company within the meaning of federal law. As such, the Company is registered with the FRB and subject
to FRB regulations, examination, supervision and reporting requirements. In addition, the FRB has enforcement authorities over
the Company and its non-savings association subsidiaries. Among other things, that authority permits the FRB to restrict or prohibit
activities that it determines to be a serious risk to the subsidiary savings association.
Activities Restrictions.
Pursuant
to federal law and regulations and policy, a savings and loan holding company such as the Company may generally engage in the activities
permitted for financial holding companies under Section 4(k) of the Bank Holding Company Act and certain other activities that
have been authorized for savings and loan holding companies by regulation.
Federal law prohibits a savings and loan holding
company from, directly or indirectly, or through one or more subsidiaries, acquiring more than 5% of the voting stock of another
savings association or savings and loan holding company, without prior written approval of the FRB or from acquiring or retaining,
with certain exceptions, more than 5% of a non-subsidiary savings association, a non-subsidiary holding company, or a non-subsidiary
company engaged in activities other than those authorized by federal law, or from acquiring or retaining control of a depository
institution that is not insured by the FDIC. In evaluating applications by holding companies to acquire savings associations, the
FRB considers, among other things, factors such as the financial and managerial resources and future prospects of the Company and
institution involved, the effect of the acquisition on the risk to the deposit insurance fund
s
, the convenience
and needs of the community and competitive effects.
The FRB may not approve any acquisition that would
result in a multiple savings and loan holding company controlling savings associations in more than one state, subject to two exceptions:
(i) the approval of interstate supervisory acquisitions by savings and loan holding companies; and (ii) the acquisition of a savings
association in another state if the laws of the state of the target savings association specifically permit such acquisitions.
The states vary in the extent to which they permit interstate savings and loan holding company acquisitions.
Source of Strength.
The Dodd-Frank
Act also extends the “source of strength” doctrine to savings and loan holding companies. The regulatory agencies must
issue regulations requiring that all bank and savings and loan holding companies serve as a source of strength to their subsidiary
depository institutions by providing capital, liquidity and other support to their subsidiary depository institutions in times
of financial stress.
Dividends.
The Bank must notify the
FRB thirty (30) days before declaring any dividend to the Company. The FRB’s policy is that a bank holding company experiencing
earnings weakness should not pay cash dividends exceeding its net income or which could only be funded in ways that weaken the
bank holding company's financial health, such as by borrowing. Additionally, the FRB possesses enforcement powers over bank holding
companies and their non-bank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations
of applicable statutes and regulations. Among these powers is the ability to proscribe the payment of dividends by banks and bank
holding companies.
Acquisition of the Company
.
Under
the Federal Change in Control Act, a notice must be submitted to the FRB if any person (including a company), or group acting in
concert, seeks to acquire direct or indirect “control” of a savings and loan holding company or savings association.
Under certain circumstances, a change of control may occur, and prior notice is required, upon the acquisition of 10% or more of
the Company’s outstanding voting stock, unless the FRB has found that the acquisition will not result in control of the Company.
A change in control definitively occurs upon the acquisition of 25% or more of the Company’s outstanding voting stock. Under
the Change in Control Act, the FRB generally has 60 days from the filing of a complete notice to act, taking into consideration
certain factors, including the financial and managerial resources of the acquirer and the competitive effects of the acquisition.
Any company that acquires control would then be subject to regulation as a savings and loan holding company.
Federal Banking Regulation
Business Activities.
The activities
of federal savings banks are governed by federal laws and regulations. Those laws and regulations delineate the nature and extent
of the business activities in which federal savings banks may engage. In particular, certain lending authority for federal savings
banks,
e.g.
, commercial, non-residential real property loans and consumer loans, is limited to a specified percentage of
the institution’s capital or assets.
Capital Requirements
.
The applicable
capital regulations prior to January 1, 2015 required savings associations to meet three minimum capital standards: a 1.5% tangible
capital to total assets ratio; a 4% tier 1 capital to total assets leverage ratio (3% for institutions receiving the highest rating
on the CAMELS examination rating system) and an 8% risk-based capital ratio.
Prior to January 1, 2015, the risk-based capital
standard for savings associations required the maintenance of Tier 1 (core) and total capital (which is defined as core capital
and supplementary capital less certain specified deductions from total capital such as reciprocal holdings of depository institution
capital instruments and equity investments) to risk-weighted assets of at least 4% and 8%, respectively. In determining the amount
of risk-weighted assets, all assets, including certain off-balance sheet activities, recourse obligations, residual interests and
direct credit substitutes, were multiplied by a risk-weight factor of 0% to 100%, assigned by the capital regulation based on the
risks believed inherent in the type of asset. Core (Tier 1) capital was generally defined as common stockholders’ equity
(including retained earnings), certain non-cumulative perpetual preferred stock and related surplus and minority interests in equity
accounts of consolidated subsidiaries less intangibles other than certain mortgage servicing rights and credit card relationships.
The components of supplementary capital (Tier 2 Capital) included cumulative preferred stock, long-term perpetual preferred stock,
mandatory convertible debt securities, subordinated debt and intermediate preferred stock, the allowance for loan and lease losses
limited to a maximum of 1.25% of risk-weighted assets, and up to 45% of unrealized gains on available-for-sale equity securities
with readily determinable fair market values. Overall, the amount of supplementary capital included as part of total capital could
not exceed 100% of core capital.
The OCC also has authority to establish individual
minimum capital requirements in appropriate cases upon a determination that an institution’s capital level is or may become
inadequate in light of the particular circumstances.
Effective January 1, 2015, the new capital standards
discussed under “BASEL III Capital Rules” above became effective.
Prompt Corrective Regulatory Action.
The Federal Deposit Insurance Act, as amended (“FDIA”), requires among other things, the federal banking agencies to
take “prompt corrective action” in respect of depository institutions that do not meet minimum capital requirements.
The FDIA includes the following five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,”
“significantly undercapitalized” and “critically undercapitalized.” A depository institution’s capital
tier will depend upon how its capital levels compare with various relevant capital measures and certain other factors, as established
by regulation. The relevant capital measures are the total risk-based capital ratio, the Tier 1 risk-based capital ratio, the common
equity Tier 1 risk-based capital ratio, and the leverage ratio.
A bank will be (i) “well capitalized”
if the institution has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 8.0% or greater,
a common equity Tier 1 risk-based capital ratio of 6.5% or greater, and a leverage ratio of 5.0% or greater, and is not subject
to any order or written directive by any such regulatory authority to meet and maintain a specific capital level for any capital
measure; (ii) “adequately capitalized” if the institution has a total risk-based capital ratio of 8.0% or greater,
a Tier 1 risk-based capital ratio of 6.0% or greater, a common equity Tier 1 risk-based capital ratio of 4.5% or greater, and a
leverage ratio of 4.0% or greater and is not “well capitalized”; (iii) “undercapitalized” if the institution
has a total risk-based capital ratio that is less than 8.0%, a Tier 1 risk-based capital ratio of less than 6.0%, a common equity
Tier 1 risk-based capital ratio of less than 4.5%, or a leverage ratio of less than 4.0%; (iv) “significantly undercapitalized”
if the institution has a total risk-based capital ratio of less than 6.0%, a Tier 1 risk-based capital ratio of less than 4.0%,
a common equity Tier 1 risk-based capital ratio of less than 3.0%, or a leverage ratio of less than 3.0%; and (v) “critically
undercapitalized” if the institution’s tangible equity is equal to or less than 2.0% of average quarterly tangible
assets. An institution may be downgraded to, or deemed to be in, a capital category that is lower than indicated by its capital
ratios if it is determined to be in an unsafe or unsound condition or if it receives an unsatisfactory examination rating with
respect to certain matters. A bank’s capital category is determined solely for the purpose of applying prompt corrective
action regulations, and the capital category may not constitute an accurate representation of the bank’s overall financial
condition or prospects for other purposes.
The FDIA generally prohibits a depository institution
from making any capital distributions (including payment of a dividend) or paying any management fee to its parent holding company
if the depository institution would thereafter be “undercapitalized.” “Undercapitalized” institutions are
subject to growth limitations and are required to submit a capital restoration plan. The agencies may not accept such a plan without
determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository
institution’s capital. In addition, for a capital restoration plan to be acceptable, the depository institution’s parent
holding company must guarantee that the institution will comply with such capital restoration plan. The bank holding company must
also provide appropriate assurances of performance. The aggregate liability of the parent holding company is limited to the lesser
of (i) an amount equal to 5.0% of the depository institution’s total assets at the time it became undercapitalized and (ii)
the amount which is necessary (or would have been necessary) to bring the institution into compliance with all capital standards
applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails
to submit an acceptable plan, it is treated as if it is “significantly undercapitalized.”
“Significantly undercapitalized” depository
institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become
“adequately capitalized,” requirements to reduce total assets, and cessation of receipt of deposits from correspondent
banks. “Critically undercapitalized” institutions are subject to the appointment of a receiver or conservator.
The appropriate federal banking agency may, under
certain circumstances, reclassify a well-capitalized insured depository institution as adequately capitalized. The FDIA provides
that an institution may be reclassified if the appropriate federal banking agency determines (after notice and opportunity for
hearing) that the institution is in an unsafe or unsound condition or deems the institution to be engaging in an unsafe or unsound
practice.
The appropriate agency is also permitted to require
an adequately capitalized or undercapitalized institution to comply with the supervisory provisions as if the institution were
in the next lower category (but not treat a significantly undercapitalized institution as critically undercapitalized) based on
supervisory information other than the capital levels of the institution.
The Company believes that, as of December 31, 2015,
the Bank was “well capitalized” based on the aforementioned ratios.
Insurance of Deposit Accounts.
The Bank’s deposits are insured up to applicable limits by the Deposit Insurance Fund of the FDIC. Deposit insurance per
account owner is currently $250,000. Under the Federal Deposit Insurance Corporation’s risk-based assessment system, insured
institutions are assigned a risk category based on supervisory evaluations, regulatory capital levels and certain other factors.
An institution’s assessment rate depends upon the category to which it is assigned, and certain adjustments specified by
FDIC regulations. Institutions deemed less risky pay lower assessments. The FDIC may adjust the scale uniformly, except that no
adjustment can deviate more than two basis points from the base scale without notice and comment. No institution may pay a dividend
if in default of the federal deposit insurance assessment.
The Dodd-Frank Act required the FDIC to revise its
procedures to base its assessments upon each insured institution’s total assets less tangible equity instead of deposits.
The FDIC finalized a rule, effective April 1, 2011, that set the assessment range at 2.5 to 45 basis points of total assets less
tangible equity.
The FDIC has authority to increase insurance assessments.
A significant increase in insurance premiums would likely have an adverse effect on the operating expenses and results of operations
of the Bank. Management cannot predict what insurance assessment rates will be in the future.
Insurance of deposits may be terminated by the FDIC
upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue
operations or has violated any applicable law, regulation, rule, order or regulatory condition imposed in writing by the FDIC or
the OCC. The management of the Bank does not know of any practice, condition or violation that might lead to termination of deposit
insurance.
Loans to One Borrower
. Federal law
provides that savings associations are generally subject to the limits on loans to one borrower applicable to national banks. Generally,
subject to certain exceptions, a savings association may not make a loan or extend credit to a single or related group of borrowers
in excess of 15% of its unimpaired capital and surplus. An additional amount may be lent, equal to 10% of unimpaired capital and
surplus, if secured by specified readily-marketable collateral.
Qualified Thrift Lender (QTL) Test
.
Federal law requires savings associations to meet a qualified thrift lender test. Under the test, a savings association is required
to either qualify as a “domestic building and loan association” under the Internal Revenue Code or maintain at least
65% of its “portfolio assets” (total assets less: (i) specified liquid assets up to 20% of total assets; (ii) intangibles,
including goodwill; and (iii) the value of property used to conduct business) in certain “qualified thrift investments”
(primarily residential mortgages and related investments, including certain mortgage-backed securities but also including education,
credit card and small business loans) in at least nine months out of each 12-month period.
A savings association that fails the qualified thrift
lender test is subject to certain operating restrictions and the Dodd-Frank Act also specifies that failing the qualified thrift
lender test is a violation of law that could result in an enforcement action and dividend limitations. As of December 31, 2015,
the Bank maintained 65% of its portfolio assets in qualified thrift investments and, therefore, met the qualified thrift lender
test.
Limitation on Capital Distributions
.
Federal regulations impose limitations upon all capital distributions by a savings association, including cash dividends, payments
to repurchase its shares and payments to shareholders of another institution in a cash-out merger. Under the regulations, an application
to and prior approval of the OCC is required before any capital distribution if the institution does not meet the criteria for
“expedited treatment” of applications under OCC regulations (i.e., generally, examination and Community Reinvestment
Act ratings in the two top categories), the total capital distributions for the calendar year exceed net income for that year plus
the amount of retained net income for the preceding two years, the institution would be undercapitalized following the distribution
or the distribution would otherwise be contrary to a statute, regulation or agreement with the OCC. If an application is not required,
the institution must still provide 30 days prior written notice to FRB of the capital distribution if, like the Bank, it is a subsidiary
of a holding company, as well as an informational notice filing to the OCC.
If the Bank’s capital fell below its regulatory
requirements or the OCC notified it that it was in need of increased supervision, the Bank’s ability to make capital distributions
could be restricted. In addition, the OCC could prohibit a proposed capital distribution by any institution, which would otherwise
be permitted by the regulation, if the OCC determines that such distribution would constitute an unsafe or unsound practice.
Standards for Safety and Soundness
.
The federal banking agencies have adopted Interagency Guidelines prescribing Standards for Safety and Soundness in various areas
such as internal controls and information systems, internal audit, loan documentation and credit underwriting, interest rate exposure,
asset growth and quality, earnings and compensation, fees and benefits. The guidelines set forth the safety and soundness standards
that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes
impaired. If the OCC determines that a savings association fails to meet any standard prescribed by the guidelines, the OCC may
require the institution to submit an acceptable plan to achieve compliance with the standard.
Community Reinvestment Act
. All federal
savings associations have a responsibility under the Community Reinvestment Act and related regulations to help meet the credit
needs of their communities, including low- and moderate-income neighborhoods. An institution’s failure to satisfactorily
comply with the provisions of the Community Reinvestment Act could result in denials of regulatory applications. Responsibility
for administering the Community Reinvestment Act, unlike other fair lending laws, is not being transferred to the Consumer Financial
Protection Bureau. The Bank received a “satisfactory” Community Reinvestment Act rating in its most recently completed
examination.
Transactions with Related Parties
.
The Bank’s authority to engage in transactions with “affiliates” (e.g., any entity that controls, is under common
control with, or, to a certain extent, controlled by the Bank, including the Company and its other subsidiaries) is limited by
federal law. The aggregate amount of covered transactions with any individual affiliate is limited to 10% of the capital and surplus
of the savings association. The aggregate amount of covered transactions with all affiliates is limited to 20% of the savings association’s
capital and surplus. Certain transactions with affiliates are required to be secured by collateral in an amount and of a type specified
by federal law. The purchase of low quality assets from affiliates is generally prohibited. Transactions with affiliates must generally
be on terms and under circumstances, that are at least as favorable to the institution as those prevailing at the time for comparable
transactions with non-affiliated companies. In addition, savings associations are prohibited from lending to any affiliate that
is engaged in activities that are not permissible for bank holding companies and no savings association may purchase the securities
of any affiliate other than a subsidiary.
The Sarbanes-Oxley Act of 2002 generally prohibits
loans by the Company to its executive officers and directors. However, the law contains a specific exception for loans by a depository
institution to its executive officers and directors in compliance with federal banking laws. Under such laws, the Bank’s
authority to extend credit to executive officers, directors and 10% shareholders (“insiders”), as well as entities
such persons control, is limited. The laws limit both the individual and aggregate amount of loans that the Bank may make to insiders
based, in part, on the Bank’s capital level and requires that certain board approval procedures be followed. Such loans are
required to be made on terms substantially the same as those offered to unaffiliated individuals and not involve more than the
normal risk of repayment. There is an exception for loans made pursuant to a benefit or compensation program that is widely available
to all employees of the institution and does not give preference to insiders over other employees. Loans to executive officers
are subject to additional limitations based on the type of loan involved.
Enforcement.
The OCC has primary enforcement
responsibility over savings associations and has authority to bring actions against the institution and all institution-affiliated
parties, including stockholders, and any attorneys, appraisers and accountants who knowingly or recklessly participate in wrongful
action likely to have an adverse effect on an insured institution. Formal enforcement action may range from the issuance of a capital
directive or cease and desist order to removal of officers and/or directors to institution of receivership, conservatorship or
termination of deposit insurance. Civil penalties cover a wide range of violations and can amount to $25,000 per day, or even $1
million per day in especially egregious cases. The FDIC has the authority to recommend to the Director of the OCC that enforcement
action to be taken with respect to a particular savings association. If action is not taken by the Director, the FDIC has authority
to take such action under certain circumstances. Federal law also establishes criminal penalties for certain violations.
Assessments
. Savings associations
were previously required to pay assessments to the OTS to fund the agency’s operations. The general assessments, paid on
a semi-annual basis, are computer based upon the savings association’s (including consolidated subsidiaries) total assets,
condition and complexity of portfolio. The OCC assessments paid by the Bank for the year ended December 31, 2015 totaled $134,000.
Federal Home Loan Bank System
The Bank is a member of the FHLB System, which consists
of 12 regional FHLBs. The FHLB provides a central credit facility primarily for member institutions. The Bank, as a member of the
FHLB, is required to acquire and hold shares of capital stock in that FHLB. The Bank was in compliance with this requirement with
an investment in FHLB stock at December 31, 2015 of $1.6 million.
The FHLBs have been required to provide funds for
the resolution of insolvent thrifts in the late 1980s and contribute funds for affordable housing programs. These and similar requirements,
or general economic conditions, could reduce the amount of dividends that the FHLBs pay to their members and result in the FHLBs
imposing a higher rate of interest on advances to their members. If dividends were reduced, or interest on future FHLB advances
increased, the Bank’s net interest income would likely also be reduced.
Federal Reserve System
The FRB regulations require savings associations
to maintain non-interest earning reserves against their transaction accounts (primarily NOW and regular checking accounts). The
regulations generally provide that reserves be maintained against aggregate transaction accounts as follows for 2015: a 3% reserve
ratio is assessed on net transaction accounts up to and including $103.6 million; a 10% reserve ratio is applied above $103.6 million.
The first $14.5 million of otherwise reservable balances (subject to adjustments by the FRB) are exempted from the reserve requirements.
The Bank complies with the foregoing requirements. The amounts are adjusted annually and, for 2016, establish a 3% reserve ratio
for aggregate transaction accounts up to $110.2 million, a 10% ratio above $110.2 million, and an exemption of $15.2 million. In
October 2008, the FRB began paying interest on certain reserve balances.
Other Regulations
The Bank’s operations are also subject
to federal laws applicable to credit transactions, including the:
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Truth-In-Lending Act, governing disclosures of credit terms to consumer borrowers;
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Home Mortgage Disclosure Act of 1975, requiring financial institutions to provide information to
enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the
housing needs of the community it serves;
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Equal Credit Opportunity Act, prohibiting discrimination on the basis of race, creed or other prohibited
factors in extending credit;
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Fair Credit Reporting Act of 1978, governing the use and provision of information to credit reporting
agencies;
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Fair Debt Collection Act, governing the manner in which consumer debts may be collected by collection
agencies; and
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Rules and regulations of the various federal agencies charged with the responsibility of implementing
such federal laws.
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The operations of the Bank also are subject
to laws such as the:
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Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial
records and prescribes procedures for complying with administrative subpoenas of financial records;
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Electronic Funds Transfer Act and Regulation E promulgated thereunder, which govern automatic deposits
to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines
and other electronic banking services; and
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Check Clearing for the 21st Century Act (also known as “Check 21”), which gives certain
check reproductions, such as digital check images and copies made from that image (a “substitute check”), the same
legal standing as the original paper check.
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FEDERAL AND STATE TAXATION
Federal Taxation
General.
The Company and its subsidiaries
report their income on a calendar year basis using the accrual method of accounting and are subject to federal income taxation
in the same manner as other corporations with some exceptions, including particularly the Bank’s reserve for bad debts, as
discussed below. The following discussion of tax matters is intended only as a summary and does not purport to be a comprehensive
description of the tax rules applicable to the Bank or the Company. The Company and the Bank have not been audited by the Internal
Revenue Service in the past five years.
The Company and the Bank have entered into a tax
allocation agreement. Because the Company owns 100% of the issued and outstanding capital stock of the Bank, the Company and the
Bank are members of an affiliated group within the meaning of Section 1504(a) of the Internal Revenue Code, of which group the
Company is the common parent corporation. As a result of this affiliation, the Bank may be included in the filing of a consolidated
federal income tax return with the Company and, if a decision to file a consolidated tax return is made, the parties agree to compensate
each other for their individual share of the consolidated tax liability and/or any tax benefits provided by them in the filing
of the consolidated federal tax return.
Bad Debt Reserve.
For taxable years
beginning after December 31, 1995, the Bank is entitled to take a bad debt deduction for federal income tax purposes which
is based on its current or historic net charge-offs by applying the experience reserve method for banks, as long as the Bank does
not meet the definition of a “large bank”. Under the Internal Revenue Code, if a bank’s average adjusted assets
exceeds $500 million for any tax year it is considered a “large bank” and must utilize the specific charge-off method
to compute bad debt deductions. The Bank is expected to meet the definition of a “large bank” for the tax year ending
December 31, 2016 as a result of the acquisition of Peoples. As such, the Bank will be required to use the specific charge-off
method to compute bad debt deductions beginning in 2016 and its bad debt reserves calculated using the experience reserve method
will be recaptured in taxable income over the four-year period ending December 31, 2019.
Potential Recapture of Base Year Bad Debt
Reserve.
The Bank’s bad debt reserve as of the base year (which is the Bank’s last taxable year beginning before
January 1, 1988) is not subject to automatic recapture as long as the Bank continues to carry on the business of banking and
does not make “non-dividend distributions” as discussed below. If the Bank no longer qualifies as a bank, the balance
of the pre-1988 reserves (the base year reserves) are restored to income over a six-year period beginning in the tax year the Bank
no longer qualifies as a bank. Such base year bad debt reserve is also subject to recapture to the extent that the Bank makes “non-dividend
distributions” that are considered as made from the base year bad debt reserve. To the extent that such reserves exceed the
amount that would have been allowed under the experience method (“Excess Distributions”), then an amount based on the
amount distributed will be included in the Bank’s taxable income. Non-dividend distributions include distributions in excess
of the Bank’s current and accumulated earnings and profits, distributions in redemption of stock, and distributions in partial
or complete liquidation. However, dividends paid out of the Bank’s current or accumulated earnings and profits, as calculated
for federal income tax purposes, will not be considered to result in a distribution from the Bank’s bad debt reserve. Thus,
any dividends to the Company that would reduce amounts appropriated to the Bank’s bad debt reserve and deducted for federal
income tax purposes would create a tax liability for the Bank. The amount of additional taxable income created from an Excess Distribution
is an amount that, when reduced by the tax attributable to the income, is equal to the amount of the distribution. If the Bank
makes a “non-dividend distribution,” then approximately one and one-half times the amount so used would be includable
in gross income for federal income tax purposes, assuming a 34% corporate income tax rate (exclusive of state and local taxes).
The Bank does not intend to pay dividends that would result in a recapture of any portion of its bad debt reserve.
Corporate Alternative Minimum Tax.
The
Internal Revenue Code imposes a tax on alternative minimum taxable income (“AMTI”) at a rate of 20%. The excess of
the bad debt reserve deduction claimed by the Bank over the deduction that would have been allowable under the experience method
is treated as a preference item for purposes of computing the AMTI. Only 90% of AMTI can be offset by net operating loss carry-overs,
of which the Bank currently has none. AMTI is increased by an amount equal to 75% of the amount by which the Bank’s adjusted
current earnings exceed its AMTI (determined without regard to this preference and before reduction for net operating losses).
In addition, for taxable years beginning after June 30, 1986 and before January 1, 1996, an environmental tax of 0.12%
of the excess of AMTI (with certain modifications) over $2.0 million is imposed on corporations, including the Bank, whether or
not an Alternative Minimum Tax (“AMT”) is paid. The Bank does not expect to be subject to the AMT.
Dividends Received Deduction and Other Matters.
The Company may exclude from its income 100% of dividends received from the Bank as a member of the same affiliated group of
corporations. The corporate dividends received deduction is generally 70% in the case of dividends received from unaffiliated corporations
with which the Company and the Bank will not file a consolidated tax return, except that if the Company or the Bank own more than
20% of the stock of a corporation distributing a dividend, then 80% of any dividends received may be deducted.
State Taxation
Indiana.
Effective July 1, 2013, Indiana
amended its tax code to provide for reductions in the franchise tax rate. For the year ended December 31, 2015, Indiana imposed
a 7.5% franchise tax based on a financial institution’s adjusted gross income as defined by statute. The Indiana franchise
tax rate will be reduced to 7.0% and 6.5% for the Company’s tax years ending December 31, 2016 and 2017, respectively, and
will remain at 6.5% for the tax year ending December 31, 2018. The Indiana franchise tax rate will then be reduced to 6.25%, 6.00%,
5.50% and 5.00% for the Company’s tax years ending December 31, 2019, 2020, 2021 and 2022, respectively. Finally, the franchise
tax rate will be reduced to 4.90% for the Company’s tax year ending December 31, 2023 and will remain 4.90% thereafter. In
computing adjusted gross income, deductions for municipal interest, United States Government interest, the bad debt deduction computed
using the reserve method and pre-1990 net operating losses is disallowed. The Company’s Indiana state income tax returns
have not been audited in the past five years.
Kentucky.
With the acquisition of
Peoples in December 2015, the Bank is now subject to a tax on the Bank’s capital attributable to Kentucky as of January 1
each year beginning January 1, 2016. The capital stock tax on savings banks is imposed on the capital of the institution attributable
to Kentucky at a rate of $1 for each $1,000 in capital. Taxable capital includes certificates of deposit, savings accounts, demand
deposits, undivided profits, surplus and general reserves, less an amount equal to the market value of qualifying U.S. government
securities. Because the Bank has business activity both within and without Kentucky, the amount of its capital attributable to
Kentucky is determined using a three-factor apportionment formula which considers gross receipts, outstanding loan balances and
payroll.
ITEM 1A. RISK FACTORS
Risks Related To Our Business.
Above average interest rate risk associated with fixed-rate loans
may have an adverse effect on our financial position or results of operations.
The Bank’s loan portfolio includes a significant
amount of loans with fixed rates of interest. At December 31, 2015, $201.6 million, or 54.9% of the Bank’s total loans receivable,
had fixed interest rates all of which were held for investment. The Bank offers ARM loans and fixed-rate loans. Unlike ARM loans,
fixed-rate loans carry the risk that, because they do not reprice to market interest rates, their yield may be insufficient to
offset increases in the Bank’s cost of funds during a rising interest rate environment. Accordingly, a material and prolonged
increase in market interest rates could be expected to have a greater adverse effect on the Bank’s net interest income compared
to other institutions that hold a materially larger portion of their assets in ARM loans or fixed-rate loans that are originated
for committed sale in the secondary market. For a discussion of the Bank’s loan portfolio, see “
Item 1. Business–
Lending Activities
.”
Higher loan losses could require the Company to increase its allowance
for loan losses through a charge to earnings.
When we loan money we incur the risk that our borrowers
do not repay their loans. We reserve for loan losses by establishing an allowance through a charge to earnings. The amount of this
allowance is based on our assessment of loan losses inherent in our loan portfolio. The process for determining the amount of the
allowance is critical to our financial results and condition. It requires subjective and complex judgments about the future, including
forecasts of economic or market conditions that might impair the ability of our borrowers to repay their loans. We might underestimate
the loan losses inherent in our loan portfolio and have loan losses in excess of the amount reserved. We might increase the allowance
because of changing economic conditions. For example, in a rising interest rate environment, borrowers with adjustable-rate loans
could see their payments increase. There may be a significant increase in the number of borrowers who are unable or unwilling to
repay their loans, resulting in our charging off more loans and increasing our allowance. In addition, when real estate values
decline, the potential severity of loss on a real estate-secured loan can increase significantly, especially in the case of loans
with high combined loan-to-value ratios. Our allowance for loan losses at any particular date may not be sufficient to cover future
loan losses. We may be required to increase our allowance for loan losses, thus reducing earnings.
Commercial business lending may expose the Company to increased lending risks.
At December 31, 2015, the Bank’s commercial
business loan portfolio amounted to $23.1 million, or 6.3% of total loans. Subject to market conditions and other factors, the
Bank intends to expand its commercial business lending activities within its primary market area. Commercial business lending is
inherently riskier than residential mortgage lending. Although commercial business loans are often collateralized by equipment,
inventory, accounts receivable or other business assets, the liquidation value of these assets in the event of a borrower default
is often an insufficient source of repayment because accounts receivable may be uncollectible and inventories and equipment may
be obsolete or of limited use, among other things. See “
Item 1. Business–Lending Activities–Commercial Business
Loans
.”
Commercial real estate lending may expose the Company to increased
lending risks.
At December 31, 2015, the Bank’s commercial
real estate loan portfolio amounted to $84.5 million, or 23.0% of total loans. Commercial real estate lending is inherently riskier
than residential mortgage lending. Because payments on loans secured by commercial properties often depend upon the successful
operation and management of the properties, repayment of such loans may be affected by adverse conditions in the real estate market
or the economy, among other things. See “
Item 1. Business–Lending Activities–Commercial Real Estate Loans
.”
Our information systems may experience an interruption or
breach in security.
The Bank relies heavily on internal and outsourced
digital technologies, communications, and information systems to conduct its business. As our reliance on technology systems increases,
the potential risks of technology-related operation interruptions in our customer relationship management, general ledger, deposit,
loan, or other systems or the occurrence of cyber incidents also increases. Cyber incidents can result from deliberate attacks
or unintentional events including (i) gaining unauthorized access to digital systems for purposes of misappropriating assets or
sensitive information, corrupting data, or causing operational disruptions; (ii) causing denial-of-service attacks on websites;
or (iii) intelligence gathering and social engineering aimed at obtaining information. The occurrence of operational interruption,
cyber incident, or a deficiency in the cyber security of our technology systems (internal or outsourced) could negatively impact
our financial condition or results of operations.
We have policies and procedures expressly designed
to prevent or limit the effect of a failure, interruption, or security breach of our systems and maintain cyber security insurance.
However, such policies, procedures, or insurance may prove insufficient to prevent, repel, or mitigate a cyber incident. Significant
interruptions to our business from technology issues could result in expensive remediation efforts and distraction of management.
During the year, we experienced certain immaterial cyber-attacks or breaches and continue to invest in security and controls to
prevent and mitigate future incidents. Although we have not experienced any material losses related to a technology-related operational
interruption or cyber-attack, there can be no assurance that such failures, interruptions, or security breaches will not occur
in the future or, if they do occur, that the impact will not be substantial.
The occurrence of any failures, interruptions, or
security breaches of our technology systems could damage our reputation, result in a loss of customer business, result in the unauthorized
release, gathering, monitoring, misuse, loss, or destruction of proprietary information, subject us to additional regulatory scrutiny,
or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial
condition, results of operations, or stock price. As cyber threats continue to evolve, we may also be required to spend significant
additional resources to continue to modify or enhance our protective measures or to investigate and remediate any information security
vulnerabilities.
We depend on outside third parties for processing and handling
of our records and data.
The Bank relies on software developed by third party
vendors to process various transactions. In some cases, we have contracted with third parties to run their proprietary software
on our behalf. These systems include, but are not limited to, general ledger, payroll, employee benefits, and loan and deposit
processing, and securities portfolio management. While we perform a review of controls instituted by the vendors over these programs
in accordance with industry standards and perform our own testing of user controls, we must rely on the continued maintenance of
these controls by the outside party, including safeguards over the security of customer data. In addition, we maintain backups
of key processing output daily in the event of a failure on the part of any of these systems. Nonetheless, we may incur a temporary
disruption in its ability to conduct our business or process our transactions or incur damage to our reputation if the third party
vendor fails to adequately maintain internal controls or institute necessary changes to systems. Such disruption or breach of security
may have a material adverse effect on our financial condition and results of operations.
We continually encounter technological change.
The banking and financial services industry continually
undergoes technological changes, with frequent introductions of new technology-driven products and services. In addition to better
meeting customer needs, the effective use of technology increases efficiency and enables financial institutions to reduce costs.
Our future success will depend, in part, on our ability to address the needs of our customers by using technology to provide products
and services that enhance customer convenience and that create additional efficiencies in our operations. Many of our competitors
have greater resources to invest in technological improvements, and we may not effectively implement new technology-driven products
and services or do so as quickly as our competitors, which could reduce our ability to effectively compete. Failure to successfully
keep pace with technological change affecting the financial services industry could have a material adverse effect on our business,
financial condition, and results of operations.
We may not be able to attract and retain skilled people.
The Bank’s success depends on its ability
to attract and retain skilled people. Competition for the best people in most activities in which we engage can be intense, and
we may not be able to hire people or retain them. The unexpected loss of services of certain of our skilled personnel could have
a material adverse impact on our business because of their skills, knowledge of our market, years of industry experience, customer
relationships, and the difficulty of promptly finding qualified replacement personnel.
Loss of key employees may disrupt relationships with certain customers.
Our customer relationships are critical to the success
of our business, and loss of key employees with significant customer relationships may lead to the loss of business if the customers
were to follow that employee to a competitor. While we believe our relationships with its key personnel are strong, we cannot guarantee
that all of our key personnel will remain with the organization, which could result in the loss of some of our customers and could
have a negative impact on our business, financial condition, and results of operations.
Risks Related to the Banking Industry.
Our business may be adversely affected by conditions in the
financial markets and economic conditions generally.
Our financial performance depends to a large
extent on the business environment in our geographically concentrated five-county market area, the nearby suburban metropolitan
Louisville market, the states of Indiana and Kentucky, and the U.S. as a whole. In particular, the current environment impacts
the ability of borrowers to pay interest on and repay principal of outstanding loans as well as the value of collateral securing
those loans. A favorable business environment is generally characterized by economic growth, low unemployment, efficient capital
markets, low inflation, high business and investor confidence, strong business earnings, and other factors. Unfavorable or uncertain
economic and market conditions can be caused by declines in economic growth, business activity, or investor or business confidence;
limitations on the availability or increases in the cost of credit and capital; increases in inflation or interest rates; high
unemployment; natural disasters; or a combination of these or other factors.
In recent years, our market area, the suburban
metropolitan Louisville market, the states of Indiana and Kentucky, and the U.S. as a whole experienced a downward economic cycle.
Significant weakness in market conditions adversely impacted all aspects of the economy, including our business. In particular,
dramatic declines in the housing market, with decreasing home prices and increasing delinquencies and foreclosures, negatively
impacted the credit performance of construction loans, which resulted in significant write-downs of assets by many financial institutions.
Business activity across a wide range of industries and regions was greatly reduced, and local governments and many businesses
experienced serious difficulty due to the lack of consumer spending and the lack of liquidity in the credit markets. In addition,
unemployment increased significantly during that period, which further contributed to the adverse business environment for households
and businesses.
While economic conditions have shown signs
of improvement through 2015, there can be no assurance that economic recovery will continue, and future deterioration would likely
exacerbate the adverse effects of recent difficult market conditions on us and others in the financial institutions industry. Market
stress could have a material adverse effect on the credit quality of our loans, and therefore, our financial condition and results
of operations as well as other potential adverse impacts including:
-
There could be an increased level of commercial and consumer
delinquencies, lack of consumer confidence, increased market volatility, and widespread reduction of business activity generally.
-
There could be an increase in write-downs of asset values by
financial institutions, such as the Bank.
-
There could be the loss of collateral value on commercial and
real estate loans that are secured by real estate located in our market area. A further significant decline in real estate values
in our market would mean that the collateral for many of our loans would provide less security. As a result, we would be more likely
to suffer losses on defaulted loans because our ability to fully recover on defaulted loans by selling the real estate collateral
would be diminished.
-
Our ability to assess the creditworthiness of customers could
be impaired if the models and approaches it uses to select, manage, and underwrite credits become less predictive of future performance.
-
The process we use to estimate losses inherent in our loan portfolio
requires difficult, subjective, and complex judgments. This process includes analysis of economic conditions and the impact of
these economic conditions on borrowers’ ability to repay their loans. The process could no longer be capable of accurate
estimation and may, in turn, impact its reliability.
-
The Bank could be required to pay significantly higher FDIC
premiums in the future if losses further deplete the Deposit Insurance Fund.
-
We could face increased competition due to intensified consolidation
of the financial services industry. If current levels of market disruption and volatility continue or worsen, there can be no assurance
that we will not experience an adverse effect, which may be material, on our ability to access capital and on our business, financial
condition, and results of operations.
Future economic conditions in our market
will depend on factors outside of our control such as political and market conditions, broad trends in industry and finance, legislative
and regulatory changes, changes in government, military and fiscal policies and inflation.
Turmoil in the financial markets could result in lower fair
values for our investment securities.
Major disruptions in the capital markets
experienced in recent years have adversely affected investor demand for all classes of securities, excluding U.S. Treasury securities,
and resulted in volatility in the fair values of our investment securities. Significant prolonged reduced investor demand could
manifest itself in lower fair values for these securities and may result in recognition of an other-than-temporary impairment (“OTTI”),
which could have a material adverse effect on our financial condition and results of operations.
Municipal securities can also be impacted
by the business environment of their geographic location. Although this type of security historically experienced extremely low
default rates, municipal securities are subject to systemic risk since cash flows generally depend on (i) the ability of the issuing
authority to levy and collect taxes or (ii) the ability of the issuer to charge for and collect payment for essential services
rendered. If the issuer defaults on its payments, it may result in the recognition of OTTI or total loss, which could have a material
adverse effect on our financial condition and results of operations.
Strong competition within the Bank’s market area could hurt
the Company’s profitability and growth.
The Bank faces intense competition both in making
loans and attracting deposits. This competition has made it more difficult for it to make new loans and at times has forced it
to offer higher deposit rates. Price competition for loans and deposits might result in the Bank earning less on loans and paying
more on deposits, which would reduce net interest income. Competition also makes it more difficult to grow loans and deposits.
Some of the institutions with which the Bank competes have substantially greater resources and lending limits than it has and may
offer services that the Bank does not provide. Future competition will likely increase because of legislative, regulatory and technological
changes and the continuing trend of consolidation in the financial services industry. The Company’s profitability depends
upon the Bank’s continued ability to compete successfully in its market area.
We are subject to federal regulations that seek to protect the Deposit
Insurance Fund and the depositors and borrowers of the Bank, and our federal regulators may impose restrictions on our operations
that are detrimental to holders of the Company’s common stock.
We are subject to extensive regulation, supervision
and examination by the FRB and the OCC, our primary federal regulators, and the FDIC, as insurer of our deposits. Such regulation
and supervision governs the activities in which an institution and its holding company may engage, and are intended primarily for
the protection of the insurance fund and the depositors and borrowers of the Bank rather than for holders of the Company’s
common stock. Our regulators may subject us to supervisory and enforcement actions, such as the imposition of certain restrictions
on our operations, the classification of our assets and the determination of the level of our allowance for loan losses, that are
aimed at protecting the insurance fund and the depositors and borrowers of the Bank but that are detrimental to holders of the
Company’s common stock. Any change in our regulation or oversight, whether in the form of regulatory policy, regulations,
legislation or supervisory action, may have a material impact on our operations.
Financial regulatory reform may have a material impact on the Company’s operations.
The Dodd-Frank Act contains various provisions designed
to enhance the regulation of depository institutions and prevent the recurrence of a financial crisis such as occurred in 2008
and 2009. These include provisions strengthening holding company capital requirements, requiring retention of a portion of the
risk of securitized loans and regulating debit card interchange fees. The Dodd-Frank Act also created the Consumer Financial Protection
Bureau to administer consumer protection and fair lending laws, a function that was formerly performed by the depository institution
regulators. The full impact of the Dodd-Frank Act on our business and operations will not be known for years until regulations
implementing the statute are written and adopted. However, it is likely that the provisions of the Dodd-Frank Act will have an
adverse impact on our operations, particularly through increased regulatory burden and compliance costs.
Additionally, in July 2013, the federal banking
agencies issued a final rule to revise their risk-based and leverage capital requirements and their method for calculating risk-weighted
assets, to make them consistent with the agreements that were reached by the Basel Committee on Banking Supervision and certain
provisions of the Dodd-Frank Act. The final rule applies to all depository institutions, top-tier bank holding companies with total
consolidated assets of $500 million or more, and top-tier savings and loan holding companies (“banking organizations”).
Among other things, the rule establishes a new common equity Tier 1 minimum capital requirement (4.5% of risk-weighted assets),
increases the minimum Tier 1 capital to risk-based assets requirement (from 4% to 6% of risk-weighted assets) and assigns a higher
risk weight (150%) to exposures that are more than 90 days past due or are on nonaccrual status and to certain commercial real
estate facilities that finance the acquisition, development or construction of real property. The final rule also limits a banking
organization’s capital distributions and certain discretionary bonus payments if the banking organization does not hold a
“capital conservation buffer” consisting of 2.5% of common equity Tier 1 capital to risk-weighted assets in addition
to the amount necessary to meet its minimum risk-based capital requirements. The final rule became effective on January 1, 2015.
The capital conservation buffer requirement began phasing in on January 1, 2016 and will end January 1, 2019, when the full capital
conservation buffer requirement will be effective.
Compliance with these rules, which are still being
analyzed, will impose additional costs on banking entities and their holding companies.
Acquisitions and the addition of branch facilities may not produce
revenue enhancements or cost savings at levels or within timeframes originally anticipated and may result in unforeseen integration
difficulties and dilution to existing shareholder value.
We acquired Peoples on December 4, 2015. We may
have difficulty in integrating Peoples or other acquired companies which may cause us not to realize expected revenue increases,
cost savings, increases in geographic or product presence, and/or other projected benefits. The integration could result in higher
than expected deposit attrition (run-off), loss of key employees, disruption of our business or the business of the acquired company,
or otherwise adversely affect our ability to maintain relationships with customers and employees or achieve the anticipated benefits
of the acquisition. Also, the acquisition of Peoples significantly increases the size of the Company as well as our level of nonperforming
assets. The success of the acquisition will depend, in part, to our ability to reduce the level of nonperforming assets and grow
the loan portfolio.
We regularly explore opportunities to establish
branch facilities and acquire other banks or financial institutions. New or acquired branch facilities and other facilities may
not be profitable. We may not be able to correctly identify profitable locations for new branches. The costs to start up new branch
facilities or to acquire existing branches, and the additional costs to operate these facilities, may increase our noninterest
expense and decrease earnings in the short term. It may be difficult to adequately and profitably manage growth through the establishment
of these branches. In addition, we can provide no assurance that these branch sites will successfully attract enough deposits to
offset the expenses of operating these branch sites. Any new or acquired branches will be subject to regulatory approval, and there
can be no assurance that we will succeed in securing such approvals.
Risks Related to the Company’s Stock.
An investment in the Company’s Common Stock is not an insured
deposit.
The Company’s common stock is not a bank deposit
and, therefore, is not insured against loss by the FDIC, any other deposit insurance fund, or by any other public or private entity.
Investment in the Company’s Common Stock is inherently risky for the reasons described in this “Risk Factors”
section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any public
company. As a result, if you acquire the Company’s common stock, you could lose some or all of your investment.
The price of the Company’s common stock may be volatile, which
may result in losses for investors.
General market price declines or market volatility
in the future could adversely affect the price of the Company’s common stock. In addition, the following factors may cause
the market price for shares of the Company’s common stock to fluctuate:
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announcements of developments related to the Company’s business;
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fluctuations in the Company’s results of operations;
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sales or purchases of substantial amounts of the Company’s
securities in the marketplace;
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general conditions in the Company’s banking niche or the worldwide
economy;
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a shortfall or excess in revenues or earnings compared to securities
analysts’ expectations;
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changes in analysts’ recommendations or projections; and
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the Company’s announcement of new acquisitions or other projects.
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The trading volume in the Company’s common stock is less than
that of other larger financial services institutions.
Although the Company’s common stock is listed
for trading on the NASDAQ Capital Market, the trading volume in its common stock may be less than that of other, larger financial
services companies. A public trading market having the desired characteristics of depth, liquidity, and orderliness depends on
the presence in the marketplace of willing buyers and sellers of the Company’s common stock at any given time. This presence
depends on the individual decisions of investors and general economic and market conditions over which the Company has no control.
During any period of lower trading volume of the Company’s common stock, significant sales of shares of the Company’s
common stock, or the expectation of these sales could cause the Company’s common stock price to fall.
The Company’s Articles of Incorporation, Indiana law, and certain
banking laws may have an anti-takeover effect.
Provisions of the Company’s Articles of Incorporation,
the Indiana Business Corporation Law and federal banking laws, including regulatory approval requirements, could make it more difficult
for a third party to acquire the Company, even if doing so would be perceived to be beneficial by the Company’s shareholders.
The combination of these provisions could have the effect of inhibiting a non-negotiated merger or other business combination,
which, in turn, could adversely affect the market price of the Company’s common stock.
The Company may issue additional securities, which could dilute the
ownership percentage of holders of the Company’s common stock.
The Company may issue additional securities to,
among other reasons, raise additional capital or finance acquisitions, and, if it does, the ownership percentage of holders of
the Company’s common stock could be diluted potentially materially.
We may not be able to pay dividends in the future in accordance with
past practice.
The Company has traditionally paid a quarterly dividend
to common shareholders. The payment of dividends is subject to legal and regulatory restrictions. Any payment of dividends in the
future will depend, in large part, on our earnings, capital requirements, financial condition and other factors considered relevant
by the Company’s Board of Directors. The Board may, at its discretion, further reduce or eliminate dividends or change its
dividend policy in the future.