• the results of our efforts to implement our retail strategy;
• adverse changes in our loan portfolio and the resulting credit risk-related losses and expenses;
• interest rate fluctuations and other economic conditions;
• continued levels of our loan quality and origination volume;
• our ability to attract core deposits;
• continued relationships with major customers;
• competition in product offerings and product pricing;
• adverse changes in the economy that could increase credit-related losses and expenses;
• adverse changes in the market price of our common stock;
• proxy contests and litigation;
• compliance with laws and regulatory requirements, including our formal agreement with the Office of the Comptroller of the Currency, and compliance with Nasdaq standards;
• other factors, including those matters discussed in additional detail under the heading “Risk Factors;” and
• other risks and uncertainties detailed from time to time in our filings with the SEC.
Although forward-looking statements help to provide complete information about us, readers should keep in mind that forward-looking statements may not be reliable. Readers are cautioned not to place undue reliance on the forward-looking statements. We assume no obligation to update or supplement forward-looking statements that become untrue because of subsequent events.
General
Yardville National Bancorp, referred to as “we” or the “Company,” is a registered bank holding company headquartered in Mercer County, New Jersey with total assets of $2.96 billion, total deposits of $1.97 billion and total stockholders’ equity of $177.5 million at December 31, 2005. We conduct a general commercial and retail banking business through our principal operating subsidiary, The Yardville National Bank, referred to as the “Bank,” which commenced operations as a commercial bank in 1925. We provide a broad range of lending, deposit and other financial products and services with an emphasis on commercial real estate and commercial and industrial lending to small to mid-sized businesses and individuals. Our existing and target markets are located in the corridor between New York City and Philadelphia. We currently operate 28 full-service branches throughout Mercer, Hunterdon, Somerset, Middlesex, Burlington and Ocean Counties in New Jersey and Bucks County, Pennsylvania.
Due to continued consolidation among financial institutions, we have grown our asset base both in our existing markets and by expanding into contiguous markets, and we see opportunities for continued growth. We believe these markets have customers with banking needs that can no longer be adequately served by smaller local institutions but who still desire the personalized service that larger institutions typically do not offer. We believe that the key differentiating factors between us and our larger competitors are our philosophy of relationship banking and our in-market expertise, while our ability to enter into larger loan relationships enables us to effectively compete against smaller institutions.
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Our goals are to further develop the earnings power and increase the value of our franchise. In order to achieve these goals, we need to continue to manage our cost of funds and increase our non-interest income by attracting lower cost transaction and other core deposit accounts. Specifically in 2006, we plan to continue to execute our retail strategy by expanding our branch network, enhancing our brand image and upgrading our technology infrastructure.
The Company’s annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed with or furnished to the SEC are available without charge through the “Investor” or “Investor Relations” section of our Internet web site, www.ynb.com, as soon as reasonably practicable after such materials are filed with or furnished to the SEC. Neither our Internet web site nor the information contained in or connected with that web site are incorporated by reference into this report.
Our principal and executive offices are located at 2465 Kuser Road, Hamilton, New Jersey 08690. Our telephone number is (609) 585-5100.
Subsidiaries
The Company directly owns the Bank and six additional subsidiaries, Yardville Capital Trust, Yardville Capital Trust II, Yardville Capital Trust III, Yardville Capital Trust IV, Yardville Capital Trust V and Yardville Capital Trust VI. The Company is also the indirect owner, through the Bank, of ten subsidiaries, which provide insurance and financial services and own a portion of the real estate, loans and securities utilized by the Bank. The assets, liabilities and results of operations of the Bank and its subsidiaries are consolidated with the Company for financial reporting purposes. The trusts are not consolidated subsidiaries. See Note 8 of the Notes to Consolidated Financial Statements filed with this annual report.
Competition
The Bank’s primary market area in Central New Jersey is highly competitive for financial services and the Bank faces significant competition both in making loans and in attracting deposits. The Bank is subject to competition in all aspects of its business from other financial institutions such as commercial banks, savings banks, savings and loan associations, credit unions, insurance companies and finance and mortgage companies. Within the direct market area of the Bank, there are a significant number of competing financial institutions. The Bank competes in its market area with a number of larger commercial banks which have substantially greater resources, higher lending limits and larger branch systems, and which provide a broader array of banking products and services. Liberalized branching and acquisition laws have lowered barriers to entry into the banking business, and increased both competition for and opportunities to acquire other financial institutions. Savings banks, savings and loan associations and credit unions also actively compete for deposits and for various types of loans. In its lending business, the Bank is subject to competition from consumer finance companies and mortgage companies, which are subject to fewer regulatory restrictions than banks, and can often offer lower loan rates than banks. Financial institutions are intensely competitive in the interest rates they offer on deposits. In addition, the Bank faces competition for deposits from non-bank institutions such as brokerage firms, insurance companies and investment companies who offer the opportunity to invest in such instruments as short-term money market funds, corporate and government securities funds, mutual funds and annuities.
Supervision and Regulation
General
The Company and its subsidiaries are subject to extensive supervision and regulation under both Federal and state laws. These laws restrict permissible activities and investments and require compliance with various consumer protection provisions applicable to lending, deposit, brokerage and fiduciary activities. They also impose capital adequacy requirements and restrict the Company’s ability to repurchase stock or to receive dividends from the Bank. The Company and its subsidiaries are also subject to comprehensive examination and supervision by the Board of Governors of the Federal Reserve System (“FRB”) and the Office of the Comptroller of the Currency (“OCC”). The Company and certain of its subsidiaries are also functionally regulated by the Securities and Exchange Commission (“SEC”) and state insurance regulators. These regulatory agencies generally have broad discretion to impose
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restrictions and limitations on the operations of the Company and the Bank. The consequences of noncompliance with these laws and regulations can include substantial monetary and administrative penalties and sanctions. This supervisory framework could materially impact the conduct and profitability of the Company’s activities.
To the extent that the following information describes statutory and regulatory provisions, it is qualified in its entirety by reference to the particular statutory and regulatory provisions. A change in applicable statutes, regulations or regulatory policy may have a material effect on the business of the Company and the Bank.
Bank Holding Company Act
The Company is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (the “BHC Act”), and is subject to regulation and supervision by the FRB. The BHC Act requires the Company to secure the prior approval of the FRB before it owns or controls, directly or indirectly, more than five percent (5%) of the voting shares or substantially all of the assets of, any bank or thrift, or merges or consolidates with another bank or thrift holding company. In addition, bank holding companies are restricted in the types of activities in which they may engage, directly or indirectly through subsidiaries, and prior approval of the FRB may be required before engaging in certain activities.
The Company had elected to become a “financial holding company” under the Gramm-Leach-Bliley Act of 1999 (“GLB Act”) in March of 2000. The GLB Act amended the BHC Act to allow a “financial holding company” to engage in certain activities that were not previously permitted for a bank holding company, and to engage on less restrictive terms in certain activities that were previously permitted. These expanded activities include securities underwriting and dealing, insurance underwriting and sales, and merchant banking activities. In order to maintain its status as a financial holding company, the Company and the Bank must be “well capitalized” and “well managed,” and have a “satisfactory” rating under the Community Reinvestment Act (“CRA”). For bank holding companies that are not financial holding companies, the permissible activities are limited to those previously determined by the FRB to be so “closely related to banking” as to be a “proper incident thereto.” As a result of the agreement between the Bank and the OCC (which is more fully discussed under “Regulatory Matters” in Part I, Item 3 ), the Company elected to decertify as a financial holding company. Because the Company was not engaged in any activity that would have required it to be a financial holding company at the time of its decertification, such decertification did not impact the Company’s activities or operations.
There are a number of restrictions imposed on the Company and the Bank by Federal law which are designed to reduce potential loss exposure to the depositors of the Bank and Federal Deposit Insurance Corporation (“FDIC”) insurance funds in the event the Bank should become insolvent. For example, FRB policy requires a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks and to commit resources to support such institutions in circumstances where it might not do so otherwise. The FRB has, in some cases, entered orders for bank holding companies to take affirmative action to strengthen the finances or management of subsidiary banks.
Supervision and Regulation of the Bank
The operations and investments of the Bank are also limited by Federal and state statutes and regulations. The primary Federal regulator of the Bank is the OCC. The Bank and its operating subsidiaries may engage in any activities that are determined by the OCC to be part of or incidental to the business of banking. Under the GLB Act, the Bank may engage in expanded activities through the formation of a “financial subsidiary.” The Bank has filed a financial subsidiary certification with OCC and thus may engage through a financial subsidiary in such expanded activities as insurance sales and securities underwriting. As a result of the agreement between the Bank and the OCC (which is more fully discussed under “Regulatory Matters” in Part I, Item 3), the Bank is no longer eligible to establish or acquire a financial subsidiary. Because the Bank is not engaged in any activity that could only be conducted through a financial subsidiary, this status will not impact its current activities and operations.
In order to be eligible to establish or acquire a financial subsidiary, the Bank must be “well capitalized” and “well managed” and may not have less than a “satisfactory” CRA rating. In addition, the total assets of all financial subsidiaries of a national bank may not exceed the lesser of $50 billion or 45% of the parent bank’s total assets. In calculating its risk-based capital, the Bank must exclude from its assets and equity all equity investments, including retained earnings, in a financial subsidiary, and the assets of the financial subsidiary from the Bank’s consolidated
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assets. If the Bank were to fail to meet the “well capitalized” or “well managed” criteria, it would not be permitted to continue these expanded activities. In addition, if the Bank receives less than a “satisfactory” CRA rating, it would not be permitted to engage in any new activities or to make new investments in reliance on the financial subsidiary authority.
OCC banking laws and regulations generally govern, among other things, the scope of a bank’s business, the investments a bank may make, the loans a bank makes and collateral it takes, the activities of a bank with respect to mergers and consolidations and the establishment of branches. In addition, the OCC possesses broad powers to prohibit the Bank from engaging in any activity that it determines would be an unsafe and unsound banking practice.
The Bank is also subject to Federal laws that limit the amount of transactions between the Bank and its nonbank affiliates, including the Company. Under these provisions, transactions (such as a loan or investment) by the Bank with any nonbank affiliate are generally limited to 10% of the Bank’s capital and surplus for all covered transactions with such affiliate or 20% of capital and surplus for all covered transactions. Any extensions of credit, with limited exceptions, must be secured by eligible collateral in specified amounts. The Bank is also prohibited from purchasing any “low quality” asset from an affiliate. The GLB Act imposes similar restrictions on transactions between the Bank and its financial subsidiaries.
Under the CRA, the record of a bank holding company and its subsidiary banks must be considered by the appropriate Federal banking agencies in reviewing and approving or disapproving a variety of regulatory applications including approval of a branch or other deposit facility, office relocation, a merger and certain acquisitions of bank shares. Regulators are required to assess the record of the Company and the Bank to determine if they are meeting the credit needs of the communities they serve. Regulators make publicly available an evaluation of banks’ records in meeting credit needs in their communities, including a descriptive rating and a statement describing the basis for the rating.
Deposit Insurance
The deposits of the Bank are insured up to $100,000 per insured depositor by the FDIC. The premiums paid by insured depository institutions range from $0.00 to $0.27 per $100 of insured deposits, and are based on an institution’s relative risk to the deposit insurance funds, as measured by the institution’s regulatory capital position and other supervisory factors. The Bank currently pays FDIC insurance premiums of $0.0075 per $100 of insured deposits based on this risk assessment.
As FDIC deposit insurance premiums are “risk-based,” higher premiums would be charged to banks that have lower capital ratios or higher risk profiles. Consequently, a decrease in the Bank’s capital ratios, or a negative evaluation by the OCC, as the Bank’s primary Federal banking regulator, may also increase the Bank’s net funding costs and reduce its net income.
All FDIC-insured depository institutions must pay an annual assessment to provide funds for the payment of interest on bonds issued by the Financing Corporation, a Federal corporation chartered under the authority of the Federal Housing Finance Board. The bonds (commonly referred to as FICO bonds) were issued to capitalize the Federal Savings and Loan Insurance Corporation. FDIC-insured depository institutions paid approximately 1.5 cents per $100 of assessable deposits in 2005. The FDIC established the FICO assessment rate effective for the first quarter of 2006 at approximately 1.4 cents annually per $100 of assessable deposits.
As a result of recently enacted legislation, the federal deposit insurance system has been substantially reformed. The more important features of this legislation would include (1) merging the Bank Insurance Fund and the Savings Association Insurance Fund into the new Deposit Insurance Fund, (2) increasing the deposit insurance limit for certain retirement accounts to $250,000, (3) indexing the insurance limit to allow for inflation, (4) providing credits (totaling $4.7 billion) to offset future premium payments by banks in recognition of their contributions to the FDIC since 1996 and (5) eliminating the current 1.25% coverage ratio in favor of FDIC discretion to set the ratio within a range of 1.15% to 1.50% annually. The FDIC is required to implement most of these provisions by November 5, 2006. Two provisions, merger of the two insurance funds and raising the coverage for certain retirement accounts, should be completed by May 9, 2006. Until these final regulations are enacted, the Company is unable to determine the financial impact of this legislation on the Bank.
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Capital Rules
Under risk-based capital requirements for bank holding companies, the Company is required to maintain a minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) of eight percent. At least half of the total capital is to be composed of common equity, retained earnings and qualifying perpetual preferred stock, less certain intangible assets (“Tier 1 Capital”). The remainder may consist of certain subordinated debt, certain hybrid capital instruments and other qualifying preferred stock, and a limited amount of the allowance for loan losses (“Tier 2 Capital” and, together with Tier 1 Capital, “Total Capital”). At December 31, 2005, the Company’s Tier 1 Capital and Total Capital ratios were 10.8 percent and 11.8 percent, respectively.
In addition, the FRB has established minimum leverage ratio requirements for bank holding companies. For bank holding companies that meet certain specified criteria, including having the highest regulatory rating and not experiencing significant growth or expansion, these requirements provide for a minimum leverage ratio of Tier 1 Capital to adjusted average assets, equal to three percent. Other bank holding companies that fail to meet such criteria will generally be required to maintain a leverage ratio of four to five percent. The Company’s leverage ratio at December 31, 2005, was 8.6 percent. The Bank is subject to similar capital requirements adopted by the OCC.
Both the FRB and the OCC risk-based capital standards explicitly identify concentrations of credit risk and the risk arising from non-traditional activities, as well as an institution’s ability to manage these risks, as important factors to be taken into account by the agency in assessing an institution’s general capital adequacy. The capital guidelines also provide that an institution’s exposure to a decline in the economic value of its capital due to changes in interest rates be considered by the agency as a factor in evaluation the Bank’s capital adequacy. The FRB has issued additional guidelines for certain bank holding companies that engage in trading activities. The Company does not believe that consideration of these additional factors will affect the regulators’ assessment of the Company’s or the Bank’s capital position.
In addition to the required minimum capital levels described above, Federal law establishes a system of “prompt corrective actions” which Federal banking agencies are required to take, and certain actions which they have discretion to take, based upon the capital category into which a federally regulated depository institution falls. The extent of these powers depends upon whether the institution in question is considered “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” Generally, the smaller an institution’s capital base relative to its total assets, the greater the scope and severity of the agencies’ powers. The capital thresholds for a “well capitalized” institution and “adequately capitalized” institution are set forth below. An institution will be deemed “undercapitalized” if it fails to meet the minimum capital requirements, “significantly undercapitalized” if it has a Total Capital ratio that is less than 6.0 percent, a Tier 1 Capital ratio that is less than 3.0 percent or a leverage ratio that is less than 3.0 percent and “critically undercapitalized” if the institution has a ratio of tangible equity to total assets that is equal to or less than 2.0 percent. Business activities may also be influenced by an institution’s capital classification. For example, only a “well capitalized” institution may accept brokered deposits without prior regulatory approval. An “adequately capitalized” institution may accept brokered deposits only with prior regulatory approval.
The following table sets forth the minimum capital ratios that a bank must satisfy in order to be considered adequately capitalized or well capitalized under the prompt corrective action regulations, the minimum capital ratios applicable to the Bank under its agreement with the OCC, and the Bank’s capital ratios at December 31, 2005:
| Adequately | Well | OCC Required | ||||||||||||||
| Capitalized | Capitalized | Minimums | Bank ratios | |||||||||||||
Total Risk-Based Capital Ratio |
8.00 | % | 10.00 | % | 10.75 | % | 10.95 | % | ||||||||
Tier 1 Risk-Based Capital Ratio |
4.00 | % | 6.00 | % | 9.75 | % | 9.95 | % | ||||||||
Leverage Ratio |
4.00 | % | 5.00 | % | 7.50 | % | 7.62 | % | ||||||||
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As a result of the agreement with the OCC, the Bank is no longer deemed to be “well-capitalized” for regulatory purposes. This classification, however, is not intended to be and should not be construed as a representation of the overall financial condition or prospects of the Bank.
The prompt corrective action rules require an undercapitalized institution to file a written capital restoration plan, along with a performance guaranty by its holding company or a third party. In addition, an undercapitalized institution becomes subject to certain automatic restrictions including a prohibition on payment of dividends, a limitation on asset growth and expansion, in certain cases, a limitation on the payment of bonuses or raises to senior executive officers, and a prohibition on the payment of certain “management fees” to any “controlling person.” Institutions that are classified as undercapitalized are also subject to certain additional supervisory actions, including increased reporting burdens and regulatory monitoring, a limitation on the institution’s ability to make acquisitions, open new branch offices, or engage in new lines of business, obligations to raise additional capital, restrictions on transactions with affiliates, and restrictions on interest rates paid by the institution on deposits. In certain cases, bank regulatory agencies may require replacement of senior executive officers or directors, or sale of the institution to a willing purchaser. If an institution is deemed to be “critically undercapitalized” and continues in that category for four quarters, the statute requires, with certain narrowly limited exceptions, that the institution be placed in receivership.
Under currently applicable guidance, subordinated debentures recorded on the Company’s balance sheet (issued in connection with trust preferred securities) are included in Tier 1 Capital of the Company, up to a maximum of 25% of Tier 1 Capital. Historically, this capital treatment was based on the accounting for these instruments, however, trust preferred securities are no longer consolidated under U.S. generally accepted accounting principles, or “GAAP.” Partly in response to this accounting change, the FRB amended its risk-based capital standards for bank holding companies to allow for the continued inclusion of outstanding and prospective issuances of trust preferred securities in Tier 1 Capital subject to stricter quantitative limits and qualitative standards. Under the amended rule, the aggregate amount of trust preferred securities and certain other capital instruments would be limited to 25% of Tier 1 Capital, net of goodwill less any deferred tax liability. The amount of trust preferred securities and certain other capital instruments in excess of the limit could be included in Tier 2 Capital, subject to restrictions. The amended rule provides a five-year transition period for the application of the quantitative limits. The Company would continue to follow GAAP in accounting for these instruments for regulatory reporting purposes. The amended rule would not impact the Company’s existing treatment of trust preferred securities for purposes of computing its Tier 1 Capital, nor would it affect the capital adequacy rating of the Bank. See “Subordinated Debentures” and “Regulatory Capital” in Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Limitations on Payment of Dividends
Under applicable New Jersey law, the Company is not permitted to pay dividends on its capital stock if, following the payment of the dividend, (1) it would be unable to pay its debts as they become due in the usual course of business or (2) its total assets would be less than its total liabilities. Further, it is the policy of the FRB that bank holding companies should pay dividends only out of current earnings and only if future retained earnings would be consistent with the Company’s capital, asset quality and financial condition.
Since it has no significant independent sources of income, the ability of the Company to pay dividends is dependent on its ability to receive dividends from the Bank. Under national banking laws, the Bank must obtain the approval of the OCC before declaring any dividend which, together with all other dividends declared by the Bank in the same calendar year, will exceed the total of the bank’s net profits of that year combined with its retained net profits of the preceding two years, less any required transfers to surplus or a fund for the retirement of any preferred stock. Net profits are to be calculated without adding back any provision for the Bank’s allowance for loan losses. Furthermore, the Bank, as an FDIC-insured institution, may not pay dividends or make distributions that would cause the institution to fail to meet minimum capital requirements. These restrictions would not prevent the Bank from paying dividends from current earnings to the Company at this time.
In addition, as a bank whose deposits are insured by the FDIC, the Bank may not pay dividends or distribute any of its capital assets while it remains in default of any assessment due to the FDIC. The Bank is not in default under any of its obligations to the FDIC.
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Under the agreement with the OCC, and the supervisory letter from the Federal Reserve Bank of Philadelphia, prior regulatory approval is required for dividend payments by both the Bank and the Company.
Effect of Government Monetary Policies
The earnings of the Company are and will be affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. The FRB has had, and will likely continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order, among other things, to curb inflation or combat a recession. The FRB has a major effect upon the levels of bank loans, investments and deposits through its open market operations in United States government securities and through its regulation of, among other things, the discount rate on borrowings of member banks and the reserve requirements against member banks’ deposits. It is not possible to predict the nature and impact of future changes in monetary and fiscal policies.
USA PATRIOT Act
The USA PATRIOT Act authorizes the Secretary of the Treasury, in consultation with the other Federal financial institution regulatory agencies, to adopt special measures applicable to financial institutions. Among its provisions, the USA PATRIOT Act requires each financial institution to (1) establish an anti-money laundering program, (2) establish due diligence policies, procedures and controls that are reasonably designed to detect and report instances of money laundering in United States private bank accounts and correspondent accounts maintained for non-United States persons or their representatives, and (3) avoid establishing, maintaining, administering or managing correspondent accounts in the United States for, or on behalf of, a foreign bank that does not have a physical presence in any country. In addition, the USA PATRIOT Act expands the circumstances under which funds in a bank account may be forfeited and requires covered financial institutions to respond under certain circumstances to request for information from Federal banking agencies within 120 hours.
The USA PATRIOT Act also requires the Federal banking regulators to consider the effectiveness of a financial institution’s anti-money laundering activities when reviewing bank mergers and bank holding company acquisitions.
The Department of Treasury has issued regulations implementing the due diligence requirements of the USA PATRIOT Act. These regulations require minimum standards to verify customer identity and maintain accurate records, encourage cooperation among financial institutions, Federal banking agencies, and law enforcement authorities regarding possible money laundering or terrorist activities, prohibit the anonymous use of “concentration accounts,” and require all covered financial institutions to have in place an anti-money laundering compliance program.
Sarbanes-Oxley Act
The Sarbanes-Oxley Act of 2002 comprehensively revised the laws affecting corporate governance, auditing and accounting, executive compensation and corporate reporting for entities, such as the Company, with equity or debt securities registered under the Securities Exchange Act of 1934. Among other things, Sarbanes-Oxley and its implementing regulations have established new membership requirements and additional responsibilities for our audit committee, imposed restrictions on the relationship between the Company and its outside auditors (including restrictions on the types of non-audit services our auditors may provide to us), imposed additional responsibilities for our external financial statements on our chief executive officer and chief financial officer, expanded the disclosure requirements for our corporate insiders, required our management to evaluate the Company’s disclosure controls and procedures and its internal control over financial reporting, and required our auditors to issue a report on our internal control over financial reporting. The Nasdaq Stock Market, Inc. (“NASDAQ”) has also adopted corporate governance rules that have been approved by the SEC. The requirements are intended to allow shareholders to more easily and efficiently monitor the performance of companies and directors. The Company and its Board of Directors have, as appropriate, adopted or modified the Company’s policies and practices in order to comply with these regulatory requirements and to enhance the Company’s corporate governance practices.
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Other Laws and Regulations
The Company and the Bank are subject to a variety of laws and regulations which are not limited to banking organizations. In lending to commercial and consumer borrowers, and in owning and operating its own property, the Bank is subject to regulations and potential liabilities under state and Federal environmental laws.
Legislation and Regulatory Changes
Legislation and regulations may be enacted which increase the cost of doing business, limit or expand permissible activities, or affect the competitive balance between banks and other financial services providers. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies, and other financial institutions are frequently made in Congress and before various bank regulatory agencies. No prediction can be made as to the likelihood of any major changes or the impact such changes might have on the Company and the Bank.
Employees
At December 31, 2005, the Company employed 395 full-time employees and 22 part-time employees.
Statistical Disclosure
The Company’s statistical disclosure information, required of bank holding companies, is contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which is set forth in Item 7 of this report.
Item 1A. Risk Factors.
The following is a discussion of certain significant risk factors that could potentially negatively impact our financial condition and results of operations.
We may not be able to continue to grow our business, which may adversely impact our results of operations.
During the last five years, our total assets have grown substantially from $1.94 billion at December 31, 2001 to $2.96 billion at December 31, 2005. Our business strategy calls for continued expansion, but we do not anticipate growth to continue at this rate. Our ability to continue to grow depends, in part, upon our ability to open new branch locations, successfully attract deposits to existing and new branches, and identify favorable loan and acquisition opportunities. In the event that we do not continue to grow, our results of operations could be adversely impacted.
We may not be able to manage our growth, which may adversely impact our financial results.
As part of our expansion strategy, we plan to open new branches in our existing and target markets. However, we may be unable to identify attractive locations on terms favorable to us or to hire qualified management to operate the new branches. In addition, the organizational and overhead costs may be greater than we anticipated or we may not be able to obtain the regulatory approvals necessary to open new branches. New branches may take longer than expected to reach profitability, and we cannot assure that they will become profitable. The additional costs of starting new branches may adversely impact our financial results.
Our ability to manage growth successfully will depend on whether we can continue to fund this growth while maintaining cost controls and asset quality, as well as on factors beyond our control, such as national and regional economic conditions and interest rate trends. If we are not able to control costs and maintain asset quality, such growth could adversely impact our earnings and financial condition.
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The Company may require additional capital in the future, but that capital may not be available when it is needed.
The Company is required by Federal regulatory authorities to maintain adequate levels of capital to support its operations. The Company may at some point need to raise additional capital to comply with regulatory requirements, including requirements under the Bank’s agreement with the OCC, or to support continued growth. The Company’s ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside the Company’s control, and on its financial performance. Accordingly, the Company cannot assure you of its ability to raise additional capital if needed or on terms acceptable to the Company. If the Company cannot raise additional capital when needed, the ability to further expand its operations could be materially impaired.
Our exposure to credit risk, because we focus on commercial lending, could adversely affect our earnings and financial condition.
There are certain risks inherent in making loans. These risks include interest rate changes over the time period in which loans may be repaid, risks resulting from changes in the economy, risks inherent in dealing with borrowers and, in the case of a loan backed by collateral, risks resulting from uncertainties about the future value of the collateral.
Commercial loans are generally viewed as having a higher credit risk than residential real estate or consumer loans because they usually involve larger loan balances to a single borrower and are more susceptible to a risk of default during an economic downturn. Commercial and industrial loans and commercial real estate loans, which comprise our commercial loan portfolio, were 82.5% of our total loan portfolio at December 31, 2005. Construction and development loans, which are included as part of our commercial real estate loans, were 14.0% of our total loan portfolio at December 31, 2005. Construction financing typically involves a higher degree of credit risk than commercial mortgage lending. Risk of loss on a construction loan depends largely on the accuracy of the initial estimate of the property’s value at completion of construction compared to the estimated cost (including interest) of construction. If the estimated property value proves to be inaccurate, the loan may be undersecured.
Because our loan portfolio contains a significant number of commercial real estate loans and commercial and industrial loans with relatively large balances, the deterioration of one or a few of these loans may cause a significant increase in nonperforming loans. An increase in nonperforming loans could cause an increase in the provision for loan losses and an increase in loan charge offs, which could adversely impact our results of operations and financial condition.
Adverse economic and business conditions in our market area may have an adverse effect on our earnings.
Substantially all of our business is with customers located within Mercer County and contiguous counties. Generally, we make loans to small to mid-sized businesses, most of which depend on the health of the regional economy for their success. These businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities. Adverse economic and business conditions in our market area could reduce our growth rate, affect our borrowers’ ability to repay their loans and, consequently, adversely affect our financial condition and performance. Further, we place substantial reliance on real estate as collateral for our loan portfolio. A sharp downturn in real estate values in our market area could leave many of our loans undersecured. If we are required to liquidate the collateral to satisfy the debt securing a loan during a period of reduced real estate values, our earnings could be adversely affected.
If our allowance for loan losses is not sufficient to cover actual loan losses, our earnings would decrease.
In an attempt to mitigate any loan losses we may incur, we maintain an allowance for loan losses based on, among other things, national and regional economic conditions, and historical loss experience and delinquency trends among loan types. However, we cannot predict loan losses with certainty and we cannot assure you that charge offs in future periods will not exceed the allowance for loan losses. In addition, regulatory agencies, as an integral part of their examination process, review our allowance for loan losses and may require additions to the allowance
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based on their judgment about information available to them at the time of their examination. Factors that require an increase in our allowance for loan losses could reduce our earnings.
Loss of our key personnel or an inability to hire and retain qualified personnel could adversely affect our business.
Our future operating results are substantially dependent on the continued service of our senior and executive management team. The loss of key personnel could have a negative impact on our banking operations because of the loss of their business development skills, lending expertise and community involvement, among other things. Our success also depends on the experience of our branch managers and our lending officers and on their relationships with the communities they serve. Although we have employment agreements with certain key personnel, our employees may voluntarily terminate their employment at any time. We cannot assure you that we will be able to retain our key personnel or attract the qualified personnel necessary for the management of our business.
Changes in interest rates may adversely affect our earnings and financial condition.
Our net income depends primarily upon our net interest income. Net interest income is the difference between interest income earned on loans, investments and other interest-earning assets and the interest expense incurred on deposits and borrowed funds.
Different types of assets and liabilities may react differently, and at different times, to changes in market interest rates. We expect that we will periodically experience “gaps” in the interest rate sensitivities of our assets and liabilities. When interest-bearing liabilities mature or reprice more quickly than interest-earning assets, an increase in market rates of interest could reduce our net interest income. Likewise, when interest-earning assets mature or reprice more quickly than interest-bearing liabilities, falling interest rates could reduce our net interest income. We are unable to accurately predict changes in market interest rates, which are affected by many factors beyond our control, including inflation, recession, unemployment, money supply, domestic and international events and changes in the United States and other financial markets.
We may not be able to successfully integrate acquisitions, which may adversely affect our business.
We intend to consider future strategic acquisitions, some of which could be material to us and which may include companies that are substantially equivalent or larger in size compared to us. We continually explore and conduct discussions with third parties regarding possible acquisitions. As of the date of this report, we have not entered into any definitive agreement and we do not have any definitive plans relating to any specific acquisitions.
We will have to integrate any acquisitions into our business. The difficulties of combining the operations, technologies and personnel of companies we acquire include coordinating and integrating geographically separated organizations and integrating personnel with diverse business backgrounds. We may not be able to effectively manage or integrate the acquired companies. Further, we may not be successful in implementing appropriate operational, financial and management systems and controls to achieve the benefits expected to result from these acquisitions. Our efforts to integrate these businesses could be affected by a number of factors beyond our control, such as regulatory developments, general economic conditions and increased competition. In addition, the process of integrating these businesses could cause an interruption of, or loss of momentum in, the activities of our existing business and the loss of key personnel and customers. The diversion of management’s attention and any delays or difficulties encountered in connection with the transition and integration of these businesses could negatively impact our business and results of operations if any of the above adverse effects were to occur. Further, the benefits that we anticipate from any acquisitions may not be obtained.
Competition from other financial institutions in originating loans and attracting deposits may adversely affect our profitability.
We face substantial competition in originating loans. This competition comes principally from other banks, savings institutions, mortgage banking companies and other lenders. Many of our competitors enjoy advantages, including
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greater financial resources and higher lending limits, a wider geographic presence, more accessible branch office locations, the ability to offer a wider array of services or more favorable pricing alternatives, as well as lower origination and operating costs. This competition could reduce our net income by decreasing the number and size of loans that we originate and the interest rates we may charge on these loans.
In attracting deposits, we face substantial competition from other insured depository institutions such as banks, savings institutions and credit unions, as well as institutions offering uninsured investment alternatives, including money market funds. Many of our competitors enjoy advantages, including greater financial resources, more aggressive marketing campaigns, better brand recognition and more branch locations. These competitors may offer higher interest rates than we do, which could decrease the deposits that we attract or require us to increase our rates to retain existing deposits or attract new deposits. Increased deposit competition could adversely affect our ability to generate the funds necessary for lending operations and increase our cost of funds.
We also compete with non-bank providers of financial services, such as brokerage firms, consumer finance companies, insurance companies and governmental organizations which may offer more favorable terms. Some of our non-bank competitors are not subject to the same extensive regulations that govern our operations. As a result, such non-bank competitors may have advantages over us in providing certain products and services. This competition may reduce or limit our margins on banking services, reduce our market share and adversely affect our earnings and financial condition.
