HFB Financial Corporation (the "Company") is the sole stockholder of, and acts as the holding company for, Home Federal Bank Corporation ("Home Federal" or the "Bank"). The Company was organized at the direction of the Bank in September 1992 to acquire all of the capital stock issued by the Bank in its conversion from a mutual to stock form. The Company has no significant assets other than capital stock of the Bank. The Company qualifies as a bank holding company and is subject to regulation by the Federal Reserve Board ("FRB"). The Company's principal business is the business of the Bank and its subsidiary. Therefore, references to the "Company" in this Form 10-KSB are to both the Company and the Bank. The Bank operates through three full-service offices in the southeastern Kentucky communities of Middlesboro and Harlan and two full-service offices in the eastern Tennessee communities of New Tazewell and Jacksboro. At December 31, 2002, the Company had total assets of $253.5 million, deposits of $199.3 million, net loans receivable of $166.3 million and stockholders' equity of $23.6 million.
The executive offices of the Company are located at 1602 Cumberland Avenue, Middlesboro, Kentucky 40965, and the telephone number is (606) 248-1095.
The Company is engaged principally in the business of accepting deposits from the general public and originating permanent loans that are secured by one- to-four-family residential properties located in its market area. The Company also originates consumer loans and commercial real estate loans and maintains a substantial investment portfolio of mortgage-backed and other investment securities.
Change in Fiscal Year
On February 19, 2002, the board of directors of the Company made a determination to change the registrant's fiscal year-end from June 30 to December 31, effective July 1, 2002. The Company filed an Annual Report on Form 10-K with the Securities and Exchange Commission for its fiscal year ended June 30, 2002. Pursuant to the change in fiscal year, the Company has filed this Form 10-K transition report with the Securities and Exchange Commission for the six-month period ending December 31, 2002. Audited financial statements covering the six-month period ending December 31, 2002 are part of this 10-K transition filing.
The Company changed its fiscal year in order to facilitate the comparability of the Company to other bank holding companies, which have historically utilized a December 31 year-end. Moving to a December 31 year-end has aligned the Company's financial reporting with its peer group and with publicly held bank holding companies in the United States.
Approval for new branch office
On July 8, 2002, the Bank received regulatory approval to establish a branch office in the City of Jacksboro, Tennessee. Jacksboro is county seat for Campbell County and is located in the northeastern portion of Tennessee. The Bank has originated loans in this market over the last 20 years and presently has a portfolio of loans in excess of $50.0 million within this market. Management believes that the Bank's presence in Jacksboro through an office will assist in increasing the Bank's loan portfolio and obtaining new deposits. The new branch was opened during January 2003 in a temporary location. The Company's wholly owned subsidiary, Home Service Corporation, has paid $510,000 for a commercial lot in Jacksboro. Home Service Corporation will build the branch office and lease it to the Bank. The total cost of the land and building is estimated at $1.5 million. The new branch office building is expected to be ready for occupancy in approximately 18 months.
Special Note Regarding Forward-looking Statements
Certain matters discussed in this document are "forward-looking statements," intended to qualify for the safe harbors from liability established by the Private Securities Legislation Reform Act of 1995. These forward-looking statements can generally be identified as such because the context of the statement will include words such as the Company "believes," "anticipates," "expects" or "estimates," or words of similar import. Similarly, statements that describe the Company's future plans, objectives or goals are also forward-looking statements. Such forward-looking statements are subject to certain risks and uncertainties which are described in close proximity to such statements and which could cause actual results to differ materially from those anticipated as of the date of this report. Shareholders, potential investors and other readers are cautioned not to place undue reliance on such forward-looking statements. The forward-looking statements included herein are made only as of the date of this report and the Company undertakes no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances.
Lending Activities
General. The Company originates loans primarily through its main office located in Middlesboro, Kentucky. The principal lending activity of the Company is the origination of conventional mortgage loans for the purpose of purchasing or refinancing owner-occupied, one- to four-family residential properties in its primary market areas. Conventional mortgage loans are primarily adjustable-rate mortgage loans with a smaller amount of fixed-rate mortgage loans which are not insured or guaranteed by federal agencies. The Company does not originate Federal Housing Administration-insured or Veterans Administration-insured loans. The Company does originate consumer loans on a direct basis. In addition, the Company also makes conventional mortgage loans for the purpose of constructing one- to four-family residences and loans to construct commercial and multifamily real estate.
The Company emphasizes the origination of adjustable-rate loans and short-term loans in order to increase the interest rate sensitivity of its loan portfolio. However, the Company also continues to offer long-term, fixed-rate conventional mortgage loans (30-year terms or less), originated for its portfolio. The ratio of fixed-rate loans to adjustable-rate loans has increased significantly during the last six months due to the current low-interest-rate environment.
Analysis of Loan Portfolio. Set forth below is selected data relating to the composition of the Company's loan portfolio at the dates indicated. As of December 31, 2002, the Company had no concentrations of loans exceeding 10% of total loans other than as disclosed below.
(1) Includes loans on deposits, home improvement loans, automobile loans and other loans.
The following table sets forth certain information as of December 31, 2002 the regarding the dollar amount of principal repayments becoming due during the periods indicated for loans. Demand loans, loans having no schedule of repayments and no stated maturity, and overdrafts are reported as due in one year or less. The table below does not include any estimate of prepayments which significantly shorten the average life of all mortgage loans and may cause the Company's actual repayment experience to differ from that shown below.
The following table sets forth as of December 31, 2002 the dollar amount of all the loans due after one year ending December 31, 2002 and distinguishes between those with predetermined (i.e., fixed) interest rates and those with floating or adjustable interest rates.
(1) Includes loans on deposits, home improvement loans, automobile loans and other loans.
The primary emphasis of the Company's lending activity is the origination of conventional loans secured by owner-occupied, one- to four-family residential properties. The Company's conventional mortgage loan originations are generally for terms of 10 to 30 years, amortized on a monthly basis, with principal and interest due each month. Borrowers may refinance or prepay loans at their option without penalty. Conventional residential mortgage loans granted by the Company customarily contain "due-on-sale" clauses which permit the Company to accelerate the indebtedness of the loan upon transfer of ownership of the mortgaged property.
The Company's lending policies generally limit the maximum loan-to-value ratio on mortgage loans secured by owner-occupied properties to 81% and 95% of the lesser of the appraised value or purchase price. The maximum loan-to-value ratio on mortgage loans secured by non-owner-occupied properties and/or used for refinancing purposes is also 80%. The Company does originate some 81% to 95% loan-to-value ratio loans. The Company requires private mortgage insurance on loans with loan-to-value ratios of 91% and over and charges a higher effective interest rate on such loans to account for the additional risk these loans carry.
The Company also originates conventional fixed-rate mortgage loans on one- to four-family residential properties, the majority of which have a maximum term to maturity of 30 years. The Company originates and holds its fixed-rate mortgage loans in its portfolio as long-term investments.
In addition, the Company engages in a limited but increasing amount of construction lending involving loans to qualified borrowers for construction of one- to four-family residential properties. These properties are primarily located in the Company's market area. All construction loans are secured by a first lien on the property under construction. Construction/permanent loans generally have adjustable interest rates and are underwritten in accordance with the same terms and requirements as the Company's permanent mortgages, except the loans generally provide for disbursement in stages during a construction period of up to 12 months, during which period the borrower is required to make monthly payments of accrued interest on the outstanding loan balance. Interim construction loans generally have fixed interest rates, terms of up to 12 months and a maximum loan-to-value ratio of 80%. Borrowers must satisfy all credit requirements which would apply to the Company's permanent mortgage loan financing for the subject property.
The Company also originates consumer loans, primarily savings account loans, automobile loans, home equity loans and lines of credit, second mortgage loans and other consumer loans secured by mortgages on residences. The Company also makes a limited amount of unsecured loans.
The Company has historically engaged in a limited amount of commercial and multifamily real estate lending but has increased originations of such loans over the past 12 months. The Company generally makes commercial and multifamily real estate loans available on properties in its market area, with terms of 20 years or less, loan-to-value ratios of 80% or less and adjustable rates of interest. In addition, the Company, from time to time, purchases whole loans or participation interests in loans on commercial and multifamily real estate located in Kentucky and eastern Tennessee.
Asset Classification and Allowance for Loan Losses. The Company classifies its loan assets as a "substandard," "doubtful" or "loss," if warranted. Assets classified as substandard or doubtful require a general allowance for loan losses. If an asset is classified as loss, the loan must be charged off. An asset which does not currently warrant classification but which possesses weaknesses or deficiencies deserving close attention is required to be designated as "special mention." Currently, general loss allowances established to cover possible losses related to assets classified substandard or doubtful may be included in determining an institution's regulatory capital, while specific valuation allowances for loan losses do not qualify as regulatory capital. The Company has determined that at December 31, 2002 it had $2.2 million in assets classified as substandard, $688,000 in assets classified as doubtful and no assets classified as loss. In addition, the Company had $1.6 million in assets designated as special mention. Depending on their future performance, it is possible that these loans might be required to be classified in future periods.
The following table sets forth an analysis of the Company's allowance for loan losses for the periods indicated.
The following table sets forth the breakdown of the allowance for loan losses by loan category at the dates indicated. Management believes that the allowance can be allocated by category only on an approximate basis. The allocation of the allowance to each category is not necessarily indicative of future losses and does not restrict the use of the allowance to absorb losses in any category.
Nonperforming Loans and Other Problem Assets. Management reviews the credit quality of the Company's loans on a regular basis. After residential mortgage loans become past due more than 90 days, the Company generally establishes an allowance for uncollectible interest for the amount by which the principal balance and uncollected interest exceeds 90% of the appraised value of the property. Commercial and multifamily real estate loans generally are placed on nonaccrual status if the borrower is placed in bankruptcy proceedings or management concludes that payment in full is not likely. Consumer and commercial loans generally are charged off, or any expected loss is reserved for, after they become more than 90 days past due. The Company accrues interest on delinquent loans past due more than 90 days without establishing a reserve when management concludes such action is warranted, such as in the event the loan is exceptionally well collateralized or the borrower establishes the temporary nature of the delinquency. Loans are charged off when management concludes that they are uncollectible.
Real estate acquired by the Company as a result of foreclosure is classified as real estate owned until such time as it is sold. When such property is acquired, it is recorded at the lower of the unpaid principal balance or its fair market value (less estimated selling cost at the date of foreclosure). Any required write-down of the loan to its fair market value upon foreclosure is charged against the allowance for loan losses.
The following table sets forth information with respect to the Company's nonperforming assets at the dates indicated. The Company has no restructured loans.
(1) Interest on delinquent loans is accrued to income to the extent considered collectible.
As of December 31, 2002, the Company had a total of $1.1 million in 22 single-family loans classified as "substandard." As of December 31, 2002, the Company had $1.0 million in commercial real estate loans and $588,000 in single-family residential loans classified as "special mention."
In addition, the Company had two commercial real estate loans totaling $643,000 which had been classified as "substandard" and one real estate development loan in the amount of $563,000 had been classified as "doubtful." The property securing these loans is single-family and multifamily residential and commercial real estate. Management believes that these loans have been adequately classified and reserved for, but continues to monitor them as to their collectibility and as to any possible losses the Company could incur, or additional reserves that may need to be established.
As of December 31, 2002, the Company had a total of $1.7 million in real estate owned.
At December 31, 2002, the Company had no other loans of a material amount which were not classified as nonaccrual, past due 90 days or more or restructured but where known information about possible credit problems of borrowers caused management to have serious doubts as to the ability of the borrowers to comply with present loan repayment terms and could result in future disclosure as nonaccrual, 90 days past due or restructured.
Investment Activities
The Company is required under federal regulations to maintain a minimum amount of liquid assets, which can be invested in specified short-term securities, and is also permitted to make certain other investments. Liquidity levels may be increased or decreased depending upon the yields on investment alternatives, management's judgment as to the attractiveness of the yields then available in relation to other opportunities, its expectations of the level of
yield that will be available in the future and its projections as to the short-term demand for funds to be used in the Company's loan origination and other activities.
The general objectives of the Company's investment policy are to (i) protect the Company's depositor resources, (ii) maintain liquidity levels to meet the operational needs of the Company and applicable regulatory requirements, (iii) reduce credit risk by investing in high-quality, diverse investments, (iv) serve as a hedge against significant interest rate shifts, (v) contribute to earnings in a stable and dependable manner without compromising the goals of liquidity and safety, and (vi) provide collateral for pledging needs. The Company's investment activities are managed by Chief Financial Officer, Stanley Alexander, Jr., with oversight by the Investment Committee and under the supervision of the Board of Directors. An investment policy has been adopted by the Board which provides for maintenance of the investment portfolio for the purpose of providing earnings and ensuring a minimum liquidity reserve. In accordance with the investment policy, management has primarily invested in U.S. Treasury securities backed by the full faith and credit of the United States and government agency securities, mortgage-backed securities issued by FHLMC, FNMA or GNMA, federal funds sold, and federally insured interest-bearing deposits in other financial institutions. General obligation and bank qualified bonds of municipalities within the market areas served by the Company and which are considered to possess acceptable credit and limited default risk are also considered for investment.
The Company, in accordance with generally accepted accounting principles, reports its investment securities available for sale, at current market value, with unrealized gains or losses, net of tax effect, adjusted through equity and realized gains or losses in income when securities are sold. Investment securities held to maturity are reported at cost as adjusted for unaccredited discounts and unamortized premiums.
The following table sets forth the carrying value of the Company's investment securities at the dates indicated.
The following table sets forth the maturities and Weighted Average Yields of securities at December 31, 2002.
MORTGAGE-BACKED SECURITIES ACTIVITIES
In accordance with the Company's investment policy, management invests in mortgage-backed securities issued by Freddie Mac, Fannie Mae and Ginnie Mae. In addition, the Company's investment policy permits investment in collateralized mortgage obligations.
The following table sets forth the composition of the Company's mortgage-backed securities portfolio at the dates indicated.
Deposit Activity and Other Sources of Funds
General. Deposits are a significant source of the Company's funds for lending and other investment purposes. In addition to deposits, the Company derives funds from loan principal repayments and interest payments and maturing investment securities. Loan repayments and interest payments are a relatively stable source of funds, while deposit inflows and outflows are significantly influenced by general interest rates and money market conditions. Borrowings may be used on a short-term basis to compensate for reductions in the availability of funds from other sources, or on a longer term basis for general business purposes.
Deposits. Deposits are attracted principally from within the Company's primary market area through the offering of a variety of deposit instruments, including passbook and statement accounts and certificates of deposit. Deposit account terms vary, principally on the basis of the minimum balance required, the time periods the funds must remain on deposit and the interest rate. The Company also offers individual retirement accounts ("IRAs") and Keogh Plans.
The Company's policies are designed primarily to attract deposits from local residents through its branch network rather than to solicit deposits from areas outside its primary market. The Company does not accept deposits from brokers due to the volatility and rate sensitivity of such deposits. Interest rates paid, maturity terms, service fees and withdrawal penalties are established by the Company on a periodic basis. Determination of rates and terms are predicated upon funds acquisition and liquidity requirements, rates paid by competitors, growth goals and federal regulations.
The following table sets forth the average balances and interest rates for the Company's deposit accounts by type of deposit for the periods indicated.
The following table indicates the amount of the Company's certificates of deposit of $100,000 or more by time remaining until maturity as of December 31, 2002. Most of the Company's deposits of over $100,000 come from individual depositors in the Company's market area.
Maturity Period Certificates of Deposit --------------- ----------------------- (In thousands)
Three months or less $12,748 Over three through six months 7,289 Over six through 12 months 25,272 Over 12 months 17,832 -------- Total $63,141 ======
Management attributes the net decrease in deposits for the six months ended December 31, 2002 to general economic conditions and competition in the local market. The Company does not offer premiums for deposits and in the past has not offered interest rates on deposits which exceed the average rates paid by other financial institutions in its market area.
Borrowings. Savings deposits historically have been the primary source of funds for the Company's lending and investment activities and for its general business activities. The Company is authorized, however, to use advances from the FHLB of Cincinnati to supplement its supply of lendable funds and to meet deposit withdrawal requirements. All of the advances are collateralized by FHLB stock and single-family first mortgage loans with aggregate principal balances totaling 150% of the outstanding amount of advances. The FHLB of Cincinnati functions as a central reserve bank providing credit for savings institutions and certain other member financial institutions. As a member, the Company 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 home mortgages and other assets (principally, securities which are obligations of, or guaranteed by, the United States), provided certain standards related to creditworthiness have been met. The Company had $1.4 million in short-term borrowings outstanding at December 31, 2002. The average balance of short-term borrowings during the six months ended December 31, 2002 was $1.5 million with a weighted average rate of 1.7%. The maximum balance of short-term borrowings during the six months ended December 31, 2002 was $7.7 million.
At December 31, 2002, the Company had $26.3 million in long-term advances at an average rate of 4.46% outstanding with the Federal Home Loan Bank. The average balance of these advances for the six months ended December 31, 2002 was $22.4 million at a weighted-average rate of 5.5%. At December 31, 2002, the Company had sufficient collateral to borrow another $77 million, including a $13.6 million unexercised line of credit, from the Federal Home Loan Bank.
Subsidiary Activities
The Company's only subsidiary other than the Bank is Home Service Corporation, which engages in the ownership and rental of the Company's main office building and operations center in Middlesboro, Kentucky and a branch office in New Tazewell, Tennessee. Home Service Corporation also owns and rents other properties to unrelated parties.
Competition
The Company experiences substantial competition both in attracting and retaining savings deposits and in the making of mortgage and other loans.
Direct competition for savings deposits comes from other savings institutions, credit unions, regional bank holding companies and commercial banks located in its primary market area. Significant competition for the Company's other deposit products and services comes from money market mutual funds, brokerage firms, insurance companies and retail stores. The primary factors in competing for loans are interest rates and loan origination fees and the range of services offered by various financial institutions. Competition for origination of real estate loans normally comes from other savings institutions, commercial banks, mortgage bankers, mortgage brokers and insurance companies.
The Company's primary competition comprises the commercial banks near each of the Company's branch offices. In Middlesboro, where the Company's main office is located, primary competition consists of four banks. In Harlan, Kentucky, where two branch offices are located, the Company's primary competition is two banks. In New Tazewell, Tennessee, where a branch office is located, the Bank's primary competition is three banks.
The Company is able to compete effectively in its primary market area by offering competitive interest rates and loan fees, and a wide variety of deposit products, and by emphasizing personal customer service. Management believes that, as a result of the Company's commitment to competitive pricing, varied products and personal service, the Company has developed a solid base of core deposits and the loan origination quality and volume are among the leaders in the Company's market area.
Employees
As of December 31, 2002, the Company and its subsidiary had 70 full-time employees, none of whom was represented by a collective bargaining agreement. The Company believes that it enjoys excellent relations with its personnel.
REGULATION
General
The Company and the Bank are subject to the policies of various regulatory authorities. In particular, bank holding companies and their subsidiaries are affected by the credit and monetary policies of the Federal Reserve Board (the "FRB"). The Company and the Bank are subject to numerous federal and state laws and regulations affecting their business and also must undergo periodic examination by federal and state financial institution examiners. The earnings of the Bank, and the earnings of the Company, are affected not only by the laws and regulations applicable to the banking business, but also by the policies and interpretations of regulatory authorities.
The supervision and regulation of bank holding companies and their subsidiaries is intended primarily for the protection of depositors, the deposit insurance funds of the FDIC and the banking system as a whole, and not for the protection of the bank holding company shareholders or creditors. The banking agencies have broad enforcement power over bank holding companies and banks, including the power to impose substantial fines and other penalties for violations of laws and regulations, to issue cease and desist or removal orders, to seek injunctions and publicly disclose such actions, and extensive authority to police unsafe or unsound practices.
The following description summarizes some of the laws to which the Company and the Bank are subject. References herein to applicable statutes and regulations are brief summaries thereof, do not purport to be complete and are qualified in their entirety by reference to such statutes and regulations.
Regulation of the Bank
Home Federal is a Kentucky-chartered commercial banking corporation the deposits of which are insured by the FDIC. Prior to the Bank's conversion from a federally chartered savings bank to a Kentucky-chartered commercial bank, the Bank was subject to regulation by the Office of Thrift Supervision (the "OTS"). The Bank is not a member of the Federal Reserve System. The Bank is subject to supervision and regulation by the FDIC and the Kentucky Department of Financial Institutions. Such supervision and regulation subjects the Bank to special restrictions, requirements, potential enforcement actions and periodic examination by the FDIC and the Kentucky Department of Financial Institutions. Because the FRB regulates the bank holding company parent of the Bank, the FRB also has supervisory authority that directly affects the Bank.
The Kentucky banking statutes prescribe the permissible activities in which a Kentucky bank may engage and where those activities may be conducted. Kentucky's statutes contain a "super-parity" provision that permits a well-rated Kentucky banking corporation (such as the Bank) to engage in any banking activity in which a national or state bank operating in any other state or a federal savings association meeting the qualified thrift lender test and operating in any state could engage, provided it first obtains a legal opinion specifying the statutory or regulatory provisions that permit the activity.
Branching. Kentucky law currently expressly permits a Kentucky-chartered bank to establish a branch office in any county in Kentucky. Kentucky banking statutes also permit a Kentucky bank, with prior regulatory approval, to establish a branch office outside of Kentucky. Well-capitalized Kentucky banks that have been in operation at least three years and that satisfy certain criteria relating to, among other things, their composite and management ratings, may establish a branch without the approval of the Commissioner of the Department of Financial Institutions upon notice to the Department and any other state bank with its main office located in the county where the new branch will be located. Branching by all other banks requires the approval of the Commissioner, who must ascertain and determine that the public convenience and advantage will be served and promoted and that there is reasonable probability of the successful operation of the branch. In any case, the transaction must also be approved by the FDIC, which considers a number of factors, including financial history, capital adequacy, earnings prospects, character of management, needs of the community and consistency with corporate powers. An out-of-state bank is permitted to establish branch offices in Kentucky by merging with a Kentucky bank. De novo branching into Kentucky by an out-of-state bank is not permitted by the Kentucky banking statutes.
Restrictions on Affiliate Transactions. Transactions between the Bank and its nonbanking affiliates, including the Company, are subject to Section 23A of the Federal Reserve Act. In general, Section 23A imposes limits on the amount of such transactions and also requires certain levels of collateral for loans to affiliated parties. It also limits the amount of advances to third parties which are collateralized by the securities or obligations of the Company or its subsidiary.
Affiliate transactions are also subject to Section 23B of the Federal Reserve Act, which generally requires that certain transactions between the Bank and its affiliates be on terms substantially the same, or at least as favorable to the Bank, as those prevailing at the time for comparable transactions with or involving other nonaffiliated persons.
The Bank's regulatory lending limit to one borrower was $3.6 million at December 31, 2002. Currently, the Bank has only one borrower, a real estate developer, that approaches that limit, with a balance of $2.7 million. The Bank imposes the same limits to affiliates and insiders. At December 31, 2002, loans to directors, executive officers and control persons totaled $634,000 in aggregate.
Restrictions on Distribution of Subsidiary Bank Dividends and Assets. Dividends paid by the Bank have provided substantially all of the Company's operating funds, and for the foreseeable future it is anticipated that dividends paid by the Bank to the Company will continue to be the Company's principal source of operating funds.
Capital adequacy requirements and state law serve to limit the amount of dividends that may be paid by the Bank. Under federal law, the Bank cannot pay a dividend if, after paying the dividend, the Bank will be "undercapitalized." The FDIC may declare a dividend payment to be unsafe and unsound even though the Bank would continue to meet its capital requirements after the dividend. Under Kentucky banking law, the dividends the Bank can pay during any calendar year are generally limited to its profits for that year, plus its retained net profits for the two preceding years, less any required transfers to surplus or to fund the retirement of preferred stock or debt, absent approval of the Commissioner of the Kentucky Department of Financial Institutions.
Because the Company is a legal entity separate and distinct from its subsidiary, its right to participate in the distribution of assets of any subsidiary upon the subsidiary's liquidation or reorganization will be subject to the prior claims of the subsidiary's creditors. In the event of a liquidation or other resolution of an insured depository institution, the claims of depositors and other general or subordinated creditors are entitled to a priority of payment over the claims of holders of any obligation of the institution to its shareholders, including any depository institution holding company (such as the Company) or any shareholder or creditor thereof.
Deposit Insurance Assessments. Currently, the FDIC maintains two funds for the insurance of deposits of financial institutions: the Bank Insurance Fund ("BIF") for deposits originated by banks and the Savings Association Insurance Fund ("SAIF") for deposits originated by savings associations, including savings association deposits acquired by banks. The Bank must pay assessments to the FDIC for federal deposit insurance protection based on a risk-based assessment system. Under this system, FDIC-insured depository institutions pay insurance premiums at rates based on their risk classification. Institutions assigned to higher-risk classifications (that is, institutions that pose a greater risk of loss to their respective deposit insurance funds) pay assessments at higher rates than institutions that pose a lower risk. An institution's risk classification is assigned based on its capital levels and the level of supervisory concern the institution poses to the regulators. In addition, the FDIC can impose special assessments in certain instances. The current range of BIF and SAIF assessments is between 0% and .27% of deposits.
The Deposit Insurance Funds Act of 1996 requires both BIF and SAIF insured institutions to share the cost of the Financing Corporation bonds, which were issued to initially fund the SAIF, through additional assessments on insured deposits.
Cross-guarantee Provisions. The Federal Deposit Insurance Act contains a "cross-guarantee" provision which generally makes commonly controlled insured depository institutions liable to the FDIC for any losses incurred in connection with the failure of a commonly controlled depository institution.
Consumer Laws and Regulations. In addition to the laws and regulations discussed herein, the Bank is also subject to certain consumer laws and regulations that are designed to protect consumers in transactions with banks. While the list set forth herein is not exhaustive, these laws and regulations include the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, the Real Estate Settlement Procedures Act and the Fair Housing Act, among others. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with clients when taking deposits or making loans. The Bank must comply with the applicable provisions of these consumer protection laws and regulations as part of its ongoing business operations.
Regulation of the Company
Prior to the Company's conversion from a savings and loan holding company to a bank holding company, the Company was subject to regulation by the OTS. As a bank holding company, the Company is subject to supervision, regulation and examination by the FRB. The Bank Holding Company Act of 1956, as amended (the "BHCA"), and other federal laws subject bank holding companies to particular restrictions on the types of activities in which they may engage and to a range of supervisory requirements and activities, including regulatory enforcement actions for violations of laws and regulations.
Bank Acquisitions by Bank Holding Companies. The Company is required to obtain the prior approval of the FRB under the BHCA before it may acquire all or substantially all of the assets of any bank, or ownership or control of any voting shares of any bank, if after such acquisition it would own or control, directly or indirectly,
more than 5% of the voting shares of such bank. In approving bank acquisitions by bank holding companies, the FRB is required to consider the financial and managerial resources and future prospects of the bank holding company and the banks concerned, the convenience and needs of the communities to be served and various competitive factors. Consideration of convenience and needs issues includes the parties' performance under the Community Reinvestment Act of 1977, as amended ("CRA"). Under the CRA, all financial institutions have a continuing and affirmative obligation consistent with safe and sound operation to help meet the credit needs of their entire communities, including low- to moderate-income neighborhoods. By virtue of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, the geographic location of the bank is no longer a factor. Under that Act, a well-capitalized and well-managed bank holding company may acquire a bank located in any state, subject to certain deposit percentage limitations and age requirements.
Gramm-Leach-Bliley Act. On November 12, 1999, the Gramm-Leach-Bliley Act was signed into law, eliminating many of the remaining barriers to full convergence of the banking, securities and insurance industries. The major provisions of the Act took effect March 12, 2000.
The Gramm-Leach-Bliley Act enables a broad-scale consolidation among banks, securities firms and insurance companies by creating a new type of financial services company called a "financial holding company," a bank holding company with dramatically expanded powers. Financial holding companies can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking. In addition, the Act permits the FRB and the Treasury Department to authorize additional activities for financial holding companies, but only if they jointly determine that such activities are "financial in nature" or "complementary to financial activities."
The FRB serves as the primary "umbrella" regulator of financial holding companies, with jurisdiction over the parent company and more limited oversight over its subsidiaries. The primary regulator of each subsidiary of a financial holding company depends on the activities conducted by the subsidiary. A financial holding company need not obtain FRB approval prior to engaging, either de novo or through acquisitions, in financial activities previously determined to be permissible by the FRB. Instead, a financial holding company need only provide notice to the FRB within 30 days after commencing the new activity or consummating the acquisition.
The Gramm-Leach-Bliley Act includes consumer privacy protections and CRA "sunshine" rules, "modernizes" various other banking-related statutes, permits mutual bank holding companies and requires a number of studies and reports to Congress.
Safe and Sound Banking Practices. Bank holding companies are not permitted to engage in unsafe and unsound banking practices. The FRB may prohibit a bank holding company from engaging in an activity if it believes that the transaction would constitute an unsafe or unsound practice or would violate any law or regulation. The FDIC and the Kentucky Department of Financial Institutions have similar authority with respect to the Company's bank subsidiary.
Source of Strength. Under FRB policy, a bank holding company is expected to act as a source of financial strength to each of its banking subsidiaries and to commit resources to their support. Such support may be required at times when, absent this FRB policy, a holding company may not be inclined to provide it. As noted below, a bank holding company may also be required to guarantee the capital restoration plan of an undercapitalized banking subsidiary.
Capital Adequacy Requirements
Capital Guidelines. The FRB and FDIC have substantially similar risk-based and leverage ratio guidelines for banking organizations, which are intended to ensure that banking organizations have adequate capital related to the risk levels of assets and off-balance-sheet instruments. Under the risk-based guidelines, specific categories of assets are assigned different risk weights, based generally on the perceived credit risk of the asset. These risk weights are multiplied by corresponding asset balances to determine a "risk-weighted" asset base. The guidelines require a minimum total risk-based capital ratio of 8.0%, of which at least 4.0% is required to consist of Tier 1 capital elements (generally, common shareholders' equity, minority interests in the equity accounts of consolidated subsidiaries, noncumulative perpetual preferred stock, less goodwill and certain other intangible assets). Total
capital is the sum of Tier 1 and Tier 2 capital. Tier 2 capital generally may consist of limited amounts of subordinated debt, qualifying hybrid capital instruments, other preferred stock, loan loss reserves and unrealized gains on certain equity securities. As of December 31, 2002, the Company's ratio of Tier 1 capital to total risk-weighted assets was 15.0% and its ratio of total capital to total risk-weighted assets was 15.8%. As of December 31, 2002, the Bank's ratio of Tier 1 capital to total risk-weighted assets was 14.5% and its ratio of total capital to total risk-weighted assets was 15.3%.
In addition to the risk-based capital guidelines, the FRB uses a leverage ratio as an additional tool to evaluate the capital adequacy of bank holding companies. The leverage ratio is a company's Tier 1 capital divided by its average total consolidated assets (less goodwill and certain other intangible assets). Certain highly rated bank holding companies may maintain a minimum leverage ratio of 3.0%, but other bank holding companies may be required to maintain a leverage ratio of up to 200 basis points above the regulatory minimum. As of December 31, 2002, the Company's leverage ratio was 8.7%. The FDIC's leverage guidelines require state banks to maintain Tier 1 capital of no less than 5% of average total assets, except in the case of certain highly rated banks for which the requirement is 3% of average total assets. As of December 31, 2002, the Bank's ratio of Tier 1 capital to average total assets (leverage ratio) was 8.4%. [See Note 11 in Item 7.]
The federal banking agencies' risk-based and leverage ratios are minimum supervisory ratios generally applicable to banking organizations that meet certain specified criteria, assuming that they have the highest regulatory rating. Banking organizations not meeting these criteria are expected to operate with capital positions well above the minimum ratios. The federal bank regulatory agencies may set capital requirements for a particular banking organization that are higher than the minimum ratios when circumstances warrant. FRB guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets. The FDIC may establish higher minimum capital adequacy requirements if, for example, a bank has previously received special attention or has a high susceptibility to interest rate risk.
Corrective Measures for Capital Deficiencies. The federal banking regulators are required to take "prompt corrective action" with respect to capital-deficient institutions. Agency regulations define, for each capital category, the levels at which institutions are "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." Under these regulations, a "well capitalized" bank has a total risk-based capital ratio of 10% or higher; a Tier 1 risk-based capital ratio of 6% or higher; and a leverage ratio of 5% or higher and is not subject to any written agreement, order or directive requiring it to maintain a specific capital level for any capital measure. An "adequately capitalized" bank has a total risk-based capital ratio of 8% or higher; a Tier 1 risk-based capital ratio of 4% or higher; and a leverage ratio of 4% or higher (3% or higher if the bank was rated a CAMEL 1 in its most recent examination report and is not experiencing significant growth) and does not meet the criteria for a well capitalized bank. A bank is "undercapitalized" if it fails to meet any one of the ratios required to be adequately capitalized.
Undercapitalized institutions are required to submit a capital restoration plan, which must be guaranteed by any holding company of the institution. In addition, agency regulations contain broad restrictions on certain activities of undercapitalized institutions, including asset growth, acquisitions, branch establishment and expansion into new lines of business. With certain exceptions, an insured depository institution is prohibited from making capital distributions, including dividends, and is prohibited from paying management fees to control persons if the institution would be undercapitalized after any such distribution or payment. A bank's capital classification will also affect its ability to accept brokered deposits. Under the FDIC regulations, a bank may not lawfully accept, roll over or renew brokered deposits unless either it is well capitalized or it is adequately capitalized and receives a waiver from the FDIC.
As an institution's capital decreases, the FDIC's enforcement powers become more enhanced. A significantly undercapitalized institution is subject to mandated capital raising activities, restrictions on interest rates paid and transactions with affiliates, removal of management and other restrictions. The FDIC has only very limited discretion in dealing with a critically undercapitalized institution and is virtually required to appoint a receiver or conservator.
Banks with risk-based capital and leverage ratios below the required minimums may also be subject to certain administrative actions, including the termination of deposit insurance upon notice and hearing, or a temporary suspension of insurance without a hearing in the event the institution has no tangible capital.
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