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THE PNC FINANCIAL SERVICES GROUP, INC.
Quarterly Report on Form 10-Q
For the quarterly period ended June 30, 2003
The Quarterly Report on Form 10-Q and cross reference index is on page 61.
CONSOLIDATED FINANCIAL HIGHLIGHTS
THE PNC FINANCIAL SERVICES GROUP, INC.
Dollars in millions, except per share data Three months ended June 30 Six months ended June 30
Unaudited 2003 2002 2003 2002
- ------------------------------------------------------------------------------------------------------------------------
FINANCIAL PERFORMANCE
Revenue
Net interest income (taxable-equivalent basis) (a) $523 $558 $1,029 $1,151
Noninterest income 776 870 1,571 1,660
------------------------------ ----------------------------
Total revenue $1,299 $1,428 $2,600 $2,811
============================== ============================
Net income $184 $320 $446 $637
============================== ============================
Per common share
Diluted earnings $.65 $1.12 $1.57 $2.23
Cash dividends declared $.48 $.48 $.96 $.96
- ------------------------------------------------------------------------------------------------------------------------
SELECTED RATIOS
Return on
Average common shareholders' equity 10.91% 21.00% 13.32% 21.41%
Average assets 1.13 1.93 1.37 1.91
Net interest margin 3.91 3.99 3.83 4.06
Noninterest income to total revenue (b) 60 61 60 59
Efficiency (c) 72 59 69 59
========================================================================================================================
Certain prior period amounts included in these Consolidated Financial Highlights
have been reclassified to conform to the current period presentation. See page
38 of this Financial Review for a glossary of certain terms used in this report.
(a) The interest income earned on certain earning assets is completely or
partially exempt from federal income tax. As such, these tax-exempt
instruments typically yield lower returns than a taxable investment. In
order to provide accurate comparisons of yields and margins for all earning
assets, the interest income earned on tax-exempt assets has been increased
to make them fully equivalent to other taxable interest income investments.
A reconciliation of net interest income as reported in the Consolidated
Statement of Income to net interest income on a taxable-equivalent basis
follows (in millions):
Three months ended June 30 Six months ended June 30
2003 2002 2003 2002
-------------- ------------ ------------- ------------
Net interest income, GAAP basis $521 $555 $1,024 $1,145
Taxable-equivalent adjustment 2 3 5 6
-------------- ------------ ------------- ------------
Net interest income, taxable-equivalent basis $523 $558 $1,029 $1,151
============== ============ ============= ============
(b) Computed as total noninterest income divided by the sum of net interest
income and noninterest income. For the six months ended June 30, 2002, the
ratio previously reported had been computed using taxable-equivalent net
interest income. The ratio for that period has been restated to conform to
the current period presentation.
(c) Computed as noninterest expense divided by the sum of net interest income
and noninterest income. For the six months ended June 30, 2002, the
efficiency ratio previously reported had been computed by excluding
amortization expense and distributions on capital securities from the
calculation and had used taxable-equivalent net interest income. The
efficiency ratio for that period has been restated to conform to the
current period presentation.
1
June 30 December 31 June 30
Unaudited 2003 2002 2002
- -----------------------------------------------------------------------------------------------------------------------------
BALANCE SHEET DATA (dollars in millions, except per share data)
Assets $67,262 $66,377 $66,913
Earning assets 54,748 54,833 55,778
Loans, net of unearned income 34,534 35,450 37,684
Allowance for credit losses 673 673 654
Securities 16,017 13,763 12,313
Loans held for sale 1,475 1,607 2,441
Total deposits 46,694 44,982 44,427
Borrowed funds 7,903 9,116 10,480
Allowance for unfunded loan commitments and letters of credit 78 84 73
Shareholders' equity 6,774 6,859 6,390
Common shareholders' equity 6,765 6,849 6,380
Book value per common share 24.16 24.03 22.46
Loans to deposits 74% 79% 85%
ASSETS UNDER MANAGEMENT (billions) $328 $313 $294
FUND ASSETS SERVICED (billions)
Accounting/administration net assets $618 $510 $513
Custody assets $371 $336 $323
CAPITAL RATIOS
Tier 1 Risk-based 8.9% 8.8% 8.2%
Total Risk-based 12.3 12.5 12.0
Leverage 8.1 8.1 7.4
Shareholders' equity to total assets 10.07 10.33 9.55
Common shareholders' equity to total assets 10.06 10.32 9.53
ASSET QUALITY RATIOS
Nonperforming assets to total loans,
loans held for sale and foreclosed assets 1.12% 1.13% 1.25%
Nonperforming loans to total loans .95 .87 .86
Net charge-offs to average loans (for the three months ended) .73 .39 .78
Allowance for credit losses to total loans 1.95 1.90 1.74
Allowance for credit losses to nonperforming loans 206 218 201
============================================================================================================================
2
FINANCIAL REVIEW
THE PNC FINANCIAL SERVICES GROUP, INC.
This Financial Review should be read in conjunction with The PNC Financial
Services Group, Inc. ("Corporation" or "PNC") unaudited Consolidated Financial
Statements and unaudited Statistical Information included herein and the
Financial Review, audited Consolidated Financial Statements, and Statistical
Information included in the Corporation's 2002 Annual Report on Form 10-K ("2002
Form 10-K"). Certain prior-period amounts have been reclassified to conform with
the current year presentation. The term "loans" in this report excludes loans
held for sale and securities that represent interests in pools of loans. For
information regarding certain business and regulatory risks, see the Risk
Factors and Risk Management sections in this Financial Review and the Business
section of the 2002 Form 10-K. Also, see the Forward-Looking Statements and the
Critical Accounting Policies And Judgments sections in this Financial Review for
certain other factors that could cause actual results to differ materially from
forward-looking statements or historical performance. See page 38 of this
Financial Review for a glossary of certain terms used in this report.
OVERVIEW
THE PNC FINANCIAL SERVICES GROUP, INC.
The Corporation is one of the largest diversified financial services companies
in the United States, operating businesses engaged in regional community
banking; wholesale banking, including corporate banking, real estate finance and
asset-based lending; wealth management; asset management and global fund
processing services. The Corporation provides certain products and services
nationally and others in PNC's primary geographic markets in Pennsylvania, New
Jersey, Delaware, Ohio and Kentucky. The Corporation also provides certain
banking, asset management and global fund processing services internationally.
SUMMARY FINANCIAL RESULTS
Consolidated net income for the first six months of 2003 was $446 million, or
$1.57 per diluted share, compared with net income of $637 million, or $2.23 per
diluted share, for the first six months of 2002. Return on average common
shareholders' equity was 13.32% for the first half of 2003 compared with 21.41%
for the first half of 2002. Return on average assets was 1.37% for the first six
months of 2003 compared with 1.91% for the first six months of 2002.
Consolidated net income for the second quarter of 2003 was $184 million, or $.65
per diluted share, compared with $320 million, or $1.12 per diluted share, for
the second quarter of 2002. Return on average common shareholders' equity was
10.91% for the second quarter of 2003 compared with 21.00% for the second
quarter of 2002. Return on average assets was 1.13% for the second quarter of
2003 compared with 1.93% for the second quarter of 2002.
Results for both the first six months and second quarter of 2003 included
expenses totaling $87 million after taxes, or $.31 per diluted share, in
connection with the Corporation's previously announced agreement with the United
States Department of Justice ("DOJ"), including related legal and consulting
costs. See Agreement with Department of Justice in this Financial Review for
additional information. The impact of these expenses was reflected in the return
on average common shareholders' equity and in the return on average assets for
both the first half and second quarter of 2003.
The Corporation's progress during the first half and second quarter of 2003 in
addressing several of the challenges referred to in the 2002 Form 10-K included
the following:
Asset quality remained stable.
o The provision for credit losses was $93 million for the first six
months of 2003 compared with $171 million for the first six months
of 2002. The provision for credit losses was $57 million for the
second quarter of 2003 compared with $89 million for the second
quarter of 2002.
o While nonperforming loans increased $18 million, to $327 million,
compared with the balance at December 31, 2002, total nonperforming
assets declined $14 million, to $404 million, at June 30, 2003.
Total revenues declined in the first half and second quarter of 2003 compared
with the same periods in 2002 due to the effects of a lower interest rate
environment, declines in average interest-earning assets and comparatively
weaker equity markets in 2003. However, growth in certain facets of the business
included the following:
o Earnings from BlackRock for the first half of 2003 increased 12%
compared with the first half of 2002 and second quarter earnings
improved 11% compared with the second quarter of 2002.
o Regional Community Banking grew home equity loans 14% on average in
both the six-month and second quarter 2002 comparisons and grew
demand deposits 5% on average compared with the first half of 2002
and 6% on average compared with the prior year quarter.
PNC's development of value-added customer relationships was evidenced by the
following:
o The number of Regional Community Banking checking relationships at
June 30, 2003 reflected growth of 2% compared with December 31, 2002
and 5% compared with June 30, 2002.
3
o PFPC provided accounting/administration services for $618 billion of
pooled investment assets at June 30, 2003, up from $510 billion at
December 31, 2002 and $513 billion at June 30, 2002. These increases
from prior periods primarily resulted from net new business activity
and positive equity market performance during the second quarter of
2003.
Other strategic initiatives:
o The Corporation's $100 million efficiency initiative is on track and
has resulted in expense savings of approximately $37 million for the
first half of 2003, including $21 million in the second quarter.
o PNC repurchased 6.6 million common shares under its 35 million share
repurchase program during the first half of 2003, including 2.2
million shares during the second quarter of 2003.
o PFPC completed the sale of its retirement services business
effective June 30, 2003, which is expected to improve its operating
margins.
Results for the first half of 2003 included a $211 million, or 8%, decline in
total taxable-equivalent revenue compared with the first half of 2002, comprised
of a $122 million decline in taxable-equivalent net interest income and an $89
million decline in noninterest income. Results for the second quarter of 2003
reflected a $129 million, or 9%, decrease in total taxable-equivalent revenue
compared with the second quarter of 2002, including a $94 million decline in
noninterest income and a $35 million decline in taxable-equivalent net interest
income. Taxable-equivalent net interest income in both 2003 periods reflected a
narrower net interest margin and downsizing of the loan portfolio. See Note (a)
to net interest income (taxable-equivalent basis) in the Consolidated Financial
Highlights for a reconciliation of taxable-equivalent net interest income to net
interest income as reported under generally accepted accounting principles
("GAAP"). The impact of comparatively weaker equity markets in 2003 and reduced
net gains in excess of valuation adjustments related to the liquidation of the
institutional loans held for sale contributed to the decline in noninterest
income in the 2003 periods compared with the corresponding 2002 periods.
Total noninterest expense increased $145 million, or 9%, for the first six
months of 2003 compared with the first half of 2002 and increased $96 million,
or 11%, in the second quarter of 2003 compared with the second quarter of 2002.
Noninterest expense for both 2003 periods included DOJ-related expenses of $120
million.
Management expects that the remainder of 2003 will continue to be a challenge to
the Corporation and that success will depend on PNC's ability to meet its key
operating challenges. These challenges include the stability of asset quality,
revenue growth and the development of value-added customer relationships. Other
factors that will affect the Corporation's success include leveraging
technology, managing the revenue/expense relationship and regulatory and other
governmental actions. For additional factors that could affect the Corporation's
success, see the Risk Factors, Risk Management and Forward-Looking Statements
sections of this Financial Review.
BALANCE SHEET HIGHLIGHTS
Total assets were $67.3 billion at June 30, 2003 compared with $66.4 billion at
December 31, 2002 and $66.9 billion at June 30, 2002. Average interest-earning
assets for the first half of 2003 were $53.6 billion, down $3.0 billion, or 5%,
compared with the first half of 2002. Declines in average loans of $3.2 billion
and average loans held for sale of $2.0 billion were partially offset by an
increase of $2.2 billion in average securities available for sale.
Average loans for the first six months of 2003 were $35.0 billion compared with
$38.2 billion for the first six months of 2002. Average loans represented 65% of
total average interest-earning assets for the first half of 2003 compared with
67% for the first half of 2002. Declines in average residential mortgage and
commercial loans drove the decline compared with the prior year quarter,
partially offset by an increase in home equity loans.
Changes in loans held for sale are described in Loans Held For Sale in the
Consolidated Balance Sheet Review section of this Financial Review.
Average securities for the first half of 2003 were $13.9 billion, compared with
$12.0 billion for the first half of 2002. Securities represented 26% of average
total interest-earning assets for the first half of 2003 compared with 21% for
the first half of 2002.
Funding cost is affected by the volume and composition of funding sources as
well as related rates paid thereon. Average deposits represented 67% of total
sources of funds for the first half of 2003 and 66% for the first half of 2002,
with the remainder primarily comprised of wholesale funding obtained at
prevailing market rates.
Average interest-bearing demand and money market deposits totaled $22.1 billion
for the first half of 2003, up slightly compared with the first half of 2002.
Average borrowed funds were $8.7 billion for the first six months of 2003, down
$3.3 billion compared with the first six months of 2002. This decline is
consistent with the decline in average total interest-earning assets in the
first half of 2003 compared with the year-ago period and reflected the retention
of capital. See the Consolidated Average Balance Sheet and Net Interest Analysis
for additional information.
4
REVIEW OF BUSINESSES
PNC operates seven major businesses engaged in regional community banking;
wholesale banking, including corporate banking, real estate finance and
asset-based lending; wealth management; asset management and global fund
processing services. Treasury management activities, which include cash and
investment management, receivables management, disbursement services and global
trade services; capital markets products, which include foreign exchange,
derivatives trading and loan syndications; and equipment leasing products are
offered through Corporate Banking and sold by several businesses across the
Corporation.
Results of individual businesses are presented based on PNC's management
accounting practices and the Corporation's management structure. There is no
comprehensive, authoritative body of guidance for management accounting
equivalent to GAAP; therefore, the financial results of individual businesses
are not necessarily comparable with similar information for any other company.
Financial results are presented, to the extent practicable, as if each business
operated on a stand-alone basis. Also, certain amounts for 2002 have been
reclassified to conform with the 2003 presentation.
The management accounting process uses various balance sheet and income
statement assignments and transfers to measure performance of the businesses.
Methodologies are refined from time to time as management accounting practices
are enhanced and businesses change. There were no significant changes to the
measurement methods during the second quarter of 2003. Securities or borrowings
and related net interest income are assigned based on the net asset or liability
position of each business. Capital is assigned based on management's assessment
of inherent risks and equity levels at independent companies providing similar
products and services. The allowance for credit losses is allocated based on
management's assessment of risk inherent in the loan portfolios. The costs
incurred by support areas not directly aligned with the businesses are allocated
primarily based on the utilization of services.
Total business financial results differ from total consolidated results. The
impact of these differences is reflected in the "Intercompany eliminations" and
"Other" categories. "Intercompany eliminations" reflects activities conducted
among PNC's businesses that are eliminated in the consolidated results. "Other"
includes differences between management accounting practices and GAAP such as
economic capital assignments rather than legal entity shareholders' equity, unit
cost allocations rather than actual expense assignments, and policies that do
not fully allocate holding company expenses; minority interest in income of
consolidated entities; and other corporate items. "Other" also includes equity
management activities and residual asset and liability management activities
which do not meet the criteria for disclosure as a separate reportable business.
"Other" reflected a net loss of $134 million for the first six months of 2003
compared with a net loss of $20 million for the first six months of 2002.
"Other" for the first half of 2003 includes pretax expenses of $120 million ($87
million after taxes) in connection with the DOJ agreement, including related
legal and consulting costs, and a pretax charge of $23 million ($15 million
after taxes) related to leased facilities. Business results, including
inter-segment revenues, are included in Note 13 Segment Reporting.
"Other Information" included in the tables that follow is presented as of period
end, except for consolidated revenue from treasury management, net charge-offs,
net gains (losses) on loans held for sale and average full-time equivalent
employees (FTEs), which represent amounts for the periods presented. FTE
statistics as reported by business reflect staff directly employed by the
respective businesses and exclude corporate and shared services employees. Prior
period FTE amounts are not restated for organizational changes.
RESULTS OF BUSINESSES
Return on
Earnings (Loss) Revenue (a) Assigned Capital(b) Average Assets (c)
---------------------------------------------------------------------------------------
Six months ended June 30 - dollars in
millions 2003 2002 2003 2002 2003 2002 2003 2002
- --------------------------------------------------------------------------------------------------------------------------------
Banking businesses
Regional Community Banking $311 $353 $1,055 $1,094 24% 27% $38,710 $38,920
Wholesale Banking
Corporate Banking 75 87 348 411 18 16 11,501 14,752
PNC Real Estate Finance 40 48 118 116 23 24 4,766 5,081
PNC Business Credit 20 4 90 90 17 3 3,703 3,898
- ------------------------------------------------------------------------------------ -----------------------
Total wholesale banking 135 139 556 617 19 16 19,970 23,731
PNC Advisors 36 64 301 354 14 25 2,863 3,029
- ------------------------------------------------------------------------------------ -----------------------
Total banking businesses 482 556 1,912 2,065 21 23 61,543 65,680
- ------------------------------------------------------------------------------------ -----------------------
Asset management and processing businesses
BlackRock 74 66 287 303 22 25 901 734
PFPC 27 38 380 430 26 37 1,878 1,890
- ------------------------------------------------------------------------------------ -----------------------
Total asset management and
processing businesses 101 104 667 733 23 28 2,779 2,624
- ------------------------------------------------------------------------------------ -----------------------
Total business results 583 660 2,579 2,798 21 24 64,322 68,304
Intercompany eliminations (3) (3) (47) (52) (1,906) (2,033)
Other (134) (20) 68 65 3,343 1,069
- ------------------------------------------------------------------------------------ -----------------------
Total consolidated (a) $446 $637 $2,600 $2,811 13 21 $65,759 $67,340
================================================================================================================================
(a) Business revenue is presented on a taxable-equivalent basis except for
BlackRock and PFPC, which are presented on a book (GAAP) basis. A
reconciliation of total consolidated revenue on a book basis to total
consolidated revenue on a taxable-equivalent basis is as follows:
Six months ended June 30 - in millions 2003 2002
- ------------------------------------------------------------------------------
Total consolidated revenue, book (GAAP) basis $2,595 $2,805
Taxable-equivalent adjustment 5 6
- ------------------------------------------------------------------------------
Total consolidated revenue, taxable-equivalent basis $2,600 $2,811
==============================================================================
(b) Percentages for BlackRock reflect return on equity.
(c) Period-end balances for BlackRock.
5
REGIONAL COMMUNITY BANKING
Six months ended June 30
Taxable-equivalent basis
Dollars in millions 2003 2002
- ----------------------------------------------------------------
INCOME STATEMENT
Net interest income $651 $741
Other noninterest income 344 335
Net securities gains 60 18
- ----------------------------------------------------------------
Total revenue 1,055 1,094
Provision for credit losses 21 23
Noninterest expense 560 529
- ----------------------------------------------------------------
Pretax earnings 474 542
Income taxes 163 189
- ----------------------------------------------------------------
Earnings $311 $353
================================================================
AVERAGE BALANCE SHEET
Loans
Consumer
Home equity $7,862 $6,883
Indirect 453 600
Other consumer 531 669
- ----------------------------------------------------------------
Total consumer 8,846 8,152
Residential mortgage 3,122 4,757
Commercial 3,970 3,529
Vehicle leasing 1,256 1,823
Other 117 121
- ----------------------------------------------------------------
Total loans 17,311 18,382
Securities 13,362 11,180
Education and other loans held for sale 1,197 1,442
Assigned assets and other assets 6,840 7,916
- ----------------------------------------------------------------
Total assets $38,710 $38,920
================================================================
Deposits
Noninterest-bearing demand $5,368 $4,938
Interest-bearing demand 6,124 6,023
Money market 12,384 12,320
- ----------------------------------------------------------------
Total transaction deposits 23,876 23,281
Savings 2,011 1,960
Certificates 9,011 10,259
- ----------------------------------------------------------------
Total deposits 34,898 35,500
Other liabilities 1,198 794
Assigned capital 2,614 2,626
- ----------------------------------------------------------------
Total funds $38,710 $38,920
================================================================
PERFORMANCE RATIOS
Return on assigned capital 24% 27%
Noninterest income to total revenue 38 32
Efficiency 53 48
- ----------------------------------------------------------------
OTHER INFORMATION
Total nonperforming assets (a) $75 $65
Vehicle leasing outstandings,
net of unearned income (b) $1,048 $1,661
Net charge-offs $26 $24
Home equity portfolio credit statistics:
Percentage of first lien positions 46% 36%
Weighted average loan-to-value ratios 72% 73%
Weighted average FICO scores 712 710
Gains on sales of education loans $8 $10
Average FTEs 9,394 9,544
ATMs 3,660 3,350
Branches 713 713
Financial consultants 693 650
Business banking centers 193 158
Checking relationships 1,575,000 1,494,000
Online banking users 684,134 508,608
Deposit households using online banking 40.2% 32.6%
=================================================================
(a) Includes nonperforming loans of $65 million and $56 million at June 30,
2003 and 2002, respectively.
(b) At June 30.
Regional Community Banking provides deposit, lending, cash management and
investment services to two million consumer and small business customers within
PNC's geographic region.
The strategic focus of the Regional Community Bank is to generate sustainable
revenue growth by consistently increasing its base of satisfied and loyal
customers. The strategy is to drive revenue growth by building a base of
checking account relationships which provide fee revenue and a low-cost funding
source for loans and investments. In turn, these relationships generate
additional revenue growth by deepening relationships with these customers
through cross-selling of other products and services. Consistent with this
strategy, PNC Bank, N.A. announced in August 2003 an alliance with The Stop and
Shop Supermarket Company to become the exclusive bank in all new Stop & Shop
stores located in New Jersey going forward and expects to place 40 branches in
Stop and Shop's New Jersey stores over the next four years.
Regional Community Banking increased the number of checking relationships by 5%
compared with June 30, 2002, which drove increases in average transaction
deposits and fee revenues. The cross-sell of home equity loans to consumers and
growth in checking accounts and the ATM network have generated additional growth
in loans and fee revenues. One of the key priorities for the business is to
continue to improve customer loyalty and retention by investing in improvements
to on-line banking services. This focus has resulted in a 35% increase in online
banking users since June 30, 2002.
Regional Community Banking earnings were $311 million for the first six months
of 2003 compared with $353 million in the first six months of 2002. Revenue was
negatively impacted by low interest rates in the first half of 2003 and the
down-sizing of non-relationship lending activities. These factors, and a
significant increase in employee benefit costs, contributed to the decline in
earnings. As a result, the efficiency ratio declined in 2003 compared with the
prior year period.
Total revenue was $1.1 billion for both the first six months of 2003 and 2002.
Taxable-equivalent net interest income declined $90 million, or 12%, compared
with the first six months of 2002. Declines in taxable-equivalent net interest
income of $56 million related to the residential mortgage portfolio and of $22
million from the securities portfolio, reflecting the lower interest rate
environment in 2003 and partially offset by an increase of $12 million from
higher average home equity loan balances, were the primary reasons for the
decline. Other noninterest income increased $9 million compared with the first
six months of 2002 as a $14 million improvement in deposit-related fee revenue
and a $3 million increase in ATM fees more than offset declines in other income.
Net securities gains increased $42 million for the first half of 2003 compared
with the prior year period.
6
The provision for credit losses for the first six months of 2003 was $21
million, a decline of $2 million compared with the prior year period primarily
due to a decrease in specific reserves partially offset by a $2 million increase
in net charge-offs.
Noninterest expense totaled $560 million in the first six months of 2003, up $31
million compared with the prior year period. The increase reflected higher
pension cost, increases in net occupancy costs related to additional offsite
ATMs and investments in the branch network and marketing costs.
Average total loans decreased 6% for the first half of 2003 compared with the
first six months of 2002. Regional Community Banking has adopted a
relationship-based lending strategy that will target certain portfolios for
growth (home equity and commercial) while allowing other portfolios to run-off.
Home equity loans grew by 14% on average compared with the first half of 2002
driven by record levels of new loan volume. As of June 30, 2003, 95% of the home
equity portfolio was within Regional Community Banking's geographic footprint.
The growth in home equity loans and residential mortgage prepayments reflected
consumer debt trends during the periods presented. However, if mortgage interest
rates continue to rise subsequent to June 30, 2003, consumer demand for home
equity loans may change. The overall decline in loans primarily resulted from
residential mortgage prepayments and the run-off of vehicle leases and indirect
loans consistent with the relationship-based lending strategy.
Average total deposits declined 2% in the first six months of 2003 compared with
the prior year period as increases in checking, money market and savings
deposits were more than offset by a decline in certificates of deposit. Demand
and money market deposits increased due to the ongoing strategic marketing
efforts to add new accounts and retain existing customers while higher cost,
less valuable certificates of deposit were not emphasized.
As previously reported, the Corporation decided to discontinue its vehicle
leasing business in the fourth quarter of 2001. As a result, this portfolio has
declined 37% since June 30, 2002 and is performing overall as expected. See
Loans in the Consolidated Balance Sheet Review section of this Financial Review
for additional information.
7
WHOLESALE BANKING - CORPORATE BANKING
Six months ended June 30
Taxable-equivalent basis
Dollars in millions 2003 2002
- ------------------------------------------------------------------
INCOME STATEMENT
Net interest income $147 $183
Noninterest income 201 228
- ------------------------------------------------------------------
Total revenue 348 411
Provision for credit losses 40 95
Noninterest expense 193 183
- ------------------------------------------------------------------
Pretax earnings 115 133
Income tax 40 46
- ------------------------------------------------------------------
Earnings $75 $87
==================================================================
AVERAGE BALANCE SHEET
Loans $8,432 $9,815
Loans held for sale 243 2,116
Other assets 2,826 2,821
- ------------------------------------------------------------------
Total assets $11,501 $14,752
==================================================================
Deposits $5,043 $4,538
Assigned funds and other liabilities 5,595 9,108
Assigned capital 863 1,106
- ------------------------------------------------------------------
Total funds $11,501 $14,752
==================================================================
PERFORMANCE RATIOS
Return on assigned capital 18% 16%
Noninterest income to total revenue 58 55
Efficiency 55 45
- ------------------------------------------------------------------
OTHER INFORMATION
Total nonperforming assets (a) $176 $261
Net charge-offs $60 $71
Average FTEs 1,899 1,932
INSTITUTIONAL LENDING REPOSITIONING
Loans held for sale
Credit exposure $173 $1,822
Outstandings $101 $920
Exit portfolio
Credit exposure $251 $1,178
Outstandings $11 $12
Net gains on loans held for sale (b) $30 $79
==================================================================
(a) Includes nonperforming loans of $121 million and $126 million at June 30,
2003 and 2002, respectively.
(b) Included in Noninterest income.
Corporate Banking provides credit, equipment leasing, treasury management and
capital markets products and services to mid-sized corporations, government
entities and selectively to large corporations primarily within PNC's geographic
region. Additionally, PNC, through the Corporate Banking line of business,
administers Market Street Funding Corporation ("Market Street"), a multi-seller
asset-backed commercial paper conduit. See Note 1 Accounting Policies regarding
the potential effect on the accounting for Market Street of the Corporation's
adoption of the Financial Accounting Standards Board's FASB Interpretation No.
("FIN") 46, "Consolidation of Variable Interest Entities," effective July 1,
2003. The strategic focus for Corporate Banking is to adapt its institutional
expertise to the middle market with an emphasis on higher-margin noncredit
products and services, especially treasury management and capital markets, and
to improve the risk/return characteristics of the lending business. Corporate
Banking intends to continue its efforts to manage credit risk, liquidate loans
held for sale and sustain relationships with traditional customers by
emphasizing noncredit products.
Corporate Banking earnings were $75 million for the first six months of 2003
compared with $87 million for the first six months of 2002. The earnings decline
reflected decreased revenue and higher noninterest expenses that more than
offset a lower provision for credit losses compared with the first half of 2002.
Total revenue of $348 million for the first six months of 2003 decreased $63
million compared with the first six months of 2002. Taxable-equivalent net
interest income for the first six months of 2003 decreased $36 million compared
with the prior year period primarily due to the reduction in average loans and
average loans held for sale resulting from the institutional lending
repositioning and lower interest rates. Noninterest income decreased $27 million
compared with the first six months of 2002. This decline reflected a $49 million
reduction in net gains on loans held for sale compared with the first half of
2002 that was partially offset by $23 million of net securities gains recognized
in 2003 in connection with the liquidation of two entities formed in 2001 in the
PAGIC transactions with American International Group, Inc. ("AIG").
The provision for credit losses decreased $55 million, to $40 million, in the
first six months of 2003 compared with the same period in 2002. The provision
for credit losses for the first six months of 2002 reflected reserve allocations
related to Market Street liquidity facilities.
Noninterest expense totaled $193 million in the first six months of 2003
compared with $183 million for the first six months of 2002. The increase
reflects $22 million of costs paid in 2003 in connection with the liquidation of
two entities formed in 2001 in the PAGIC transactions, partially offset by lower
staff-related costs in 2003 as a result of the institutional lending downsizing.
Treasury management, capital markets and equipment leasing products offered
through Corporate Banking are marketed by several businesses across the
Corporation. A portion of the revenue and expense related to these products is
reflected in Corporate Banking and the remainder is reflected in the results of
other businesses. Consolidated revenue from treasury management products was
$175 million for the first six months of 2003, up $5 million compared with the
first half of 2002 reflecting higher sales activity. Consolidated revenue from
capital markets products was $56 million for the first six months of 2003, a
decrease of $6 million compared with the same period in 2002 primarily due to
lower transaction volume attributable to the comparatively weaker market
conditions in 2003. Consolidated revenue from equipment leasing products was $38
million for the first half of 2003 compared with $37 million for the first half
of 2002.
Nonperforming assets were $176 million at June 30, 2003 compared with $261
million at June 30, 2002. Nonperforming assets at June 30, 2002 included the
second quarter 2002 funding of approximately $63 million resulting from a draw
on a liquidity facility with Market Street. The decrease from June 30, 2002 also
reflects the Corporation's continued liquidation of the institutional lending
held for sale portfolio.
8
WHOLESALE BANKING - PNC REAL ESTATE FINANCE
Six months ended June 30
Taxable-equivalent basis
Dollars in millions 2003 2002
- -----------------------------------------------------------------
INCOME STATEMENT
Net interest income $56 $60
Noninterest income
Net commercial mortgage banking
Net gains on loan sales 23 14
Servicing and other fees, net
of amortization 19 20
Other 20 22
- -----------------------------------------------------------------
Total noninterest income 62 56
- -----------------------------------------------------------------
Total revenue 118 116
Provision for credit losses 7 (5)
Noninterest expense 82 74
- -----------------------------------------------------------------
Pretax earnings 29 47
- -----------------------------------------------------------------
Minority interest benefit (2)
Income tax (benefit) (9) (1)
- -----------------------------------------------------------------
Earnings $40 $48
=================================================================
AVERAGE BALANCE SHEET
Loans
Commercial real estate $2,002 $2,237
Commercial - real estate related 1,418 1,508
- -----------------------------------------------------------------
Total loans 3,420 3,745
Commercial mortgages held for sale 344 282
Other loans held for sale 45 183
Other assets 957 871
- -----------------------------------------------------------------
Total assets $4,766 $5,081
=================================================================
Deposits $997 $658
Assigned funds and other liabilities 3,411 4,025
Assigned capital 358 398
- -----------------------------------------------------------------
Total funds $4,766 $5,081
================================================================
PERFORMANCE RATIOS
Return on assigned capital 23% 24%
Noninterest income to total revenue 53 48
Efficiency 69 64
- -----------------------------------------------------------------
COMMERCIAL MORTGAGE SERVICING PORTFOLIO (a)
January 1 $74 $68
Acquisitions/additions 12 9
Repayments/transfers (7) (6)
- -----------------------------------------------------------------
June 30 $79 $71
=================================================================
OTHER INFORMATION
Total nonperforming assets (b) $3 $6
Net charge-offs (recoveries) $2 $(5)
Average FTEs 747 764
Net carrying amount of commercial
mortgage servicing rights $199 $200
Institutional lending repositioning
Loans held for sale
Credit exposure $16 $124
Outstandings $16 $105
Exit portfolio
Credit exposure $25
Outstandings $6
Net gains on loans held for sale (c) $1 $6
=================================================================
(a) Dollars in billions.
(b) Includes nonperforming loans of $1 million and $3 million at June 30, 2003
and 2002, respectively.
(c) Included in Noninterest income-Other above.
PNC Real Estate Finance specializes in financial solutions for the acquisition,
development, permanent financing and operation of commercial real estate
nationally. PNC Real Estate Finance offers treasury and investment management,
access to the capital markets, commercial mortgage loan servicing and other
products and services to clients that develop, own, manage or invest in
commercial real estate. PNC's commercial real estate financial services platform
provides processing services through Midland Loan Services, Inc. ("Midland").
Midland is a leading third-party provider of loan servicing and technology to
the commercial real estate finance industry. PNC Real Estate Finance also
includes PNC MultiFamily Capital, a national provider of financial services for
the multi-family housing industry, particularly affordable, senior and
healthcare housing.
PNC Real Estate Finance seeks to position its business mix for a more balanced
revenue stream. The current economic cycle offers limited opportunities to
replace run-off loans with new loans having acceptable risks and returns.
However, the continued origination and sale of commercial mortgage loans has
been profitable in the first six months of 2003.
PNC Real Estate Finance earned $40 million for the first six months of 2003 and
$48 million for the first six months of 2002. The decline compared with the
prior year period was primarily due to higher provision for credit losses in
2003 compared with net recoveries in the 2002 period. The provision for the
first half of 2003 reflected increases to specific reserves and the impact of
refinements to the Corporation's reserve methodology related to impaired loans
and pooled reserves. The recovery in 2002 occurred in the exited warehouse
lending business which recorded $6 million of net loan recoveries in the first
half of 2002.
Total revenue increased $2 million for the first half of 2003 compared with the
first six months of 2002 as a $6 million increase in noninterest income more
than offset a $4 million decline in taxable-equivalent net interest income. The
increase in noninterest income reflected an increase of $9 million in net gains
on commercial mortgage loan sales. The origination and sale of certain
commercial mortgages is part of the ongoing business of PNC Real Estate Finance.
The higher gains in 2003 reflected more favorable market conditions for this
activity. The decline in taxable-equivalent net interest income was primarily
due to a $325 million decline in average loans in the comparison.
Noninterest expense for the first six months of 2003 increased $8 million
compared with the prior year period primarily due to increased impairment costs
on certain low income housing tax credits and receipt and recognition of updated
financial information during the second quarter of 2003 related to certain
operating partnerships that PNC Real Estate Finance, as the general partner,
consolidates. Expenses related to these partnerships increased occupancy and
depreciation costs but were offset by noninterest income and minority interest
benefit and, therefore, had no impact on earnings.
PNC Real Estate Finance recognized an income tax benefit for both the first half
of 2003 and 2002 due to the impact of tax credits received on low income housing
tax credit investments. The income tax benefits were partially offset by passive
losses from these investments included in noninterest expense.
The commercial mortgage servicing portfolio increased $8 billion to $79 billion
at June 30, 2003 compared with the balance at June 30, 2002. Midland, as a
third-party servicer, is required to comply with various contractual
obligations, including the obligation to monitor property taxes and insurance
and to advance funds for delinquent borrower payments and property protection
purposes, subject to certain recoverability provisions. A total of $85 million
of advances were outstanding at June 30, 2003, compared with $70 million at June
30, 2002. Midland's right to be reimbursed for these advances from borrower
repayments, liquidation proceeds and other sources as set forth in the
applicable servicing contracts is superior in priority to all other claims on
cash flows from the related securitizations, including claims by the security
holders.
9
WHOLESALE BANKING - PNC BUSINESS CREDIT
Six months ended June 30
Taxable-equivalent basis
Dollars in millions 2003 2002
- -----------------------------------------------------------------
INCOME STATEMENT
Net interest income $66 $66
Noninterest income 24 24
- -----------------------------------------------------------------
Total revenue 90 90
Provision for credit losses 28 57
Noninterest expense 29 27
- -----------------------------------------------------------------
Pretax earnings 33 6
Income taxes 13 2
- -----------------------------------------------------------------
Earnings $20 $4
=================================================================
AVERAGE BALANCE SHEET
Loans $3,455 $3,563
Loans held for sale 21 89
Other assets 227 246
- -----------------------------------------------------------------
Total assets $3,703 $3,898
=================================================================
Deposits $94 $73
Assigned funds and other liabilities 3,369 3,572
Assigned capital 240 253
- -----------------------------------------------------------------
Total funds $3,703 $3,898
=================================================================
PERFORMANCE RATIOS
Return on assigned capital 17% 3%
Noninterest income to total revenue 27 27
Efficiency 32 30
- -----------------------------------------------------------------
OTHER INFORMATION
Total nonperforming assets (a) $145 $164
Net charge-offs $11 $22
NBOC put option liability $43 $86
NBOC put option valuation income (b) $7 $15
Marketing locations 24 24
Average FTEs 250 233
INSTITUTIONAL LENDING REPOSITIONING
Loans held for sale
Credit exposure $10 $73
Outstandings $9 $41
Net losses on loans held for sale (b) $(1) $(7)
=================================================================
(a) Includes nonperforming loans of $135 million and $136 million at June 30,
2003 and 2002, respectively.
(b) Included in Noninterest income above.
PNC Business Credit provides asset-based lending, treasury management and
capital markets products and services to middle market customers nationally. PNC
Business Credit's lending services include loans secured by accounts receivable,
inventory, machinery and equipment, and other collateral, and its customers
include manufacturing, wholesale, distribution, retailing and service industry
companies.
In January 2002, PNC Business Credit acquired a portion of National Bank of
Canada's ("NBOC") U.S. asset-based lending business in a purchase business
combination. NBOC exercised its put option effective July 15, 2003 related to
the loan portfolio it had retained as part of the 2002 transaction. See Note 2
NBOC Acquisition for additional information.
PNC Business Credit earned $20 million for the first six months of 2003 compared
with $4 million for the first six months of 2002. Higher earnings for the first
six months of 2003 compared with the same period of 2002 were primarily due to a
$29 million decline in the provision for credit losses in 2003.
Total revenue was $90 million for the first six months of 2003 and 2002. The
difficult economic conditions have adversely impacted customer sales which
constrained their borrowing capacity and contributed to the decline in average
loans. Total noninterest income was flat for the first half of 2003 compared
with the prior year period as an $8 million decline in income resulting from the
reduction in the value of the put option liability related to the NBOC
acquisition was offset by a decrease of $6 million in losses recognized on the
institutional loans held for sale and a $2 million increase in product-related
income.
The provision for credit losses for the first six months of 2003 was $28
million, a decrease of $29 million compared with the same period in 2002. The
decline in the provision reflected an $11 million decline in net charge-offs
compared with the first six months of 2002 and the comparative impact of a
significant addition to reserves at June 30, 2002. Management expects net
charge-offs to increase in the third quarter of 2003 compared with the second
quarter of 2003 due to an anticipated charge-off on a single large nonperforming
loan. PNC Business Credit loans, including those acquired in the NBOC
acquisition, are secured loans to borrowers, many of whom are highly leveraged,
experiencing rapid growth, or have elected to utilize asset-based financing. As
a result, the risk profile of these loans typically reflects a higher risk of
default and a greater proportion being classified as nonperforming. The impact
of these loans on the provision for credit losses and the level of nonperforming
assets may be even more pronounced during periods of economic downturn. The
ability of customers to borrow under these loan agreements is typically
constrained by the amount of collateral that the customer has available to
support the loan. Collateral is monitored and periodically audited by PNC
Business Credit to verify its existence and condition. Therefore, net
charge-offs on asset-based loans have historically been relatively low due to
recoveries provided by the underlying collateral. Compensation for this higher
risk of default is obtained by way of higher interest rates charged.
Total noninterest expense increased $2 million for the first six months of 2003
compared with the first half of 2002. Higher average FTEs and benefit costs in
2003 were partially mitigated by expense reduction initiatives.
Nonperforming assets were $145 million at June 30, 2003 compared with $164
million at June 30, 2002. The decrease was primarily due to reductions to
credits through managed liquidation and run-offs.
10
PNC ADVISORS
Six months ended June 30
Taxable-equivalent basis
Dollars in millions 2003 2002
- -----------------------------------------------------------------
INCOME STATEMENT
Net interest income $42 $52
Noninterest income
Investment management and trust 154 182
Brokerage 57 73
Other 48 47
- -----------------------------------------------------------------
Total noninterest income 259 302
- -----------------------------------------------------------------
Total revenue 301 354
Provision for credit losses 1 1
Noninterest expense 243 252
- -----------------------------------------------------------------
Pretax earnings 57 101
Income taxes 21 37
- -----------------------------------------------------------------
Earnings $36 $64
=================================================================
AVERAGE BALANCE SHEET
Loans
Consumer $1,282 $1,198
Residential mortgage 295 574
Commercial 437 485
Other 285 345
- -----------------------------------------------------------------
Total loans 2,299 2,602
Other assets 564 427
- -----------------------------------------------------------------
Total assets $2,863 $3,029
=================================================================
Deposits $2,081 $2,029
Assigned funds and other liabilities 259 475
Assigned capital 523 525
- -----------------------------------------------------------------
Total funds $2,863 $3,029
================================================================
PERFORMANCE RATIOS
Return on assigned capital 14% 25%
Noninterest income to total revenue 86 85
Efficiency 81 71
- -----------------------------------------------------------------
ASSETS UNDER MANAGEMENT (a)
Personal investment management and trust $42 $45
Institutional trust 9 11
- -----------------------------------------------------------------
Total $51 $56
ASSET TYPE
Equity $28 $31
Fixed income 16 18
Liquidity 7 7
- -----------------------------------------------------------------
Total $51 $56
=================================================================
OTHER INFORMATION
Total nonperforming assets (loans) $5 $4
Brokerage assets administered (in
billions) $34 $33
Full service brokerage offices 99 109
Financial consultants 577 644
Margin loans $253 $297
Average FTEs 3,156 3,332
=================================================================
(a) At June 30 - in billions. Excludes brokerage assets administered.
PNC Advisors provides a full range of tailored investment, trust and private
banking products and services to affluent individuals and families, including
full-service brokerage through J.J.B. Hilliard, W.L. Lyons, Inc. ("Hilliard
Lyons") and investment consulting and trust services to the ultra-affluent
through Hawthorn. PNC Advisors also serves as investment manager and trustee for
employee benefit plans and charitable and endowment assets and provides defined
contribution plan services and investment options through its Vested Interest(R)
product. PNC Advisors provides services to individuals and corporations
primarily within PNC's geographic region.
Although the second quarter of 2003 reflected an upward trend in the financial
markets, the business has been affected adversely in both 2003 and 2002 by
financial market performance and the impact on its clients. PNC Advisors
continues to emphasize deepening customer relationships through a focused
retention program and a broad array of product offerings. The anticipated
introduction of separately managed accounts in the second half of 2003 is
expected to provide clients with an even broader array of investment choices.
PNC Advisors is also initiating several cost reduction measures, including
centralization of backoffice functions and realignment of resources. The impact
of these initiatives on the ongoing cost structure of PNC Advisors is estimated
to be a reduction of expense of $15 million in 2004.
PNC Advisors earned $36 million for the first six months of 2003 compared with
$64 million in the first six months of 2002. The earnings decline reflected the
impact of comparatively weaker equity market conditions on asset management and
brokerage revenues and the effect of reduced loan levels and the lower interest
rate environment on taxable-equivalent net interest income.
Total revenue for the first six months of 2003 decreased $53 million compared
with the prior year period. The run-off of residential mortgages along with a
narrower net interest margin reflecting the lower interest rate environment in
2003 resulted in a $10 million decline in net interest income. Investment
management and trust fees declined $28 million, resulting from comparatively
weaker financial market conditions and net customer outflows. Although retention
efforts are yielding positive results, management expects that revenues in this
business will continue to be challenged.
Assets under management and related noninterest income are closely tied to the
performance of the equity markets. Assets under management at June 30, 2003
increased $2 billion from March 31, 2003 as the impact of higher equity markets
more than offset net asset outflows. Assets under management at June 30, 2003
decreased $5 billion compared with the balance at June 30, 2002 due to net asset
outflows and a relative decline in the financial markets.
Brokerage assets administered by Hilliard Lyons were $34 billion at June 30,
2003 compared with $33 billion at June 30, 2002. Consolidated revenue from
brokerage was $87 million for the first six months of 2003 compared with $110
million for the first six months of 2002. Hilliard Lyons has responded to the
decline in revenue through selectively closing underperforming brokerage offices
and reducing headcount.
11
BLACKROCK
Six months ended June 30
Dollars in millions 2003 2002
- ------------------------------------------------------------------
INCOME STATEMENT
Investment advisory and
administration fees $255 $275
Other income 32 28
- ------------------------------------------------------------------
Total revenue 287 303
Operating expense 162 172
Fund administration and servicing costs 16 26
- ------------------------------------------------------------------
Total expense 178 198
- ------------------------------------------------------------------
Operating income 109 105
Nonoperating income (a) 11 6
- ------------------------------------------------------------------
Pretax earnings 120 111
Income taxes 46 45
- ------------------------------------------------------------------
Earnings $74 $66
==================================================================
PERIOD-END BALANCE SHEET
Goodwill and other intangible assets $192 $181
Other assets 709 553
- ------------------------------------------------------------------
Total assets $901 $734
==================================================================
Liabilities $192 $173
Stockholders' equity 709 561
- ------------------------------------------------------------------
Total liabilities and
stockholders' equity $901 $734
==================================================================
PERFORMANCE DATA
Return on equity 22% 25%
Operating margin (b) 40 38
Diluted earnings per share $1.12 $1.01
==================================================================
ASSETS UNDER MANAGEMENT (c)
Separate accounts
Fixed income $175 $141
Liquidity 5 6
Liquidity - securities lending 8 6
Equity 9 10
Alternative investment products 6 5
- ------------------------------------------------------------------
Total separate accounts 203 168
- ------------------------------------------------------------------
Mutual funds (d)
Fixed income 22 17
Liquidity 58 59
Equity 3 6
- ------------------------------------------------------------------
Total mutual funds 83 82
- ------------------------------------------------------------------
Total assets under management $286 $250
- ------------------------------------------------------------------
OTHER INFORMATION
Average FTEs 944 857
==================================================================
(a) Net of nonoperating expense.
(b) Calculated as operating income divided by total revenue less fund
administration and servicing costs. A reconciliation of this presentation
to operating margin calculated on a GAAP basis (operating income divided by
total revenue) follows in millions:
Operating income $109 $105
- ------------------------------------------------------------------
Total revenue $287 $303
Less fund administration and servicing costs 16 26
- ------------------------------------------------------------------
Revenue used for operating margin
calculation, as reported $271 $277
Operating margin, as reported 40% 38%
Operating margin, GAAP basis 38% 35%
PNC believes that operating margin, as reported, is an effective indicator of
management's ability to effectively employ BlackRock's resources. Fund
administration and servicing costs have been excluded from the operating margin
calculation because these costs are a fixed, asset-based expense which can
fluctuate based on the discretion of a third party.
(c) At June 30 - in billions.
(d) Includes BlackRock Funds, BlackRock Provident Institutional Funds,
BlackRock Closed End Funds, Short Term Investment Fund and BlackRock Global
Series.
The financial information presented reflects BlackRock on a stand-alone basis.
BlackRock is approximately 69% owned by PNC and is consolidated into PNC's
financial statements. Accordingly, approximately 31% of BlackRock's earnings are
recognized as a minority interest expense in the Consolidated Statement of
Income.
BlackRock is one of the largest publicly traded investment management firms in
the United States with approximately $286 billion of assets under management at
June 30, 2003. BlackRock manages assets on behalf of institutions and
individuals worldwide through a variety of fixed income, liquidity and equity
mutual funds, separate accounts and alternative investment products. Mutual
funds include the flagship fund families - BlackRock Funds and BlackRock
Provident Institutional Funds. In addition, BlackRock provides risk management
and investment system services to institutional investors under the BlackRock
Solutions(R) brand name. BlackRock continues to focus on delivering superior
relative investment performance to clients while pursuing strategies to build on
core strengths and to selectively expand the firm's expertise and breadth of
distribution.
BlackRock earned $74 million for the first six months of 2003 compared with $66
million for the first six months of 2002. Higher earnings for the first six
months of 2003 reflected the impact of lower total expenses that more than
offset the effect of lower revenue in the first six months of 2003.
Total revenue for the first half of 2003 of $287 million decreased $16 million,
or 5%, compared with the first six months of 2002. Increases in separate account
base fees of $25 million and other income of $5 million were more than offset by
a $33 million decrease in separate account performance fees and a $13 million
decrease in mutual fund revenue.
Assets under management totaled $286 billion at June 30, 2003, an increase of
$36 billion, or 15%, compared with assets under management at June 30, 2002. The
increase in assets under management reflected net subscriptions of $22 billion
and net market appreciation of $14 billion.
Total expenses for the first six months of 2003 decreased $20 million, or 10%,
compared with the prior year period. The decrease was due to declines in
compensation and benefits expenses of $17 million and a $10 million decrease in
fund administration and servicing costs, partially offset by a $7 million
increase in general and administration expenses.
Nonoperating income, net of nonoperating expense, increased $5 million for the
first half of 2003 compared with the first six months of 2002 due primarily to
securities gains and higher investment income on Rabbi Trust assets associated
with BlackRock's deferred compensation plans.
Income taxes increased only slightly compared with the first six months of 2002
despite a $9 million increase in pretax earnings. The effective tax rate for
2003 has decreased due to a decision that BlackRock will file certain combined
and unitary state income tax returns with other PNC subsidiaries.
See Note 1 Accounting Policies regarding investments in variable interest
entities that are expected to be accounted for under FIN 46 beginning July 1,
2003 and the expected impact on BlackRock earnings.
BlackRock is listed on the New York Stock Exchange under the symbol BLK.
Additional information about BlackRock is available in its SEC filings at
www.sec.gov and on BlackRock's website at www.blackrock.com.
12
PFPC
Six months ended June 30
Dollars in millions 2003 2002
- -----------------------------------------------------------------
INCOME STATEMENT
Fund servicing revenue $380 $430
Operating expense 313 337
(Accretion)/amortization of
other intangibles, net (8) (10)
- -----------------------------------------------------------------
Operating income 75 103
Nonoperating income (a) 4 6
Debt financing 35 45
- -----------------------------------------------------------------
Pretax earnings 44 64
Income taxes 17 26
- -----------------------------------------------------------------
Earnings $27 $38
=================================================================
AVERAGE BALANCE SHEET
Goodwill and other intangible assets $1,040 $1,033
Other assets 838 857
- -----------------------------------------------------------------
Total assets $1,878 $1,890
- -----------------------------------------------------------------
Assigned funds and other liabilities $1,670 $1,682
Assigned capital 208 208
- -----------------------------------------------------------------
Total funds $1,878 $1,890
=================================================================
PERFORMANCE RATIOS
Return on assigned capital 26% 37%
Operating margin (b) 20 24
- -----------------------------------------------------------------
SERVICING STATISTICS (c)
Accounting/administration net assets (d)
Domestic $583 $485
Foreign (e) 35 28
- -----------------------------------------------------------------
Total $618 $513
Custody assets (d) $371 $323
Shareholder accounts (in millions) 48 51
- -----------------------------------------------------------------
OTHER INFORMATION
Average FTEs 5,383 6,013
=================================================================
(a) Net of nonoperating expense.
(b) Operating income divided by total fund servicing revenue.
(c) At June 30.
(d) In billions.
(e) Represents net assets serviced offshore.
PFPC is the largest full-service mutual fund transfer agent and second largest
provider of mutual fund accounting and administration services in the United
States, offering a wide range of fund services to the investment management
industry and providing processing solutions to the international marketplace
through its Ireland and Luxembourg operations.
Strategically, PFPC is focusing technological resources on targeted Web-based
initiatives, streamlining operations and developing flexible systems
architecture and client-focused servicing solutions. To meet the growing needs
of the European marketplace, PFPC is also continuing its expansion offshore.
PFPC earned $27 million for the first six months of 2003 compared with $38
million for the first six months of 2002. Earnings for the first six months of
2003 declined compared with the prior year period as the $50 million decline in
fund servicing revenue more than offset a $24 million decline in operating
expenses and a $10 million decrease in debt financing costs.
Fund servicing revenue of $380 million for the first six months of 2003
decreased $50 million compared with the first six months of 2002. The positive
impact of new sales of accounting/administration services and offshore growth
was overcome by revenue declines resulting from client attrition and
comparatively weaker equity market performance that impacted both shareholder
activity levels and fund net asset valuations. In addition, fund servicing
revenue for the 2002 period included the benefit of approximately $13 million of
fees related to the renegotiation of a client contract.
Operating expense decreased $24 million, or 7%, in the period-to-period
comparison primarily due to reductions in staff and contract programmers. In the
second half of 2002, PFPC launched a series of initiatives designed to improve
efficiency. These included such projects as consolidating transfer agency
platforms, increasing automation and executing planned facilities
consolidations. PFPC's goal in 2003 is to reduce expenses by approximately $50
million before considering the impact of technology and new business
reinvestment. Accordingly, the workforce has been reduced as average FTEs
declined 10% for the first six months of 2003 compared with the first six months
of 2002.
Notwithstanding these initiatives, the comparatively weaker market conditions, a
shift in product mix and the impact of client attrition, coupled with the cost
of technology and infrastructure enhancements, continued to exert pressure on
operating margins. Margins are expected to remain under pressure at least until
equity markets and investor sentiment and demand improve for a sustained period.
Also, the financial results for this business may be significantly impacted by
the net gain or loss of large clients or groups of smaller clients and by shifts
in client assets between higher and lower margin products. PFPC has been
adversely impacted by depressed financial market conditions, a shift in client
assets from equity to fixed income products and client attrition. Accordingly,
given these conditions, management is continuing to challenge the
revenue/expense relationship of this business. Additionally, PFPC is
increasingly focused on retaining its long-standing clients and has recently
been awarded several new servicing contracts, partially offsetting the revenue
impact of client attrition, including the loss of one large transfer agency
client during the first quarter of 2003.
On June 30, 2003, PFPC completed the previously announced agreement to sell its
retirement services business to Wachovia Corp. The net gain on sale of this
business was not significant to PFPC's financial results. PFPC recognized
revenue related to its retirement services business of $13 million for the first
six months of 2003 and $16 million for the first six months of 2002.
Operating income for both the first six months of 2003 and 2002 reflected the
accretion of a discounted client contract liability of $17 million.
Increases in both accounting/administration and custody pooled investment assets
at June 30, 2003 compared with the balances at June 30, 2002 resulted primarily
from net new business as well as existing client asset inflows. Total assets
serviced by PFPC amounted to $1.5 trillion at June 30, 2003 and $1.4 trillion at
June 30, 2002. PFPC also serviced approximately 48 million shareholder accounts
at June 30, 2003 compared with 51 million at June 30, 2002. The decline in
shareholder accounts in 2003 was primarily due to a loss of one large transfer
agency client in the first quarter.
In the fourth quarter of 2001, PFPC incurred $36 million in pretax charges
related to a plan to consolidate certain facilities. The charges primarily
reflected anticipated costs related to exiting certain lease agreements and the
abandonment of related leasehold improvements. During the first six months of
2003, the Corporation recognized a $6 million reduction of the related liability
largely to reflect the write-off of certain leasehold improvements and other
related assets consistent with the original consolidation plans. The remaining
liability was $8 million at June 30, 2003.
13
CONSOLIDATED INCOME STATEMENT REVIEW
NET INTEREST INCOME
Changes in net interest income and margin result from the interaction among the
volume and composition of earning assets, related yields and associated funding
costs. Accordingly, portfolio size, composition and yields earned and funding
costs can have a significant impact on net interest income and net interest
margin. See the Balance Sheet Highlights section of this Financial Review and
the Consolidated Average Balance Sheet and Net Interest Analysis for additional
information.
Taxable-equivalent net interest income was $1.029 billion and the net interest
margin was 3.83% for the first six months of 2003 compared with $1.151 billion
and 4.06%, respectively, for the first six months of 2002. The declines in
taxable-equivalent net interest income and net interest margin compared with the
first half of 2002 were primarily due to the impact of the lower interest rate
environment in 2003 and a $3.0 billion or 5% decrease in average
interest-earning assets. The decline in average interest-earning assets
reflected a $2.0 billion reduction in average loans held for sale, the
prepayment of residential mortgages that reduced the average balance of
residential mortgages by $1.9 billion, and a $1.3 billion decline in average
commercial loans. Partially offsetting these declines in average
interest-earning assets was an increase of $2.2 billion in securities available
for sale, primarily mortgage-backed and asset-backed, and a $1.1 billion
increase in average home equity loans compared with the first six months of
2002. See Market Risk Management-Interest Rate Risk in the Risk Management
section of this Financial Review for additional information.
Taxable-equivalent net interest income totaled $523 million and the net interest
margin was 3.91% for the second quarter of 2003 compared with $558 million and
3.99%, respectively, for the second quarter of 2002. Declines in
taxable-equivalent net interest income and margin compared with the second
quarter of 2002 resulted primarily from the lower interest rate environment in
2003 and a $2.4 billion decline in average interest-earning assets due to
prepayments on the residential mortgage loan portfolio and the continued
downsizing of the institutional lending portfolio. A benefit from growth in
average transaction deposits for the second quarter of 2003 compared with the
prior year second quarter partially offset the impact of these declines on
average earning assets.
PROVISION FOR CREDIT LOSSES
The provision for credit losses was $93 million for the first six months of 2003
compared with $171 million for the first six months of 2002. The provision for
credit losses for the second quarter of 2003 totaled $57 million compared with
$89 million for the prior year second quarter. The provision for both the first
six months and second quarter of 2002 reflected additional reserves provided for
Corporate Banking related to Market Street liquidity facilities.
See Allowances for Credit Losses And Unfunded Loan Commitments And Letters of
Credit in the Credit Risk Management section of this Financial Review for
additional information regarding factors impacting the provision for credit
losses.
NONINTEREST INCOME
Noninterest income was $1.571 billion for the first six month of 2003 compared
with $1.660 billion for the first six months of 2002. Second quarter 2003
noninterest income totaled $776 million compared with $870 million in the second
quarter of 2002.
Asset management fees were $416 million for the first six months of 2003, a
decline of $35 million compared with the first six months of 2002. Second
quarter 2003 asset management fees decreased $21 million, to $209 million,
compared with the second quarter of 2002. The decreases compared with the prior
year periods reflected the negative impact of the comparatively weaker equity
markets in 2003. Consolidated assets under management were $328 billion at June
30, 2003, an increase of $34 billion, or 12%, from June 30, 2002. Growth in
fixed income assets managed by BlackRock attributable to net subscriptions and
net market appreciation, partially offset by declines in equity assets, was the
primary factor in the increase.
Fund servicing fees decreased $48 million, to $381 million, for the first six
months of 2003 compared with the year-ago period. Fund servicing fees decreased
$29 million, to $188 million, for the second quarter of 2003 compared with the
second quarter of 2002. The positive impact of new sales of
accounting/administration services and offshore growth was overcome by revenue
declines resulting from client attrition and comparatively weaker equity market
performance that impacted both shareholder activity levels and fund net asset
valuations in both comparisons. In addition, fund servicing revenue for both the
first half and second quarter of 2002 included the benefit of approximately $13
million of fees related to the renegotiation of a client contract.
Service charges on deposits totaled $117 million for the first six months of
2003, an increase of $8 million compared with the first half of 2002 due to an
increase in average transaction deposits and a 5% increase in checking
relationships over the prior year period. Service charges on deposits increased
$5 million, to $60 million, for the second quarter of 2003 compared with the
second quarter of 2002. The increases in both periods reflected higher volumes
partially offset by lower monthly service charges due to the continued
implementation of free checking.
Brokerage fees totaled $87 million for the first half of 2003, a decrease of $23
million compared with the comparable prior year period. Brokerage fees declined
$9 million, to $46 million, in the second quarter of 2003 compared with the
second quarter of 2002. The decreases in both comparisons were due to lower
sales commissions and lower trading volumes that reflected the comparatively
weaker equity markets in 2003.
14
Consumer services revenue totaled $123 million for the first six months of 2003,
an increase of $7 million, or 6%, compared with the first six months of 2002.
Consumer service revenue totaled $64 million for the second quarter of 2003, an
increase of $3 million, or 5%, compared with the second quarter of 2002. The
increases in 2003 in both comparisons reflected additional fees from ATM
transactions arising from growth in transaction volumes due to an increase in
the number of ATM machines and additional fees from debit card transactions
arising from higher transaction volumes.
As previously reported, Visa settled litigation earlier in 2003 with major
retailers regarding pricing and usage of consumer debit cards. The settlement
will effectively lower prices paid by merchants to Visa and its member banks.
Although PNC was not a defendant in the litigation, the settlement will lower
future revenue from certain debit card transactions beginning in the third
quarter of 2003. Based on current cards issued and transaction mix and the
reduced fee effective August 1, 2003, the lost revenue impact to PNC is
estimated to be approximately $6 million in 2003.
Corporate services revenue totaled $230 million for the first six months of
2003, a decline of $37 million compared with the first half of 2002. Net gains
in excess of valuation adjustments related to the liquidation of institutional
loans held for sale included in corporate services revenue totaled $30 million
for the first six months of 2003 and $78 million for the first six months of
2002. Treasury management fees totaled $111 million for the first six months of
2003, a $5 million increase over the same period of 2002. This increase
partially offset the decline in net gains in excess of valuation adjustments.
Corporate services revenue was $114 million for the second quarter of 2003
compared with $149 million for the second quarter of 2002. Net gains in excess
of valuation adjustments related to the liquidation of institutional loans held
for sale declined $40 million, to $15 million, in the second quarter of 2003
compared with the second quarter of 2002.
Equity management (private equity activities) net losses on portfolio
investments were $21 million for the first six months of 2003 compared with net
losses of $15 million for the first half of 2002. For the second quarter of
2003, equity management losses totaled $17 million compared with $13 million for
the prior year quarter.
Net securities gains totaled $82 million for the first six months of 2003
compared with $20 million for the first half of 2002. Net securities gains for
the first half of 2003 included $25 million related to the liquidation in the
first quarter of 2003 of the three entities formed in 2001 in the PAGIC
transactions. Net securities gains totaled $26 million for the second quarter of
2003 and $16 million for the second quarter of 2002.
Other noninterest income totaled $156 million for the first half of 2003, a
decrease of $17 million compared with the first six months of 2002. Other
noninterest income was $86 million for the second quarter of 2003, a decline of
$14 million from the second quarter of 2002. The decreases in both comparisons
reflected the impact of a $14 million gain on the sale of a real estate
investment recognized in the second quarter of 2002. In addition, the decreases
compared with the first half and second quarter of 2002 reflected declines of $8
million and $9 million, respectively, in the income recognized in connection
with the valuation of the NBOC put option liability. Partially offsetting these
decreases was higher net trading income included in other noninterest income.
Net trading income included in other noninterest income increased $7 million, to
$60 million, for the first six months of 2003 compared with the first six months
of 2002 and increased $4 million, to $33 million, in the second quarter of 2003
compared with the prior year quarter. See Note 5 Trading Activities in the Notes
to Consolidated Financial Statements for additional information.
NONINTEREST EXPENSE
Total noninterest expense was $1.791 billion for the first six months of 2003,
an increase of $145 million, or 9%, compared with the first half of 2002. The
efficiency ratio was 69% for the first six months of 2003 and 59% for the first
six months of 2002. Other noninterest expense for the first six months of 2003
included $120 million of expenses recognized in connection with the second
quarter 2003 DOJ agreement, including $5 million of related legal and consulting
costs. In addition, noninterest expense for the first half of 2003 included $29
million of costs paid in connection with the liquidation of the three entities
formed in 2001 in the PAGIC transactions and a facilities charge of $23 million
related to leased space consistent with the requirements of Statement of
Financial Accounting Standards ("SFAS") No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." The impact of the costs incurred
in connection with the liquidation of the entities formed in 2001 in the PAGIC
transactions on first half 2003 pretax income was mostly offset by related net
securities gains included in noninterest income. Other noninterest expense for
the first six months of 2002 included a $16 million adjustment related to
incentive and retention arrangements in the form of co-investment partnerships
for certain equity management employees that was recognized in the second
quarter of 2002.
Total noninterest expense was $935 million for the second quarter of 2003, an
increase of $96 million compared with the second quarter of 2002. The efficiency
ratio was 72% for the second quarter of 2003 compared with 59% for the second
quarter of 2002. The DOJ-related expenses of $120 million are included in the
second quarter 2003 amounts. The $16 million adjustment related to incentive and
retention arrangements described above is also reflected in the second quarter
2002 amounts.
15
The changes in total noninterest expense for both the first half and second
quarter of 2003 compared with the corresponding 2002 periods also reflected the
impact of the Corporation's 2003 efficiency initiative. A $37 million benefit
from this initiative impacted the first six months of 2003, including a $21
million benefit in the second quarter. Noninterest expense for both the first
six months and second quarter of 2003 was also impacted by higher pension, stock
option and marketing expenses compared with the corresponding 2002 periods. See
Defined Benefit Pension Plan in the Critical Accounting Policies And Judgments
section of this Financial Review for further information regarding 2003 pension
expense. See Note 1 Accounting Policies for further information regarding 2003
stock option expense. Stock option expense for the first six months of 2003 has
been less than previously anticipated due to the timing of option grants in
2003, the level of forfeitures, and other factors.
Average employees totaled approximately 23,500 and 24,000 for the first six
months of 2003 and 2002, respectively. The decrease was mainly in PFPC, PNC
Advisors and Regional Community Banking.
AGREEMENT WITH DEPARTMENT OF JUSTICE
As reported on June 2, 2003, one of PNC's non-bank subsidiaries, PNC ICLC Corp.
("PNCICLC"), has entered into a deferred prosecution agreement with the DOJ
relating to PNCICLC's actions in connection with the PAGIC transactions entered
into with AIG in 2001. Under the terms of the agreement, PNCICLC established a
$90 million restitution fund to satisfy claims stemming from the PAGIC
transactions and paid a $25 million monetary penalty to the Federal government.
PNC recognized a pretax charge of $120 million in the second quarter of 2003 in
connection with the DOJ agreement, including $5 million of related legal and
consulting costs. See the Corporation's Current Report on Form 8-K dated June 2,
2003 for additional information.
16
CONSOLIDATED BALANCE SHEET REVIEW
BALANCE SHEET DATA
June 30 December 31
In millions 2003 2002
- -----------------------------------------------------------------
Assets
Loans, net of unearned income $34,534 $35,450
Securities 16,017 13,763
Loans held for sale 1,475 1,607
Other 15,236 15,557
- -----------------------------------------------------------------
Total assets $67,262 $66,377
Liabilities
Funding sources $54,597 $54,098
Other 4,782 4,302
- -----------------------------------------------------------------
Total liabilities 59,379 58,400
Minority interest and capital
securities 1,109 1,118
Total shareholders' equity 6,774 6,859
- -----------------------------------------------------------------
Total liabilities, minority
interest, capital securities and
shareholders' equity $67,262 $66,377
==================================================================
The Corporation's Consolidated Balance Sheet is presented on page 41 of this
Form 10-Q.
Total assets were $67.3 billion at June 30, 2003 compared with $66.4 billion at
December 31, 2002. The increase in total assets compared with year-end 2002
reflected changes in the mix of total assets as purchases of mortgage-backed and
asset-backed securities more than offset a smaller loan portfolio and the
continued liquidation of loans held for sale related to the institutional
lending repositioning.
The decline in "other" assets as shown above is primarily due to a $1.0 billion
decline in federal funds sold and a $.3 billion decline in other short-term
investments, partially offset by a $.6 billion increase in cash and due from
banks compared with the corresponding balances at December 31, 2002. Federal
funds sold were replaced with higher yielding securities during 2003.
An analysis of changes in other balance sheet categories follows.
LOANS
Loans were $34.5 billion at June 30, 2003, a $.9 billion decrease from December
31, 2002 primarily due to run-off in the residential mortgage and auto lease
portfolios partially offset by an increase in home equity loans.
DETAILS OF LOANS
June 30 December 31
In millions 2003 2002
- ---------------------------------------------------------------
Commercial
Retail/wholesale $4,109 $4,161
Manufacturing 3,591 3,454
Service providers 1,936 1,906
Real estate related 1,479 1,481
Financial services 1,274 1,218
Communications 78 124
Health care 407 458
Other 1,919 2,185
- ---------------------------------------------------------------
Total commercial 14,793 14,987
- ---------------------------------------------------------------
Commercial real estate
Real estate project 1,563 1,750
Mortgage 464 517
- ---------------------------------------------------------------
Total commercial real estate 2,027 2,267
- ---------------------------------------------------------------
Consumer
Home equity 8,876 8,108
Automobile 509 484
Other 1,166 1,262
- ---------------------------------------------------------------
Total consumer 10,551 9,854
- ---------------------------------------------------------------
Residential mortgage 3,114 3,921
Lease financing
Equipment 3,580 3,560
Vehicle 1,130 1,521
- ---------------------------------------------------------------
Total lease financing 4,710 5,081
- ---------------------------------------------------------------
Other 357 415
Unearned income (1,018) (1,075)
- ---------------------------------------------------------------
Total, net of unearned income $34,534 $35,450
===============================================================
Loan portfolio composition continued to be diversified across PNC's footprint
among numerous industries and types of businesses.
Wholesale commercial loan portfolio composition based on the total of loans and
unfunded commitments remained concentrated in investment grade equivalent
exposure and secured lending. The portfolio demonstrated further diversification
of exposure to client relationships with greater than $50 million in loans and
unfunded commitments, totaling $12.9 billion at June 30, 2003, including $2.8
billion of exposure to Market Street facilities secured by a highly diversified
pool of liquid assets. Of the total exposure to relationships with greater than
$50 million in loans and unfunded commitments at June 30, 2003, 71% was
investment grade equivalent.
WHOLESALE LENDING STATISTICS
June 30 December 31
Dollars in millions 2003 2002
- ---------------------------------------------------------------------
Portfolio composition-total exposure
Investment grade equivalent 53% 52%
Non-investment grade (secured lending) 24 24
Non-investment grade 23 24
- ---------------------------------------------------------------------
Total 100% 100%
- ---------------------------------------------------------------------
Client relationships >$50 million-total
exposure $12,852 $13,392
Client relationships >$50 million-customers 143 140
=====================================================================
17
The equipment lease financing portfolio totaled $3.6 billion at June 30, 2003
and included approximately $1.6 billion of cross border leases. These leases are
primarily leveraged leases of equipment located in foreign countries, primarily
in western Europe and Australia. Aggregate residual value at risk on the total
commercial lease portfolio at June 30, 2003 was $1.2 billion. Steps have been
taken to mitigate $.7 billion of this residual risk, leaving $.5 billion of
unmitigated risk.
At June 30, 2003, loans of $34.5 billion included $1.1 billion of vehicle
leases, net of unearned income, and $11 million of commercial and commercial
real estate loans that have been designated for exit. PNC's vehicle leasing
business that has been designated for exit is comprised of vehicle leases with
an aggregate residual value of $.8 billion and $.3 billion of estimated future
customer lease payments. As of June 30, 2003, the active vehicle leases
scheduled to mature are as follows.
VEHICLE LEASE MATURITY SCHEDULE
Number of Associated
Active Residual
Scheduled Maturity Date (a) Vehicle Leases Values (b)
- ----------------------------------------------------------------
2003 11,700 $207
2004 21,100 346
2005 12,600 173
2006 6,100 68
- ----------------------------------------------------------------
Total 51,500 $794
================================================================
(a) The approximate number of active leases scheduled to mature in 2007 is less
than 100.
(b) In millions.
A fourth quarter 2001 charge of $135 million in connection with the vehicle
leasing business included exit costs and additions to reserves related to
insured residual value exposures. At June 30, 2003, the related liability was
$119 million. Until the remaining leases mature, the Corporation will continue
to be subject to risks inherent in the vehicle leasing business, including
credit risk and the risk that vehicles returned during or at the conclusion of
the lease term cannot be disposed of at a price at least equal to the
Corporation's remaining investment in the vehicles after application of any
available residual value insurance or related reserves. The assumptions that
were used to establish these reserves in 2001 are monitored and evaluated on an
ongoing basis. Accordingly, these reserves were considered adequate at June 30,
2003.
NET UNFUNDED COMMITMENTS
June 30 December 31
In millions 2003 2002
- ----------------------------------------------------------------
Commercial $18,779 $19,525
Commercial real estate 638 718
Consumer 5,479 5,372
Lease financing 134 103
Other 148 125
Institutional lending repositioning 336 1,015
- ----------------------------------------------------------------
Total $25,514 $26,858
================================================================
Commitments to extend credit represent arrangements to lend funds or provide
liquidity subject to specified contractual conditions. Commitments include loan
commitments and liquidity facilities provided to Market Street. Commercial
commitments are reported net of participations, assignments and syndications,
primarily to financial institutions, totaling $6.3 billion at June 30, 2003 and
$6.2 billion at December 31, 2002.
Net outstanding letters of credit totaled $3.8 billion at June 30, 2003 and $3.7
billion at December 31, 2002 and consisted primarily of standby letters of
credit that commit the Corporation to make payments on behalf of customers if
specified future events occur.
SECURITIES
Total securities were $16.0 billion and represented 24% of total assets at June
30, 2003 compared with $13.8 billion and 21%, respectively, at December 31,
2002. The increase in total securities compared with December 31, 2002 was
primarily due to purchases during the first six months of 2003 of
mortgage-backed and asset-backed securities partially offset by the sale of
securities classified as held to maturity at December 31, 2002.
At June 30, 2003, the securities available for sale balance included a net
unrealized gain of $296 million, which represented the difference between fair
value and amortized cost. The comparable amount at December 31, 2002 was a net
unrealized gain of $274 million. Changes in the fair value of securities
available for sale reflect an inverse relationship with changes in interest
rates. The rise in interest rates subsequent to June 30, 2003, if sustained,
will adversely impact the fair value of securities available for sale at
September 30, 2003 compared with the balance at June 30, 2003. Net unrealized
gains and losses in the securities available for sale portfolio are included in
shareholders' equity as accumulated other comprehensive income or loss, net of
tax. The expected weighted-average life of securities available for sale was 2
years and 5 months at June 30, 2003 and 2 years and 8 months at December 31,
2002.
Securities designated as held to maturity at December 31, 2002 were carried at
amortized cost and were assets of companies formed in 2001 in transactions with
AIG that were consolidated in PNC's financial statements. In January 2003, these
securities were sold and these companies were liquidated. The expected
weighted-average life of securities held to maturity was 20 years and 2 months
at December 31, 2002.
18
DETAILS OF SECURITIES
Amortized Fair
In millions Cost Value
- -----------------------------------------------------------------
June 30, 2003
SECURITIES AVAILABLE FOR SALE
Debt securities
U.S. Treasury and government agencies $1,005 $1,017
Mortgage-backed 10,353 10,579
Asset-backed 3,714 3,762
State and municipal 64 64
Other debt 54 57
Corporate stocks and other 531 538
- -----------------------------------------------------------------
Total securities available for sale $15,721 $16,017
=================================================================
December 31, 2002
SECURITIES AVAILABLE FOR SALE
Debt securities
U.S. Treasury and government agencies $813 $826
Mortgage-backed 8,916 9,103
Asset-backed 2,699 2,780
State and municipal 61 63
Other debt 58 61
Corporate stocks and other 597 585
- -----------------------------------------------------------------
Total securities available for sale $13,144 $13,418
- -----------------------------------------------------------------
SECURITIES HELD TO MATURITY
Debt securities
U.S. Treasury and government agencies $276 $309
Asset-backed 8 8
Other debt 61 61
- -----------------------------------------------------------------
Total securities held to maturity $345 $378
=================================================================
LOANS HELD FOR SALE
Loans held for sale were $1.5 billion at June 30, 2003 compared with $1.6
billion at December 31, 2002. The decline in loans held for sale from December
31, 2002 reflected the continued liquidation of the institutional lending
portfolio. Substantially all education loans are classified as loans held for
sale. Generally, education loans are sold when the loans go into repayment
status.
DETAILS OF LOANS HELD FOR SALE
June 30 December 31
In millions 2003 2002
- -----------------------------------------------------------------
Education loans $1,059 $1,035
Total institutional lending
repositioning 126 298
Other 290 274
- -----------------------------------------------------------------
Total loans held for sale $1,475 $1,607
=================================================================
Details of the credit exposure and outstandings by business in the institutional
lending held for sale and exit portfolios are included in the Wholesale Banking
sections of the Review of Businesses within this Financial Review. A rollforward
of the institutional lending held for sale portfolio follows:
ROLLFORWARD OF INSTITUTIONAL LENDING HELD FOR SALE PORTFOLIO
In millions Credit Exposure Outstandings
- -----------------------------------------------------------------
January 1, 2003 $626 $298
Additions 3
Sales (125) (76)
Payments and other exposure
reductions (270) (80)
Valuation adjustments, net (32) (19)
- -----------------------------------------------------------------
June 30, 2003 $199 $126
=================================================================
During the second quarter and first six months of 2003, the liquidation of
institutional loans held for sale resulted in net gains in excess of valuation
adjustments of $15 million and $30 million, respectively. The corresponding
amounts for 2002 were $55 million for the second quarter and $78 million for the
first half. Details by Wholesale Banking business for 2003 follow:
INSTITUTIONAL LENDING HELD FOR SALE ACTIVITY
Three months ended
June 30, 2003 Net gains on Valuation
In millions liquidation adjustments Total
- -----------------------------------------------------------------
Corporate Banking $22 $(9) $13
PNC Business Credit 2 2
- -----------------------------------------------------------------
Total $24 $(9) $15
=================================================================
Six months ended
June 30, 2003 Net gains on Valuation
In millions liquidation adjustments Total
- -----------------------------------------------------------------
Corporate Banking $52 $(22) $30
PNC Real Estate Finance 8 (7) 1
PNC Business Credit 2 (3) (1)
- -----------------------------------------------------------------
Total $62 $(32) $30
=================================================================
FUNDING SOURCES
Total funding sources were $54.6 billion at June 30, 2003 and $54.1 billion at
December 31, 2002, an increase of $.5 billion corresponding to an increase of
$.9 billion in total assets and an increase in accrued expenses and other
liabilities of $.5 billion. Total deposits increased $1.7 billion from December
31, 2002 due to an increase in demand and money market deposits partially offset
by a reduction in higher yielding retail certificates of deposit due to
maturities occurring in the first six months of 2003. Total borrowed funds
decreased $1.2 billion from December 31, 2002 primarily due to a decrease in
bank notes and senior debt maturities during the first half of 2003.
DETAILS OF FUNDING SOURCES
June 30 December 31
In millions 2003 2002
- -----------------------------------------------------------------
Deposits
Demand and money market $35,316 $32,349
Savings 2,136 2,014
Retail certificates of deposit 8,652 9,839
Other time 370 317
Deposits in foreign offices 220 463
- -----------------------------------------------------------------
Total deposits 46,694 44,982
- -----------------------------------------------------------------
Borrowed funds
Federal funds purchased 36 38
Repurchase agreements 1,015 814
Bank notes and senior debt 3,306 4,400
Federal Home Loan Bank borrowings 1,134 1,256
Subordinated debt 2,260 2,423
Other borrowed funds 152 185
- -----------------------------------------------------------------
Total borrowed funds 7,903 9,116
- -----------------------------------------------------------------
Total $54,597 $54,098
=================================================================
SHAREHOLDERS' EQUITY
Total shareholders' equity was $6.8 billion at June 30, 2003 compared with $6.9
billion at December 31, 2002. The decline in total shareholders' equity compared
with the balance at December 31, 2002 reflected the impact of the
19
Corporation's repurchase of 6.6 million shares of common stock in the first half
of 2003 at a total cost of $300 million that more than offset an increase in
retained earnings during this period.
The access to and cost of funding new business initiatives, including
acquisitions, the ability to engage in expanded business activities, the ability
to pay dividends, the level of deposit insurance costs, and the level and nature
of regulatory oversight depend, in part, on a financial institution's capital
strength. Supervision and regulation is discussed in more detail in the Business
section of the 2002 Form 10-K. At June 30, 2003, each banking subsidiary of the
Corporation was considered "well capitalized" based on regulatory capital ratio
requirements.
RISK-BASED CAPITAL
June 30 December 31
Dollars in millions 2003 2002
- -------------------------------------------------------------------
Capital components
Shareholders' equity
Common $6,765 $6,849
Preferred 9 10
Trust preferred capital securities 848 848
Minority interest 261 234
Goodwill and other intangibles (2,473) (2,446)
Net unrealized securities gains (193) (179)
Net unrealized gains on cash flow
hedge derivatives (104) (135)
Equity investments in
nonfinancial companies (33) (34)
Other, net (21) (26)
- -------------------------------------------------------------------
Tier 1 risk-based capital 5,059 5,121
Subordinated debt 1,212 1,350
Minority interest 36
Eligible allowance for credit losses 709 726
- -------------------------------------------------------------------
Total risk-based capital $6,980 $7,233
===================================================================
Assets
Risk-weighted assets, including
off-balance sheet instruments and
market risk equivalent assets $56,676 $58,030
Adjusted average total assets 62,808 62,967
===================================================================
Capital ratios
Tier 1 risk-based 8.9% 8.8%
Total risk-based 12.3 12.5
Leverage 8.1 8.1
===================================================================
The capital position is managed through balance sheet size and composition,
issuance of debt and equity instruments, treasury stock activities, dividend
policies and retention of earnings.
Common shares outstanding at June 30, 2003 were 280.1 million. PNC's repurchase
program was adopted in January 2002 and permits the purchase of up to 35 million
shares of common stock through February 29, 2004. PNC purchased 2.2 million
common shares under this program during the second quarter of 2003 at a total
cost of $107 million. During the first half of 2003, 6.6 million shares were
repurchased at a total cost of $300 million. Under this program, management
expects to purchase up to a total of $1.0 billion of its common stock during
2003. The extent and timing of share repurchases during the remainder of the
year will depend on a number of factors including, among others, market and
general economic conditions, regulatory capital considerations, alternative uses
of capital and the potential impact on PNC's credit rating. Under applicable
regulations, as long as PNC remains subject to its written agreement with the
Federal Reserve Bank of Cleveland, it must obtain prior regulatory approval to
repurchase its common stock in amounts that exceed 10% of consolidated net worth
in any 12-month period. A total of 6.9 million common shares have been
repurchased under this program from inception through June 30, 2003.
RISK FACTORS
The Corporation is subject to a number of risks including, among others, those
described below, in the Consolidated Balance Sheet Review, Risk Management and
Forward-Looking Statements sections of this Financial Review and elsewhere in
this report. The Business section of the 2002 Form 10-K describes a number of
risks applicable to the Corporation, including: business and economic
conditions, supervision and regulation, monetary and other policies,
competition, disintermediation, asset management performance, fund servicing,
acquisitions, and terrorist activities and international hostilities. Reference
is made to the 2002 Form 10-K for a detailed description of these risks which
continue to have the potential to impact the Corporation's business, financial
condition and results of operations. In addition, reference is made to the
Corporation's Current Report on Form 8-K dated June 2, 2003 (including the
exhibits to that report) for a discussion of the risks associated with the DOJ
agreement, including the risk of additional expenses and collateral costs and
consequences.
CRITICAL ACCOUNTING POLICIES AND JUDGMENTS
The Corporation's consolidated financial statements are prepared based on the
application of certain accounting policies, the most significant of which are
described in Note 1 Accounting Policies in the Notes to Consolidated Financial
Statements of this report and of the 2002 Form 10-K. Certain of these policies
require numerous estimates and strategic or economic assumptions that may prove
inaccurate or be subject to variations which may significantly affect PNC's
reported results and financial position for the period or in future periods. The
use of estimates, assumptions, and judgments is necessary when financial assets
and liabilities are required to be recorded at, or adjusted to reflect, fair
value. Assets and liabilities carried at fair value inherently result in more
financial statement volatility. Fair values and the information used to record
valuation adjustments for certain assets and liabilities are based on either
quoted market prices or are provided by other independent third-party sources,
when available. When such information is not available, management estimates
valuation adjustments primarily by using internal cash flow and other financial
modeling techniques. Changes in underlying factors, assumptions, or estimates in
any of these areas could have a material impact on PNC's future financial
condition and results of operations.
20
See Note 1 Accounting Policies of this report for further information regarding
investments in variable interest entities that are expected to be accounted for
under FIN 46 and that may have a material impact on PNC's financial condition
and results of operations.
ALLOWANCES FOR CREDIT LOSSES AND UNFUNDED LOAN COMMITMENTS AND LETTERS OF CREDIT
The allowances for credit losses and unfunded loan commitments and letters of
credit are calculated with the objective of maintaining reserve levels believed
by management to be sufficient to absorb estimated probable credit losses.
Management's determination of the adequacy of the allowances is based on
periodic evaluations of the credit portfolio and other relevant factors.
However, this evaluation is inherently subjective as it requires material
estimates, including, among others, expected default probabilities, loss given
default, exposure at default, the amounts and timing of expected future cash
flows on impaired loans, value of collateral, estimated losses on consumer loans
and residential mortgages, and general amounts for historical loss experience.
The process also considers economic conditions, uncertainties in estimating
losses and inherent risks in the various credit portfolios. All of these factors
may be susceptible to significant change. Also, the allocation of the allowance
for credit losses to specific loan pools is based on historical loss trends and
management's judgment concerning those trends.
Commercial loans are the largest category of credits and are the most sensitive
to changes in assumptions and judgments underlying the determination of the
allowance for credit losses. Approximately $548 million, or 81%, of the total
allowance for credit losses at June 30, 2003 has been allocated to the
commercial loan category. This allocation also considers other relevant factors
such as actual versus estimated losses, regional and national economic
conditions, business segment and portfolio concentrations, industry competition
and consolidation, the impact of government regulations, and risk of potential
estimation or judgmental errors. To the extent actual outcomes differ from
management estimates, additional provision for credit losses may be required
that would adversely impact earnings in future periods. See the Credit Risk
Management section in the Risk Management section of this Financial Review and
Note 7 Allowances For Credit Losses And Unfunded Loan Commitments And Letters of
Credit for additional information.
LOANS HELD FOR SALE
At the time management intends to sell credit exposure, management designates
the exposure as held for sale. At the initial transfer date to held for sale,
any lower of cost or market ("LOCOM") adjustment is recorded as a charge-off,
which on an outstanding loan results in a new cost basis. On the unfunded
portion of the total exposure, a liability is established. Any subsequent
adjustment as a result of LOCOM is recorded as a valuation allowance through
noninterest income on the loan portion classified as held-for-sale. Any
permanent reduction of the exposure, such as by sale or termination of the
exposure, may impact the related valuation allowance or liability. Any change in
the valuation allowance or liability is recognized through noninterest income.
Although the market value for certain held for sale assets may be readily
obtainable, other assets require significant judgments by management as to the
value that could be realized at the balance sheet date. These assumptions
include, but are not limited to, the cash flows generated from the asset, the
timing of a sale, the value of any collateral, the market conditions for the
particular credit, overall investor demand for the asset and the determination
of a proper discount rate. Changes in market conditions and actual liquidation
experience may result in additional valuation adjustments that could adversely
impact earnings in future periods. See the Loans Held For Sale section in the
Consolidated Balance Sheet Review for additional information.
EQUITY MANAGEMENT ASSET VALUATION
Equity management (private equity) assets are valued at each balance sheet date
primarily based on either, in the case of limited partnership investments, the
financial statements received from the general partners of these partnerships
or, with respect to direct investments, the estimated fair value of the
investments. Changes in the value of equity management investments are reflected
in the Corporation's results of operations. Due to the nature of the direct
investments, management must make assumptions as to future performance,
financial condition, liquidity, availability of capital, and market conditions,
among others, to determine the estimated fair value of the investments.
Market conditions and actual performance of the companies invested in could
differ from these assumptions and from the assumptions made by the general
partners of those funds, respectively, resulting in lower valuations that could
adversely impact earnings in future periods. Accordingly, the valuations may not
represent the amounts that will ultimately be realized from these investments.
See the Market Risk Management-Equity Investment Risk section in the Risk
Management section of this Financial Review and Note 1 Accounting Policies of
this report for additional information.
COMMERCIAL MORTGAGE SERVICING RIGHTS
Commercial mortgage servicing rights ("MSR") are intangible assets that
represent the value of rights that arise from the servicing of commercial loan
contracts. While servicing is inherent in most financial assets, it becomes a
distinct asset when (a) contractually separated from the underlying financial
asset by sale or securitization of the asset with servicing retained or (b)
through the separate purchase and assumption of the servicing. The Corporation's
MSR asset value (both originated and purchased) arises from estimates of future
revenues from contractually specified servicing fees, interest income and other
ancillary revenues, net of estimated operating expenses, which are expected to
yield an acceptable level of risk adjusted return for the servicer.
21
The fair value of the Corporation's MSR asset is estimated using a discounted
cash flow methodology, which calculates the net present value of future cash
flows of the servicing portfolio over the estimated life of the asset based on
various assumptions and market factors, the most significant of which include
interest rates for escrow and deposit balance earnings, estimated prepayment
speeds, estimated servicing costs, portfolio stratification, and discount rates.
The reasonableness of these factors is reviewed by management and is based on
expectations of the portfolio, market conditions, and loan characteristics.
The Corporation's commercial loan servicing portfolio is subject to various
risks, the most significant being interest rate and prepayment risk, which
subject the MSR asset to impairment risk. While the MSR asset is amortized over
its estimated life in proportion to estimated net servicing income, it is also
tested for impairment at a strata level on a quarterly basis. The impairment
testing includes a positive and negative scenario for sensitivity
characteristics. If the estimated fair value of the MSR is less than the
carrying value, an impairment loss would be recognized in the current period;
however, any fair value in excess of the cost basis would not be recognized as
income.
LEASE RESIDUALS
Leases are carried at the aggregate of lease payments and the estimated residual
value of the leased property, less unearned income. The Corporation provides
financing for various types of equipment, aircraft, energy and power systems,
rolling stock, manufacturing and vehicles through a variety of lease
arrangements, including leveraged leases of equipment located in foreign
countries, primarily in western Europe and Australia. A significant portion of
the residual value is subject to a lessee requirement to either purchase or
provide residual value insurance. Residual values are subject to judgments as to
the value of the underlying equipment that can be affected by changes in
economic and market conditions in the United States and in the applicable
foreign countries and the financial viability of the residual guarantors and
insurers. To the extent not assumed by a third party or otherwise mitigated, the
Corporation bears the risk of ownership of the leased assets including the risk
that the actual value of the leased assets at the end of the lease term will be
less than the residual value which could result in a charge and adversely impact
earnings in future periods. Residual values are reviewed on a regular basis for
potential impairment.
GOODWILL
Goodwill arising from business acquisitions represents the value attributable to
unidentifiable intangible elements in the business acquired. The majority of the
Corporation's goodwill relates to value inherent in fund servicing and banking
businesses. The value of this goodwill is dependent upon the Corporation's
ability to provide quality, cost effective services in the face of competition
from other market leaders on a national and global basis. This ability in turn
relies upon continuing investments in processing systems, the development of
value-added service features, and the ease of use of the Corporation's services.
As such, goodwill value is supported ultimately by revenue which is driven by
the volume of business transacted and, for certain businesses, the market value
of assets under administration. A decline in earnings as a result of a lack of
growth or the Corporation's inability to deliver cost effective services over
sustained periods can lead to impairment of goodwill which could result in a
charge and adversely impact earnings in future periods.
DEFINED BENEFIT PENSION PLAN
The Corporation has a noncontributory, qualified defined benefit pension plan
("plan" or "pension plan") covering most employees. Retirement benefits are
derived from a cash balance formula based on compensation levels, age and length
of service. Contributions to the pension plan are actuarially determined with
assets transferred to a trust to fund benefits payable to plan participants.
Plan assets are currently invested approximately 60% in equity investments with
most of the remainder invested in fixed income instruments. Plan investment
strategy is determined and reviewed by plan fiduciaries. On an annual basis,
management reviews the actuarial assumptions related to the pension plan,
including the discount rate, rate of compensation increase and the expected
return on plan assets.
The expense associated with the pension plan is calculated in accordance with
SFAS No. 87, "Employers' Accounting for Pensions," and utilizes assumptions and
methods consistent with the provisions of SFAS 87, including a policy of
reflecting trust assets at their fair market value. The expense is not
significantly affected by the discount rate or compensation increase
assumptions, but is significantly affected by the expected return on asset
assumption, which was adjusted from 9.5% to 8.5% for 2003, increasing expense by
approximately $10 million. The expense is also significantly affected by actual
trust returns, with each one percentage point difference in actual return versus
the expectation causing the following year's expense to increase, given the
current financial position of the plan, by as much as $2 million. Management
currently estimates 2003 expense for the pension plan to be approximately $50
million, compared with $15 million for 2002. Actual pension expense for the
first six months of 2003 totaled $25 million. Previous years' investment results
and the change in expected return on asset assumption are the primary reasons
for estimated increase in pension expense in 2003. Expense for 2004 will
primarily depend on actual trust returns during 2003.
In accordance with SFAS No. 87 and SFAS No. 132, "Employers' Disclosures about
Pensions and Other Postretirement Benefits," the Corporation may be required to
eliminate any prepaid pension asset and recognize a minimum pension liability if
the accumulated benefit obligation exceeds the fair value of plan assets at
year-end. The corresponding charge would be recognized as a component of other
comprehensive income and reduce total shareholders' equity, but would not impact
net income. At December 31, 2002, the fair value of plan assets was $966
million, which exceeded the accumulated benefit obligation of $871 million. The
status at December 31, 2003 will
22
primarily depend upon 2003 trust asset returns and the level of contributions
made to the plan by the Corporation. While the Corporation views as remote the
possibility of a minimum pension liability, such a liability would cause a
significant reduction in shareholders' equity.
Contribution requirements are primarily affected by trust investment performance
and are not particularly sensitive to actuarial assumptions. Although there were
no required contributions to the pension plan during 2003, the Corporation
continued its strategy of fully funding the plan at maximum tax-deductible
levels, contributing $183 million in March 2003. If future investment
performance exceeds that of recent years, the permitted tax-deductible
contribution in future years will be significantly reduced. Regardless, any
large near-term contributions to the plan will be at the discretion of
management as the minimum required contributions under current law are expected
to be zero for several years.
RISK MANAGEMENT
The Corporation encounters risk as part of the normal course of its business and
designs risk management processes to help manage these risks. This section of
this report will first provide an overview of the governance structure,
measurement, control strategies, and monitoring aspects of the Corporation's
risk management processes generally. Following this discussion is an analysis of
the same aspects of the risk management process for what management views as the
Corporation's primary areas of risk: credit risk, operational risk, liquidity
risk, and market risk. The Corporation's use of financial and other derivatives
as part of its overall asset and liability risk management process is also
addressed within the Risk Management section of this report. In appropriate
places within this section, historical performance is also addressed.
OVERVIEW
As a financial services organization, the Corporation takes a certain amount of
risk in every business decision. For example, every time the Corporation opens
an account or approves a loan for a customer, processes a payment, hires a new
employee, or implements a new computer system, the Corporation incurs a certain
amount of risk. As an organization, the Corporation must balance revenue
generation and profitability with the risks associated with doing business. Risk
management is not about eliminating risks, but about accepting risks that are
expected to create shareholder value and that the Corporation should effectively
manage. PNC's objective is to understand risk and act prudently to manage it in
a disciplined way that will help create value that is sustainable in the longer
term.
The key to effective risk management is to be proactive in seeking to identify,
measure, control, and monitor risk on an ongoing basis. Risk management
practices support decision-making, improve the success rate for new initiatives,
and strengthen the organization.
CORPORATE-LEVEL RISK MANAGEMENT OVERVIEW
GOVERNANCE STRUCTURE
The Corporation has multiple organizational structures designed to support risk
management in a prompt and effective manner: committees of the Corporation's
Board of Directors ("Board"), management-level risk management committees,
business risk management, and corporate risk management.
Although the Board as a whole is responsible generally for oversight of risk
management, committees of the Board serve to provide oversight to specific areas
of risk with respect to the level of risk and risk management structure. The
committees with primary responsibility for risk management oversight are as
follows:
o Audit Committee: major financial risk exposures, compliance with legal and
regulatory requirements, internal controls, and the Corporation's Statement
of Principles and Code of Ethics
o Credit Committee: risk within the Corporation's lending and credit-related
activities
o Finance Committee: the risk management process and internal control
structure relating to interest rate and liquidity risks, trading
activities, capital management activities, equity investments, and
fiduciary activities
o Operations and Technology Committee: operations and operational risk
management, and activities related to information technology and
information security
o Nominating and Governance Committee: recommendation of nominees for the
Corporate Board and implementation of best practices in corporate
governance
Management level risk management committees are designed to help ensure that
business decisions are executed within the Board's desired risk profile. The
Executive Risk Management Committee ("ERMC"), consisting of senior management
executives, provides oversight for the establishment and implementation of new
comprehensive risk management initiatives, reviews risk profiles and discusses
key risk issues. There are several other management-level risk management
committees charged with various risk management oversight responsibilities.
Within each of the Corporation's major businesses, a business risk officer
serves an important role by helping the business to identify risks and develop
action plans to manage the risks. By acting as partners to business managers and
corporate risk officers, business risk officers help ensure that strategic
business goals, including acceptable levels of risk, are achieved.
23
The following tables outline the three primary corporate-level risk management
areas:
- ---------------------------------------------------------------
AREA RISK MANAGEMENT
- ---------------------------------------------------------------
EXECUTIVE Chief Risk Officer
- ---------------------------------------------------------------
KEY ROLES OF o Facilitates the identification,
CORPORATE TEAM measurement, control and monitoring of
risk across the Corporation
o Sets risk tolerance limits
o Has authority to review and
challenge all risk-taking activities
o Provides support and oversight to
businesses
o Identifies and implements risk
management best practices
- ---------------------------------------------------------------
- ---------------------------------------------------------------
AREA REGULATORY RELATIONS AND COMPLIANCE
- ---------------------------------------------------------------
EXECUTIVES Chief Regulatory Officer
Chief Compliance Officer
- ---------------------------------------------------------------
KEY ROLES OF o Facilitates the identification,
CORPORATE TEAM assessment and monitoring of
regulatory and compliance risk
throughout the Corporation
o Facilitates relationships with
regulatory agencies and serves as
liaison to the businesses
o Provides compliance support and
oversight at the Corporate level and
to the businesses
o Administers the Corporation's
ethics and business conduct programs
- ---------------------------------------------------------------
- ---------------------------------------------------------------
AREA LEGAL
- ---------------------------------------------------------------
EXECUTIVES Vice Chairman, Legal and Governance
General Counsel
- ---------------------------------------------------------------
KEY ROLES OF o Facilitates the identification,
CORPORATE TEAM assessment, and monitoring of legal
risk throughout the Corporation
o Provides legal counsel to the
Corporation and across all businesses
and staff areas
- ---------------------------------------------------------------
Each corporate risk management area is empowered and actively involved in risk
identification, measurement, control and monitoring in all areas of risk and in
all businesses.
RISK MEASUREMENT
Risk measurement activities are conducted specific to the area of risk.
Corporate risk management functional risk areas are involved in the development
of models and analytic tools to evaluate the level of risk, providing a holistic
approach to aggregating and understanding enterprise-wide risk. The primary
vehicle for aggregation of enterprise-wide risk is a new comprehensive risk
management methodology developed during 2003 that is based on economic capital.
This primary risk aggregation measure is augmented with secondary measures of
risk to arrive at an estimate of enterprise-wide risk. The economic capital
framework is a robust measure of potential losses above and beyond expected
losses. Potential one year losses are capitalized to a level commensurate with a
financial institution with an A rating by the credit rating agencies. Economic
capital incorporates risk associated with potential credit losses ("Credit
Risk"), fluctuations of the estimated market value of financial instruments
("Market Risk") and other risks such as the failure of people, processes or
systems ("Operational Risk"). Management has not traditionally used this
methodology for determining economic capital in evaluating the performance of
its business segments, and this methodology has not been used in the calculation
of return on assigned capital for 2003 or 2002 business segment performance as
disclosed in the Review of Businesses section of this Financial Review.
Management currently plans to adopt this methodology for calculating economic
capital in connection with the evaluation of each of the Corporation's business
segment's performance in 2004.
RISK CONTROL STRATEGIES
Policy development and exception oversight is centrally managed through
Corporate risk management. Corporate risk management is authorized to take
action to either prevent or mitigate exceptions to policies and is responsible
for monitoring compliance. The Corporate Audit function performs an independent
analysis of the internal control environment. Corporate Audit plays a critical
role in risk management, testing the operation of the internal control system
and reporting findings to management and to the Audit Committee. The Corporation
uses a review process for significant new initiatives which requires the
preparation of a business case, including a risk analysis, for review by an
appropriate risk management committee.
RISK MONITORING
Corporate risk management reports on a regular basis to the Board regarding the
enterprise risk profile of the Corporation. These reports aggregate and present
the level of risk by type of risk and communicate significant risk issues,
including performance relative to risk tolerance limits. Both the Board and the
Executive Risk Management Committee provide guidance on actions to address key
risk issues as identified in these reports.
CREDIT RISK MANAGEMENT
Credit risk represents the possibility that a customer, counterparty or issuer
may not perform in accordance with contractual terms. Credit risk is inherent in
the financial services business and results from extending credit to customers,
purchasing securities and entering into financial derivative transactions.
Credit risk is the most common risk in banking and one of the most significant
risks to PNC.
Board approved risk tolerances, in addition to credit policies and procedures,
set portfolio objectives for the level and composition of credit risk.
Guidelines have been established for acceptable levels of aggregate borrower
exposure, problem loans and other credit measures. The Corporation seeks to
achieve credit portfolio objectives by maintaining a customer base that is
diverse in borrower exposure and industry. Reductions in risk concentrations are
achieved through loan participations with third parties, loan sales and the
purchase of credit derivatives.
24
GOVERNANCE STRUCTURE
The credit lending businesses maintain direct responsibility for credit risk
within the Corporation. Corporate Credit Policy provides independent oversight
to the measurement, monitoring and reporting of the Corporation's credit risk
and reports to the Chief Risk Officer. Corporate Credit Policy is responsible
for establishing risk management policies as they relate to credit objectives
and limits. Significant changes are reviewed with and approved by the Credit
Committee of the Board. Centrally, Corporate Credit Policy monitors compliance
with policies and commercial customer covenant compliance. Corporate Credit
Policy is involved in the review of every commercial loan and provides direct
oversight to the underwriting standards for consumer lending activities. Credit
account management staff report up through the Corporate Credit Policy
organization and perform relationship transactional analysis and administration.
Corporate Credit Policy oversees the role of portfolio management. The portfolio
management function supports the development of portfolio risk limits to achieve
associated objectives and is responsible for initiating secondary market
activities to help optimize portfolio composition.
The Special Asset Committee ("SAC") is the management committee charged with the
responsibility of reviewing all criticized credits throughout the Corporation in
excess of a set dollar threshold. Additionally, SAC sets the standards for
business level committees for reviewing all criticized credits below the
corporate exposure threshold. SAC meets regularly and sets specific reserve
levels for non-performing loans and evaluates the risk rating and disclosure
status for reviewed credits.
The Reserve Adequacy Committee ("RAC") reviews the adequacy of the allowance for
loan and lease losses for business units and major bank subsidiaries. RAC
provides oversight for the allowance evaluation process, including quarterly
evaluations and methodology and estimation changes. The results of the
evaluations are reported to the Credit Committee of the Board.
RISK MEASUREMENT
The Corporation actively measures sources of credit risk based on the calculated
expected and unexpected losses in the portfolio. Expected loss is a component in
calculating the appropriate level of the allowance for credit losses. See the
Allowances for Credit Losses and Unfunded Commitments and Letters of Credit
section. Unexpected loss captures the loss volatility in the portfolio and is
the foundation for economic capital measurement at both the transaction and
business level. Stress testing and scenario analyses are performed regularly,
providing guidance to management on the potential impact of macroeconomic events
on the level of credit risk.
Loan evaluation tools are used to assess credit quality at origination and to
identify deteriorating borrower credit quality. They are employed to actively
manage and reduce exposures as warranted. These loan evaluation tools have been
developed internally as well as purchased from external vendors. Loan evaluation
tool policies are established and usage monitored by Corporate Credit Policy.
RISK CONTROL STRATEGIES
Corporate Credit Policy monitors policy compliance and communicates exceptions
to management on a monthly basis and to the Credit Committee of the Board
quarterly. PNC has established credit portfolio risk tolerance and concentration
limits, both at the corporate level and by individual lending business.
Corporate Credit Policy evaluates compliance with risk tolerance and
concentration limits quarterly and oversees appropriate adjustment of portfolio
strategies to remain or move within an acceptable range of risk, balanced by the
strategic objectives of the Corporation and business.
Critical to the measurement of commercial credit risk is the accuracy of risk
ratings in the commercial loan portfolio. Corporate Credit Policy reviews and if
necessary adjusts risk ratings at the time of approval. If a credit relationship
deteriorates subsequent to approval, problem commercial loans are reviewed with
SAC. Additionally, a corporate risk management credit review function performs
independent analyses of the quality of risk management and level of credit risk.
RISK MONITORING
On a quarterly basis, Corporate Credit Policy reports on credit risk to the
Credit Committee of the Board. Policy exceptions and compliance with portfolio
limits are included within the report. Additionally, the credit review function
provides an independent assessment of the credit risk profile and the findings
from targeted reviews. Each primary credit granting business presents a report
on the current trends, key risk factors and credit strategy of the business to
the Credit Committee of the Board.
Senior credit management receives management-level portfolio reports that
include current trends within the business. The reports contain detailed
information on exposure concentrations across portfolio segments.
NONPERFORMING, PAST DUE AND POTENTIAL PROBLEM ASSETS
Nonperforming assets include nonaccrual loans, troubled debt restructurings,
nonaccrual loans held for sale and foreclosed assets. In addition, certain
performing assets have interest payments that are past due or have the potential
for future repayment problems.
25
NONPERFORMING ASSETS BY TYPE
June 30 December 31
Dollars in millions 2003 2002
- -------------------------------------------------------------------
Nonaccrual loans
Commercial $296 $226
Lease financing 6 57
Commercial real estate 6 7
Consumer 11 11
Residential mortgage 7 7
- -------------------------------------------------------------------
Total nonaccrual loans 326 308
Troubled debt restructured loan 1 1
- -------------------------------------------------------------------
Total nonperforming loans 327 309
Nonperforming loans held for sale (a) 45 97
Foreclosed assets
Lease 19
Residential mortgage 7 6
Other 6 6
- -------------------------------------------------------------------
Total foreclosed assets 32 12
- -------------------------------------------------------------------
Total nonperforming assets $404 $418
===================================================================
Nonperforming loans to total loans .95% .87%
Nonperforming assets to total loans,
loans held for sale and foreclosed assets 1.12 1.13
Nonperforming assets to total assets .60 .63
===================================================================
(a) Includes troubled debt restructured loans held for sale of $11 million and
$17 million as of June 30, 2003 and December 31, 2002, respectively.
Of the total nonperforming loans at June 30, 2003, 41% are related to PNC
Business Credit. PNC Business Credit loans, including those acquired in the NBOC
acquisition, are secured loans to borrowers, many of whom are highly leveraged,
experiencing rapid growth, or have elected to utilize asset-based financing. As
a result, the risk profile of these loans typically reflects a higher risk of
default and a greater proportion being classified as nonperforming.
Historically, the Corporation has found that the collateralized nature of
asset-based financing has resulted in lower losses relative to comparable
commercial loans within the loan portfolio. The increase in nonaccrual loans
since December 31, 2002 reflected additional credits in the manufacturing sector
partially offset by higher charge-offs and the transfer of a single airline
industry credit to foreclosed assets as described below.
The above table excludes nonperforming equity management assets carried at
estimated fair value of $39 million and $40 million at June 30, 2003 and
December 31, 2002, respectively, and included in other assets on the
Consolidated Balance Sheet. Nonperforming equity management assets at June 30,
2003 and December 31, 2002, include $3 million and $12 million, respectively, of
troubled debt restructured assets.
The increase in foreclosed lease assets since December 31, 2002 represented the
Corporation's repossession of collateral related to a single airline industry
credit during the second quarter of 2003 that was previously classified as a
nonaccrual loan.
The amount of nonperforming loans that were current as to principal and interest
was $170 million at June 30, 2003 and $107 million at December 31, 2002. The
amount of nonperforming loans held for sale that were current as to principal
and interest was $7 million at June 30, 2003 and $46 million at December 31,
2002.
NONPERFORMING ASSETS BY BUSINESS
June 30 December 31
In millions 2003 2002
- ----------------------------------------------------------------
Regional Community Banking $75 $82
Corporate Banking 176 187
PNC Real Estate Finance 3 2
PNC Business Credit 145 142
PNC Advisors 5 5
- ----------------------------------------------------------------
Total nonperforming assets $404 $418
================================================================
At June 30, 2003, Corporate Banking and PNC Business Credit had nonperforming
loans held for sale of $36 million and $9 million, respectively, which are
included in the preceding table.
CHANGE IN NONPERFORMING ASSETS
In millions 2003 2002
- ----------------------------------------------------------------
January 1 $418 $391
Transferred from accrual 279 548
Returned to performing (3) (19)
Principal reductions (158) (189)
Asset sales (32) (98)
Charge-offs and valuation adjustments (100) (133)
- ----------------------------------------------------------------
June 30 $404 $500
================================================================
For the remainder of 2003, continued weakness of the economy or other factors
that affect asset quality, could result in an increase in the number of
delinquencies, bankruptcies or defaults, and a higher level of nonperforming
assets, net charge-offs and provision for credit losses in future periods.
ACCRUING LOANS AND LOANS HELD FOR SALE PAST DUE 90 DAYS OR MORE
Percent of Total
Amount Outstandings
----------------- --------------------
Dollars in millions Jun. 30 Dec. 31 Jun. 30 Dec. 31
2003 2002 2003 2002
- ----------------------------------------------------------------
Commercial $25 $41 .17% .27%
Commercial real estate 5 10 .25 .44
Consumer 29 25 .27 .25
Residential mortgage 37 38 1.18 .97
Lease financing 2 1 .05 .02
- ----------------------------------------------
Total loans 98 115 .28 .32
Loans held for sale 10 32 .68 1.99
- ----------------------------------------------
Total loans and
loans held for sale $108 $147 .30 .40
================================================================
Loans and loans held for sale not included in nonperforming or past due
categories, but where information about possible credit problems causes
management to be uncertain about the borrower's ability to comply with existing
repayment terms over the next six months, totaled $98 million and $1 million,
respectively, at June 30, 2003. Approximately 45% of these loans are in the PNC
Business Credit portfolio. Loans held for sale relate to the institutional
lending repositioning.
26
ALLOWANCES FOR CREDIT LOSSES AND UNFUNDED LOAN COMMITMENTS AND LETTERS OF CREDIT
The Corporation maintains an allowance for credit losses to absorb losses from
the loan portfolio. The allowance is determined based on quarterly assessments
of the probable estimated losses inherent in the loan portfolio. The methodology
for measuring the appropriate level of the allowance consists of several
elements, including specific allocations to impaired loans, allocations to pools
of non-impaired loans and unallocated reserves. While allocations are made to
specific loans and pools of loans, the total reserve is available for all loan
losses.
In addition to the allowance for credit losses, the Corporation maintains an
allowance for unfunded loan commitments and letters of credit. This amount,
reported as a liability on the Consolidated Balance Sheet, is determined using
estimates of the probability of the ultimate funding and losses related to those
credit exposures. The methodology used is similar to the methodology used for
determining the adequacy of the allowance for credit losses.
Specific allowances are established for loans considered impaired by a method
prescribed by SFAS No. 114, "Accounting by Creditors for Impairment of a Loan."
All nonperforming loans are considered impaired under SFAS No. 114. Specific
allowances are determined for individual loans over a dollar threshold by SAC
based on an analysis of the present value of its expected future cash flows
discounted at its effective interest rate, its observable market price or the
fair value of the underlying collateral. A minimum specific allowance is
established on all impaired loans at the applicable pool reserve allocation for
similar loans.
Allocations to non-impaired commercial and commercial real estate loans (pool
reserve allocations) are assigned to pools of loans as defined by PNC's business
structure and internal risk rating categories. Key elements of the pool reserve
methodology include expected default probabilities ("EDP"), loss given default
("LGD") and exposure at default ("EAD"). EDPs are derived from historical
default analyses and are a function of the borrower's risk rating grade and
expected loan term. LGDs are derived from historical loss data and are a
function of the loan's collateral value and other structural factors that may
affect the ultimate ability to collect on the loan. EADs are derived from
banking industry and PNC's own exposure at default data.
This methodology is sensitive to changes in key risk parameters such as EDPs,
LGDs and EADs. In general, a given change in any of the major risk parameters
will have a commensurate change in the pool reserve allocations to non-impaired
commercial loans. Additionally, other factors such as the rate of migration in
the severity of problem loans or changes in the maturity distribution of the
loans will contribute to the final pool reserve allocations.
Consumer (including residential mortgage) loan allocations are made at a total
portfolio level by consumer product line based on historical loss experience. A
four-quarter average loss rate is computed as net charge-offs for the prior four
quarters as a percentage of the average loans outstanding in those quarters.
This loss rate is applied to loans outstanding at the end of the current period.
The final loan reserve allocations are based on this methodology and
management's judgment of other qualitative factors which may include, among
others, regional and national economic conditions, business segment and
portfolio concentrations, historical versus estimated losses, model risk and
changes to the level of credit risk in the portfolio.
Unallocated reserves are established to provide coverage for probable losses not
considered in the specific, pool and consumer reserve methodologies, such as,
but not limited to, potential judgment and data errors. Furthermore, events may
have occurred as of the reserve evaluation date that are not yet reflected in
the risk measures or characteristics of the portfolio due to inherent lags in
information. Management's evaluation of these and other relevant factors
determines the level of unallocated reserves established at the evaluation date.
ALLOCATION OF ALLOWANCE FOR CREDIT LOSSES
June 30, 2003 December 31, 2002
--------------------------------------------------
Loans to Loans to
Dollars in millions Allowance Total Loans Allowance Total Loans
- ---------------------------------------------------------------------------
Commercial $548 42.9% $504 42.3%
Commercial
real estate 43 5.9 52 6.4
Consumer 28 30.5 28 27.8
Residential mortgage 9 9.0 10 11.0
Lease financing
and other 45 11.7 79 12.5
- ---------------------------------------------------------------------------
Total $673 100.0% $673 100.0%
===========================================================================
For purposes of this presentation, the unallocated portion of the allowance for
credit losses of $112 million at both June 30, 2003 and December 31, 2002 has
been assigned to loan categories based on the relative specific and pool
allocation amounts. The unallocated portion of the allowance for credit losses
represented 17% of the total allowance and .32% of total loans at both June 30,
2003 and December 31, 2002. Enhancements and refinements to the reserve
methodology during 2002 resulted in a reallocation of the allowance for credit
losses among the Corporation's businesses and from unallocated to specific and
pool categories.
The provision for credit losses for the first six months of 2003 and the
evaluation of the allowances for credit losses and unfunded loan commitments and
letters of credit as of June 30, 2003 reflected changes in loan portfolio
composition, the impact of refinements to the Corporation's reserve methodology
and changes in asset quality. The provision includes amounts for probable losses
on loans and credit exposure related to unfunded loan commitments and letters of
credit.
27
ROLLFORWARD OF ALLOWANCE FOR CREDIT LOSSES
In millions 2003 2002
- -----------------------------------------------------------------
January 1 $673 $560
Charge-offs (119) (139)
Recoveries 20 24
- -----------------------------------------------------------------
Net charge-offs (99) (115)
Provision for credit losses 93 171
Acquired allowance (NBOC acquisition) 41
Net change in allowance for unfunded
loan commitments and letters of credit 6 (3)
- -----------------------------------------------------------------
June 30 $673 $654
=================================================================
ROLLFORWARD OF ALLOWANCE FOR UNFUNDED LOAN COMMITMENTS AND LETTERS OF CREDIT
In millions 2003 2002
- -----------------------------------------------------------------
January 1 $84 $70
Net change in allowance for unfunded
loan commitments and letters of credit (6) 3
- -----------------------------------------------------------------
June 30 $78 $73
=================================================================
The allowance as a percent of nonperforming loans and total loans was 206% and
1.95%, respectively, at June 30, 2003. The comparable 2002 percentages were 201%
and 1.74%, respectively.
CHARGE-OFFS AND RECOVERIES
Percent of
Six months ended June 30 Net Average
Dollars in millions Charge-offs Recoveries Charge-offs Loans
- -------------------------------------------------------------------------------
2003
Commercial $59 $12 $47 .63%
Commercial real estate 2 2 .18
Consumer 20 6 14 .28
Residential mortgage 1 1 .06
Lease financing 37 2 35 1.84
- ------------------------------------------------------------------
Total $119 $20 $99 .57
===============================================================================
2002
Commercial $105 $14 $91 1.13%
Commercial real estate 2 2 .16
Consumer 20 8 12 .26
Residential mortgage 2 1 1 .04
Lease financing 10 1 9 .42
- ------------------------------------------------------------------
Total $139 $24 $115 .61
===============================================================================
The decline in net charge-offs for the first six months of 2003 compared with
the first six months of 2002 was primarily due to the impact of a $45 million
charge-off in 2002 related to Market Street that more than offset the impact of
a $24 million charge-off in the second quarter of 2003 related to a single
airline industry credit for which a reserve had been provided at December 31,
2002.
OPERATIONAL RISK MANAGEMENT
Operational risk is defined as the risk of loss resulting from inadequate or
failed internal processes, people or systems or from external events. The
definition also includes losses that may arise from legal actions that may
result from operating deficiencies or noncompliance with contracts, laws or
regulations. The Corporation is exposed to a variety of operational risks that
can affect each of its business activities, particularly those involving
processing and servicing.
GOVERNANCE STRUCTURE
Each business unit holds primary responsibility for its own operational risk
management program, given that operational risk management is integral to direct
business management and most easily affected at the business unit level,
Corporate Operational Risk oversees the day-to-day operational risk management
activities at PNC and reports to the Chief Risk Officer.
RISK MEASUREMENT AND CONTROL STRATEGIES
The Corporation maintains a system of internal controls that is designed to
reduce risk and to provide management timely and accurate information about the
operations of PNC. Senior business managers are accountable for managing the
operational risks of their respective businesses. Management believes that the
internal controls are adequate to reduce such risks to a level consistent with
the Corporation's financial strength, business and market characteristics, and
the regulatory environment to which it is subject. A comprehensive
enterprise-wide operational risk framework is currently in development to
further enhance the management of operational risk.
PNC has an integrated security and technology risk management framework
consisting of governance, strategy, technology, and control designed to help
ensure a secure, sound, and compliant infrastructure for information management.
The application of this framework across the enterprise helps to support
comprehensive and reliable internal controls.
The technology risk program, managed by Technology Processing and Services, is
the foundation for information privacy, integrity, and availability. Key
elements of the program include: technology risk assessment; privacy;
information security; crisis management; business resiliency; fraud avoidance;
and physical security.
The technology risk management process is aligned with the strategic direction
of the businesses and is integrated into the technology management culture,
structure, and practices. Through the collaborative efforts of the businesses
and technology risk management resources, PNC has a comprehensive technology
risk framework.
The security and technology risk management strategy supports existing and
emerging business risks and complies with various regulatory guidelines. Given
the strategic importance, PNC has focused technology risk management programs on
business resiliency, privacy and information security, and fraud avoidance
programs.
RISK MONITORING
Business units perform self-assessments of operational risk to identify trends
and correlations that will enable proactive steps to be taken to address
emerging operational risks and control gaps. Corporate risk management provides
oversight to the accuracy and consistency of the self-assessments.
28
LIQUIDITY RISK MANAGEMENT
Liquidity risk is the risk of potential for loss from an inability of the
Corporation to meet its funding requirements at a reasonable cost. The objective
of liquidity risk management is to help ensure that the Corporation can obtain
cost-effective funding to meet current and future obligations under both normal
"business as usual" and stressful circumstances. The Corporation typically
maintains its liquidity positions through:
o A large and stable deposit base derived from the Corporation's retail and
wholesale banking activities
o A portfolio of liquid investment securities
o Diversified sources of short-term and long-term wholesale funding; and
o Significant unused borrowing capacity at both Federal Home Loan Bank and
Federal Reserve discount window
GOVERNANCE STRUCTURE
Asset and Liability Management ("ALM"), reporting to the Vice Chairman/Chief
Financial Officer, is accountable for managing the liquidity position within the
limits and guidelines set forth in the Corporation's risk management policies
approved by the Board Finance Committee. Market Risk Management provides
independent oversight for the measurement, monitoring and reporting of the
Corporation's liquidity risk and reports to the Chief Risk Officer.
RISK MEASUREMENT
The Liquidity Risk Management Policy for the Bank and the Capital Management
Policy for the holding company established the process and operating guidelines
for measuring, monitoring and reporting liquidity, including compliance with the
limits that govern the liquidity position at both the bank and holding company
level.
For policy compliance purposes, stress scenarios are simulated monthly that
incorporate assumptions about retail deposit outflows, and other factors that
could adversely affect PNC Bank's liquidity position given adverse events
affecting the Bank.
The holding company's routine funding needs consist primarily of the return of
capital to shareholders (dividends and share repurchase), debt service and the
funding of its non-bank affiliates and acquisitions. Holding company liquidity
guidelines are designed to help ensure that sufficient liquidity is available to
meet these requirements over the succeeding twelve-month period.
RISK CONTROL STRATEGIES
Market Risk Management monitors the Corporation's liquidity positions against
established policy limits. All limit exceptions are reported to Executive ALCO
and to the Board Finance Committee.
The Corporation also establishes process and operating guidelines for managing
liquidity in a crisis situation. These activities are coordinated with the
business units to develop strategies to help minimize the outflow of funds and
obtain detailed information focused on tracking deposit and loan trends to
identify significant, unexpected withdrawals or draws on commitments which could
adversely affect the Corporation's liquidity position.
RISK MONITORING
Liquidity positions are monitored at both the bank level and the holding
(parent) company level. Compliance with the Corporation's liquidity policy
limits is reviewed with Executive ALCO and the Board Finance Committee.
Liquid assets consist of short-term investments (federal funds sold and other
short-term investments) and securities available for sale. At June 30, 2003,
such assets totaled $18.4 billion, with $6.2 billion pledged as collateral for
borrowings, trust and other commitments.
Secured advances from the Federal Home Loan Bank, of which PNC Bank is a member,
are generally secured by residential mortgages, other real estate related loans
and mortgage-backed securities. At June 30, 2003, total unused borrowing
capacity from the Federal Home Loan Bank under current collateral requirements
was $14.5 billion. Funding can also be obtained through alternative forms of
borrowing, including federal funds purchased, repurchase agreements and
short-term and long-term debt issuance.
HOLDING COMPANY LEVEL LIQUIDITY
Liquidity for the parent company and PNC's non-bank subsidiaries can be
generated through the issuance of securities in public or private markets. At
June 30, 2003, the Corporation had unused capacity under effective shelf
registration statements of approximately $3.3 billion of debt or equity
securities and $400 million of trust preferred capital securities. The parent
company also had an unused non-reciprocal credit facility of $200 million at
June 30, 2003.
The principal source of parent company revenue and cash flow is the dividends it
receives from PNC Bank, N.A. ("PNC Bank"). PNC Bank's dividend level may be
impacted by its capital needs, supervisory policies, corporate policies,
contractual restrictions and other factors. Also, there are statutory and
regulatory limitations on the ability of national banks to pay dividends or make
other capital distributions. The amount available for dividend payments to the
parent company by both bank subsidiaries without prior regulatory approval was
approximately $280 million at June 30, 2003.
In addition to dividends from PNC Bank, other sources of parent company
liquidity include cash and short-term investments, as well as dividends and loan
repayments from other subsidiaries. As of June 30, 2003, the parent company had
approximately $989 million in funds available from its cash and short-term
investments or other funds available from unrestricted subsidiaries. Based on
the amount of funds currently available at the parent company level and the
amount of dividends currently payable by PNC Bank, management expects that the
parent company will have sufficient liquidity available to meet current
obligations to its debt holders, vendors, and others and to pay dividends at
current rates through 2003.
29
MARKET RISK MANAGEMENT OVERVIEW
Market risk is the risk of potential losses due to adverse movements in market
factors such as interest rates, credit spreads, foreign exchange rates and
equity prices. Market risk is inherent in the operations of the Corporation,
arising from both trading and non-trading activities. Trading activities involve
transactions in capital market products such as bonds, stocks and their related
derivative instruments. The primary market risk in non-trading activities is the
interest rate risk inherent in the traditional banking activities of gathering
deposits and extending loans. Equity investment risk is another significant type
of non-trading market risk arising from private equity and other types of equity
investment activities.
Market Risk Management has responsibility for market risks in both trading and
non-trading activities. The four key aspects of Market Risk Management functions
are enterprise-wide market risk policy, measurement, monitoring, and reporting.
The Board Finance Committee reviews and approves the Corporation's market risk
management policies and limits.
MARKET RISK MANAGEMENT - INTEREST RATE RISK
Interest rate risk results primarily through the Corporation's traditional
banking activities of extending loans and acquiring deposits. Many factors,
including economic and financial conditions, movements in interest rates and
consumer preferences affect the spread between interest earned on assets and
interest paid on liabilities. In managing interest rate risk, the Corporation
seeks to limit its reliance on a particular interest rate scenario as a source
of earnings while helping to optimize net interest income and net interest
margin. To further these objectives, the Corporation uses securities purchases
and sales, short-term and long-term funding, financial derivatives and other
capital markets instruments.
GOVERNANCE STRUCTURE
The Board Finance Committee approves market risk policies, including the
interest rate risk management policy and the investment policy that govern
interest rate risk management. The policies define the Corporation's overall
interest rate risk management philosophy and risk tolerance level. Executive
ALCO is the management committee that oversees all market-risk taking
activities, including interest rate risk management activities conducted by ALM.
Executive ALCO delegates the execution and implementation of interest rate risk
management strategies to ALM. In this capacity, ALM is responsible for making
investment and trading decisions within the authorized limits and guidelines.
Market Risk Management is responsible for monitoring compliance with the
approved policy and market risk limits.
RISK MEASUREMENT
The Corporation measures and seeks to manage both the short-term and long-term
effects of changing interest rates through its interest-rate risk simulation
model. The simulation model measures the sensitivity of net interest income
("NII") to changing interest rates over the next 24-month period. The model also
measures the sensitivity of the economic value of equity ("EVE") of existing
on-balance-sheet and off-balance-sheet positions to changing interest rates.
The income simulation model is the primary tool used to measure the direction
and magnitude of changes in net interest income resulting from changes in
interest rates. Forecasting net interest income and its sensitivity to changes
in interest rates requires that the Corporation make assumptions about the
volume and characteristics of new business and the behavior of existing
positions. These business assumptions are based on the Corporation's experience,
business plans and published industry experience. Key assumptions employed in
the model include prepayment speeds on mortgage-related assets and consumer
loans, loan volumes and pricing, deposit volumes and pricing, the expected life
and repricing characteristics of nonmaturity loans and deposits, and
management's financial and capital plans.
The Corporation's interest rate risk simulation model is designed to capture key
components of interest rate risks such as repricing risk, yield curve or
nonparallel rate shift risk, basis risk and options risk. Because the
assumptions employed in the model are inherently uncertain, actual results may
differ from simulated results. Management uses such analyses to help it identify
risk and develop risk management strategies.
RISK CONTROL STRATEGIES
PNC has established policy limits and processes for Market Risk Management to
actively monitor its interest rate risk profile in general, and its investment
portfolio in particular. Policy limits are established both for NII and EVE
sensitivities.
In the current low rate environment, management's actions have focused on
reducing exposure to more modest rate declines and on the effects of rate
increases on net interest income and the economic value of equity.
RISK MONITORING
The Corporation has established a process for reporting its interest rate risk
profile and any significant risk issues. The official NII and EVE sensitivity
reports are reviewed regularly by Executive ALCO and the Board Finance
Committee.
The following table sets forth the sensitivity results for the quarters ended
June 30, 2003 and 2002.
30
INTEREST SENSITIVITY ANALYSIS
June 30 June 30
2003 2002
- ----------------------------------------------------------------------------
NET INTEREST INCOME SENSITIVITY SIMULATION
Effect on net interest income in first
year from gradual interest rate
change over following 12 months of:
100 basis point increase 0.7% 1.0%
100 basis point decrease (1.5)% (4.2)%
Effect on net interest income in second
year from gradual interest rate change
over the preceding 12 months of:
100 basis point increase 3.6% 2.8%
100 basis point decrease (9.0)% (12.9)%
ECONOMIC VALUE OF EQUITY SENSITIVITY MODEL
Effect on value of on- and off-balance-sheet
positions as a percentage of assets from
instantaneous change in interest rates of:
200 basis point increase (0.5)% (0.9)%
200 basis point decrease (0.8)% 0.1%
KEY PERIOD-END INTEREST RATES
One month LIBOR 1.12% 1.84%
Three-year swap 1.95% 3.85%
============================================================================
In addition to measuring the effect on net interest income assuming parallel
changes in current interest rates, PNC routinely simulates the effects of a
number of nonparallel interest rate environments. The following table reflects
the percentage change in net interest income over the next two 12 month periods
assuming the PNC economist's most likely rate forecast, implied market forward
rates, a lower/steeper rate scenario and a lower/flatter rate scenario. The
Corporation is sensitive to a low and flat yield curve.
All changes in forecasted net interest income are relative to results in a base
rate scenario where current market rates are assumed to remain unchanged over
the forecast horizon.
NET INTEREST INCOME SENSITIVITY TO ALTERNATIVE RATE SCENARIOS
(AS OF JUNE 30, 2003)
PNC Market
In millions Economist Forward Low/Steep Low/Flat
- -------------------------------------------------------------------
Change in
forecasted net
interest income:
- -------------------------------------------------------------------
First year
sensitivity (0.4)% 0.7% 1.0% (1.0)%
Second year
sensitivity (1.1)% 2.0% 1.9% (3.9)%
===================================================================
The graph below presents the yield curves for the base rate scenario and each of
the alternative scenarios one year forward.
The hard copy version of this Quarterly Report on Form 10-Q contains a graph
entitled "Alternative Interest Rate Scenarios" that reflects the following data
points:
Forecasted Rates - One Year Forward
-----------------------------------
1-month
LIBOR 2-year Swap 3-year Swap 5-year Swap
----- ----------- ----------- -----------
Base Rates 1.11% 1.60% 2.03% 2.82%
PNC Economist 1.15 1.64 2.12 2.88
Market Forward 1.50 2.40 2.81 3.21
Low / Steep 0.81 1.60 2.12 3.07
Low / Flat 1.10 1.29 1.40 1.43
MARKET RISK MANAGEMENT - EQUITY INVESTMENT RISK
Equity investment risk is the risk of potential losses associated with investing
in both private and public equity markets. The Corporation makes and manages
direct investments in a variety of transactions, including management buyouts,
recapitalizations and later stage growth financings, and in a variety of
industries. The Corporation also invests in non-affiliated and affiliated funds
that make similar private equity investments.
The private equity portfolio is diversified by industry, stage and type of
investment. The Corporation continues to make private equity investments at a
more moderate pace than in prior years, consistent with current market
conditions. From a risk management standpoint, the strategy is to invest in
companies with proven business models, structure investment transactions to
protect value in downside scenarios and invest in less volatile industries.
Currently, emphasis is being placed on the management of capital for other
investors.
GOVERNANCE STRUCTURE
PNC Equity Management Corp ("PNC EMC") manages the private equity investment
activities of PNC. The Board Finance Committee approves policies and capital
limits related to investment activities across PNC. PNC EMC is responsible for
making investment decisions within the approved policy limits and guidelines.
Market Risk Management provides independent oversight by monitoring the
compliance with these limits and guidelines, and reporting significant risks in
the business to the Board Finance Committee and ERMC.
31
RISK MEASUREMENT
Equity management (private equity) assets are valued at each balance sheet date
based primarily on either, in the case of limited partnership investments, the
financial statements received from the general partner or, with respect to
direct investments, the estimated fair value of the investments. There is a time
lag in the Corporation's receipt of the financial information that is the
primary basis for the valuation of the limited partnership interests. PNC will
recognize in the third quarter of 2003 valuation changes related to limited
partnership investments that reflect the impact of second quarter 2003 market
conditions and performance of the underlying companies. The valuation procedures
applied to direct investments include techniques such as multiples of cash flow
of the entity, independent appraisals of the entity or the pricing used to value
the entity in a recent financial transaction. See Equity Management Asset
Valuation in the Critical Accounting Policies And Judgments section of this
Financial Review for additional information.
Changes in the values of equity management investments are reflected in the
Corporation's results of operations. Due to the nature of the direct
investments, management must make assumptions as to future performance,
financial condition, liquidity, availability of capital, and market conditions,
among other factors, to determine the estimated fair value of the investments.
Market conditions and actual performance of the investments could differ from
these assumptions and from the assumptions made by the general partners.
Accordingly, lower valuations may occur that could adversely impact earnings in
future periods. Accordingly, the valuations may not represent amounts that will
ultimately be realized from these investments.
RISK CONTROL STRATEGIES
Equity investments across the Corporation are made within capital limits
approved by the Board Finance Committee. Given the illiquid nature of most of
the investments, assessing their fair values is a challenge. The fair market
value of the investments is updated and reviewed at both corporate and business
unit levels via management and PNC EMC board meetings. In addition, Market Risk
Management monitors the equity investment portfolio.
RISK MONITORING
At June 30, 2003, private equity investments carried at estimated fair value
totaled approximately $539 million compared with $530 million at December 31,
2002. As of June 30, 2003, approximately 49% of the amount is invested directly
in a variety of companies and approximately 51% is invested in various limited
partnerships. Equity management funding commitments totaled $197 million at June
30, 2003 compared with $173 million at December 31, 2002.
PNC also makes investments in affiliated and non-affiliated funds with both
traditional and alternative investment strategies. Such investments include
investments in BlackRock's mutual funds and hedge funds.
MARKET RISK MANAGEMENT - TRADING RISK
Most of the Corporation's trading activities are designed to provide capital
markets services to customers and not to position the Corporation's portfolio
for gains from market movements. Trading activities are confined to financial
instruments and financial derivatives. PNC participates in derivatives and
foreign exchange trading as well as underwriting and "market making" in equity
securities as an accommodation to customers. PNC also engages in trading
activities as part of risk management strategies. Net trading income was $60
million for the first six months of 2003 compared with $53 million for the first
half of 2002. See Note 5 Trading Activities in the Notes to Consolidated
Financial Statements for additional information.
GOVERNANCE STRUCTURE
The Board Finance Committee reviews and approves the Corporate trading risk
policy. This policy governs risk management philosophy, processes and limits for
all trading activities across the Corporation. Executive ALCO oversees all
trading activities across the Corporation.
For each trading group (e.g., fixed income derivatives, foreign exchange), there
is a specific market risk policy and a set of risk limits that govern that
particular group. The overall Corporate trading risk policy governs these
policies and limits.
RISK MEASUREMENT
The Corporation uses a variety of statistical and non-statistical measurements
to assess the level of market risk arising from trading activities. The key
market risk measure for trading activities is Value-at-Risk ("VaR"). For a
trading portfolio, VaR seeks to measure the maximal potential loss within a
specified confidence level over a given holding period. The Corporation measures
its VaR using 99% confidence level over a one-day period. VaR offers a common
currency to compare market risk across multiple instruments and portfolios. It
accounts for risk at the individual position level as well as the position's
effect on the overall portfolio. In addition to the levels of volatility of
market risk factors, the Corporation's VaR methodology incorporates market
liquidity risk by lengthening the holding period for illiquid positions.
Currently, the Corporation does not perform a VaR calculation for its portfolio
of credit default swaps that are used to hedge its on-balance sheet corporate
loans. The notional amount of credit default swaps is $242 million as of June
30, 2003. See Credit Default Swaps in this Financial Review for further
information.
The trading activities of the Corporation are governed by both a daily VaR limit
and a month-to-date stop-loss limit. As of June 30, 2003, the total VaR usage
for the Corporation is $.8 million. Total VaR usage ranged from $.6 million to
$1.8 million during the second quarter of 2003. Interest rate risk is the
primary contributor to the overall VaR level.
32
In addition to measuring VaR, Market Risk Management performs stress testing to
assess the potential impacts of extreme market scenarios beyond the 99%
confidence level on all of its trading portfolios. The appropriateness of these
scenarios is reviewed regularly by management to reflect the changing market
conditions and portfolio compositions.
RISK CONTROL STRATEGIES
Under current policy, the Board Finance Committee and Executive ALCO review the
Corporation's trading activities at least twice a year to review and approve any
significant changes to risk management policies, limits and business strategies.
On a daily basis, Market Risk Management monitors the market conditions and
their impact on the Corporation's trading positions. In addition, Market Risk
Management also monitors exposure levels relative to relevant risk limits.
RISK MONITORING
Market risk reports for the trading activities are generated daily and reviewed
by Market Risk Management staff. Monthly VaR, stop-loss and stress testing
reports, together with market risk trend and summary reports are presented to
senior management in risk management committee meetings at both the business
unit and corporate levels.
Market Risk Management also generates a backtesting report on a daily basis. The
purpose of the backtesting report is to validate the accuracy of the VaR
measurement by comparing the current day's actual trading profit/loss against
the prior day's VaR. A backtesting exception occurs when the actual loss exceeds
the relevant VaR and can be an indication that the VaR measurement is
underestimating risk. For the 12 months ended June 30, 2003, the Corporation
experienced no backtesting exceptions at the enterprise-wide level.
33
FINANCIAL AND OTHER DERIVATIVES
As previously reported, the Corporation uses a variety of financial derivatives
as part of the overall asset and liability risk management process to help
manage interest rate, market and credit risk inherent in the Corporation's
business activities, and substantially all of such instruments are used to seek
to manage risk related to changes in interest rates. Not all elements of
interest rate, market and credit risk are addressed through the use of financial
or other derivatives, and such instruments may be ineffective for their intended
purposes due to unanticipated market characteristics among other reasons.
The following table sets forth changes, during the first six months of 2003, in
the notional value of financial derivatives used for risk management and
designated as accounting hedges under SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities," as amended.
FINANCIAL DERIVATIVES ACTIVITY
Weighted-
December 31 June 30 Average
Dollars in millions 2002 Additions Maturities Terminations 2003 Maturity
- ---------------------------------------------------------------------------------------------------------------------------------
Interest rate risk management
Interest rate swaps
Receive fixed $5,823 $966 $(25) $(1,256) $5,508 3 yrs.
Pay fixed 67 228 (1) (176) 118 4 yrs. 7 mos.
Basis swaps 52 (52)
Interest rate caps 16 16 4 yrs. 2 mos.
Interest rate floors 7 (5) 2 6 yrs. 9 mos.
Futures contracts 313 165 (223) 255 8 mos.
- ----------------------------------------------------------------------------------------------------------------
Total interest rate risk
management 6,278 1,359 (31) (1,707) 5,899
- ----------------------------------------------------------------------------------------------------------------
Commercial mortgage banking risk
management
Pay fixed interest rate swaps 273 366 (514) 125 11 yrs. 4 mos.
Total rate of return swaps 100 150 (125) 125 2 mos.
- ----------------------------------------------------------------------------------------------------------------
Total commercial mortgage
banking risk management 373 516 (125) (514) 250
- ----------------------------------------------------------------------------------------------------------------
Total $6,651 $1,875 $(156) $(2,221) $6,149
=================================================================================================================================
34
The following tables set forth the notional value and the fair value of
financial derivatives used for risk management and designated as accounting
hedges under SFAS No. 133 at June 30, 2003 and December 31, 2002.
Weighted-average interest rates presented are based on contractual terms, if
fixed, or the implied forward yield curve at each respective date, if floating.
Changes in the fair value of receive fixed interest rate swaps generally reflect
an inverse relationship to changes in interest rates. The rise in interest rates
subsequent to June 30, 2003, if sustained, will adversely impact the fair value
of these swaps at September 30, 2003, compared with the balance at June 30,
2003. In addition, certain swap contracts were terminated subsequent to June 30,
2003.
FINANCIAL DERIVATIVES - 2003
Weighted-Average Interest Rates
Notional -------------------------------
June 30, 2003 - dollars in millions Value Fair Value Paid Received
- -------------------------------------------------------------------------------------------------------------------------------
Interest rate risk management
Asset rate conversion
Interest rate swaps (a)
Receive fixed designated to loans $3,171 $128 1.60% 3.74%
Pay fixed designated to loans 118 (12) 5.03 2.61
Interest rate caps designated to loans (b) 16 NM NM
Interest rate floors designated to loans (c) 2 NM NM
Futures contracts designated to loans 255 NM NM
- ------------------------------------------------------------------------------------------------
Total asset rate conversion 3,562 116
- ------------------------------------------------------------------------------------------------
Liability rate conversion
Interest rate swaps (a)
Receive fixed designated to borrowed funds 2,337 381 2.54 5.93
- ------------------------------------------------------------------------------------------------
Total liability rate conversion 2,337 381
- ------------------------------------------------------------------------------------------------
Total interest rate risk management (d) 5,899 497
- ------------------------------------------------------------------------------------------------
Commercial mortgage banking risk management
Pay fixed interest rate swaps designated to loans held for sale (c) 125 (11) 4.78 4.17
Pay total rate of return swaps designated to loans held for sale (c) 125 (6) NM .68
- ------------------------------------------------------------------------------------------------
Total commercial mortgage banking risk management 250 (17)
- ------------------------------------------------------------------------------------------------
Total financial derivatives designated for risk management $6,149 $480
===============================================================================================================================
(a) The floating rate portion of interest rate contracts is based on
money-market indices. As a percent of notional value, 59% were based on
1-month LIBOR and 41% on 3-month LIBOR.
(b) Interest rate caps with notional values of $12 million require the
counterparty to pay the Corporation the excess, if any, of 3-month LIBOR
over a weighted-average strike of 6.50%. In addition, interest rate caps
with notional values of $4 million require the counterparty to pay the
excess, if any, of Prime over a weighted-average strike of 5.03%. At June
30, 2003, 3-month LIBOR was 1.12% and Prime was 4.00%.
(c) Interest rate floors with notional values of $2 million require the
counterparty to pay the excess, if any, of the weighted-average strike of
7.25% over Prime. At June 30, 2003, Prime was 4.00%.
(d) Fair value amounts include accrued interest of $68 million.
NM-Not meaningful
FINANCIAL DERIVATIVES - 2002
Weighted-Average Interest Rates
Notional -------------------------------
December 31, 2002 - dollars in millions Value Fair Value Paid Received
- -------------------------------------------------------------------------------------------------------------------------------
Interest rate risk management
Asset rate conversion
Interest rate swaps (a)
Receive fixed designated to loans $3,460 $172 2.00% 4.08%
Pay fixed designated to loans 67 (7) 6.04 2.80
Basis swaps designated to loans 52 3.52 3.47
Interest rate caps designated to loans (b) 16 NM NM
Interest rate floors designated to loans (c) 7 NM NM
Futures contracts designated to loans 313 NM NM
- ------------------------------------------------------------------------------------------------
Total asset rate conversion 3,915 165
- ------------------------------------------------------------------------------------------------
Liability rate conversion
Interest rate swaps (a)
Receive fixed designated to borrowed funds 2,363 346 3.16 5.93
- ------------------------------------------------------------------------------------------------
Total liability rate conversion 2,363 346
- ------------------------------------------------------------------------------------------------
Total interest rate risk management (d) 6,278 511
- ------------------------------------------------------------------------------------------------
Commercial mortgage banking risk management
Pay fixed interest rate swaps designated to loans held for sale (c) 273 (13) 4.73 4.36
Pay total rate of return swaps designated to loans held for sale (c) 100 (3) NM .88
- ------------------------------------------------------------------------------------------------
Total commercial mortgage banking risk management 373 (16)
- ------------------------------------------------------------------------------------------------
Total financial derivatives designated for risk management $6,651 $495
===============================================================================================================================
(a) The floating rate portion of interest rate contracts is based on
money-market indices. As a percent of notional value, 60% were based on
1-month LIBOR and 40% on 3-month LIBOR.
(b) Interest rate caps with notional values of $12 million require the
counterparty to pay the Corporation the excess, if any, of 3-month LIBOR
over a weighted-average strike of 6.50%. In addition, interest rate caps
with notional values of $4 million require the counterparty to pay the
excess, if any, of Prime over a weighted-average strike of 5.03%. At
December 31, 2002, 3-month LIBOR was 1.38% and Prime was 4.25%.
(c) Interest rate floors with notional values of $5 million require the
counterparty to pay the excess, if any, of the weighted-average strike of
4.50% over 3-month LIBOR. In addition, interest rate floors with notional
values of $2 million require the counterparty to pay the excess, if any, of
the weighted-average strike of 7.25% over Prime. At December 31, 2002,
3-month LIBOR was 1.38% and Prime was 4.25%.
(d) Fair value amounts include accrued interest of $74 million.
NM- Not meaningful
35
OTHER DERIVATIVES
To accommodate customer needs, PNC enters into customer-related financial
derivative transactions primarily consisting of interest rate swaps, caps,
floors and foreign exchange contracts. Risk exposure from customer positions is
managed through transactions with other dealers.
Additionally, the Corporation enters into other derivative transactions for risk
management purposes that are not designated as accounting hedges, primarily
consisting of interest rate floors and caps and basis swaps. Other noninterest
income for the first six months of 2003 related to the derivatives held for risk
management purposes not designated as accounting hedges was insignificant.
OTHER DERIVATIVES
At June 30, 2003
------------------------------------------------------------------------------
Positive Negative Average
Notional Fair Fair Net Asset Fair
In millions Value Value Value (Liability) Value(a)
- ----------------------------------------------------------------------------------------------------------------------------
Customer-related
Interest rate
Swaps $29,111 $644 $(642) $2 $(9)
Caps/floors
Sold 1,275 (22) (22) (27)
Purchased 1,193 19 19 23
Futures 1,259 1
Foreign exchange 3,562 68 (66) 2 4
Equity 1,421 48 (49) (1) 2
Other 293 15 (5) 10 10
- ----------------------------------------------------------------------------------------------------------------------------
Total customer-related 38,114 794 (784) 10 4
============================================================================================================================
Other risk management and proprietary
Interest rate
Basis swaps 1,153 4 (1) 3 3
Pay fixed swaps 126 1 (3) (2) (1)
Received fixed swaps 8
Other 623 15 (3) 12 8
- ----------------------------------------------------------------------------------------------------------------------------
Total other risk management and proprietary 1,910 20 (7) 13 10
- ----------------------------------------------------------------------------------------------------------------------------
Total other derivatives $40,024 $814 $(791) $23 $14
============================================================================================================================
(a) Represents average for six months ended June 30, 2003.
CREDIT-RELATED INSTRUMENTS
CREDIT DEFAULT SWAPS
Credit default swaps provide, for a fee, an assumption of a portion of the
credit risk associated with the underlying financial instruments. The
Corporation primarily uses such contracts to mitigate credit risk associated
with commercial lending activities. At June 30, 2003, credit default swaps with
$242 million in notional value were used by the Corporation to hedge credit risk
associated with commercial lending activities and are included in the Other
Derivatives table in the Financial And Other Derivatives section of this
Financial Review. The comparable amount was $184 million at December 31, 2002.
Net losses realized in connection with credit default swaps for the six months
ending June 30, 2003 were $2.7 million and $1.8 million in the second quarter of
2003.
INTEREST RATE DERIVATIVE RISK PARTICIPATION AGREEMENTS
The Corporation enters into risk participation agreements to share credit
exposure with other financial counterparties related to interest rate derivative
contracts. Risk participation agreements executed by the Corporation to mitigate
credit risk had a total notional value of $66 million at June 30, 2003 compared
with $43 million at December 31, 2002. Additionally, risk participation
agreements entered into in which the Corporation assumed credit exposure had a
total notional value of $49 million at June 30, 2003 compared with $109 million
at December 31, 2002. These agreements are considered to be financial guarantees
and therefore are not included in the Financial And Other Derivatives section of
this Financial Review.
36
"OFF-BALANCE SHEET" ACTIVITIES
As previously reported, PNC has reputational, legal, operational and fiduciary
risks in virtually every area of its business, many of which are not reflected
in assets and liabilities recorded on the balance sheet, and some of which are
conducted through limited purpose entities known as "special purpose entities."
These activities are part of the banking business and would be found in most
larger financial institutions with the size and activities of PNC. Most of these
involve financial products distributed to customers, trust and custody services,
and servicing, processing and funds transfer services, and the amounts involved
can be quite large in relation to the Corporation's assets, equity and earnings.
See "Off-Balance Sheet Activities" in the Risk Management section of the
Financial Review included in the 2002 Form 10-K for further information.
In January 2003, the FASB issued FIN 46, "Consolidation of Variable Interest
Entities." See Note 1 Accounting Policies in the Notes to Consolidated Financial
Statements for additional information.
MARKET STREET FUNDING CORPORATION
Market Street is a multi-seller asset-backed commercial paper conduit that is
independently owned and managed. The activities of Market Street are limited to
the purchase or making of loans secured by interests primarily in pools of
receivables acquired from U.S. corporations unaffiliated with PNC that desire
access to the commercial paper market. Market Street funds the purchases by
issuing commercial paper. Market Street's commercial paper has been rated A1/P1
by Standard & Poor's and Moody's. Market Street had total assets of $2.7 billion
at June 30, 2003 compared with $3.1 billion at December 31, 2002. See Note 1
Accounting Policies regarding the effect on the accounting for Market Street
from the Corporation's adoption of FIN 46 effective July 1, 2003.
PNC Bank provides certain administrative services, a portion of the
program-level credit enhancement and the majority of the liquidity facilities to
Market Street in exchange for fees negotiated based on market rates. Credit
enhancement is provided in part by PNC Bank in the form of a cash collateral
account which is funded by a credit loan facility with a five-year term expiring
December 31, 2004. At June 30, 2003, approximately $88 million was outstanding
on this facility compared with $96 million at December 31, 2002. An additional
$263 million was provided by a major insurer. Also at June 30, 2003, Market
Street had committed liquidity facilities supporting individual pools of
receivables totaling $3.5 billion, of which $2.7 billion was provided by PNC
Bank. The comparable amounts at December 31, 2002 were $3.9 billion and $3.2
billion, respectively. Credit exposure related to PNC's liquidity facilities
provided to Market Street is included in net unfunded commitments as described
in Loans in the Consolidated Balance Sheet Review section of this Financial
Review.
As Market Street's program administrator, PNC received fees of $5.4 million for
the six months ended June 30, 2003. Commitment fees related to PNC's portion of
the liquidity facilities amounted to $1.6 million for this same time period.
INTERNAL CONTROLS AND DISCLOSURE CONTROLS AND PROCEDURES
As of June 30, 2003, an evaluation was performed under the supervision and with
the participation of the Corporation's management, including the Chairman and
Chief Executive Officer and the Vice Chairman and Chief Financial Officer, of
the effectiveness of the design and operation of the Corporation's disclosure
controls and procedures. Based on that evaluation, the Corporation's management,
including the Chairman and Chief Executive Officer and the Vice Chairman and
Chief Financial Officer, concluded that the Corporation's disclosure controls
and procedures were effective as of June 30, 2003.
There has been no change in the Corporation's internal control over financial
reporting that occurred during the second quarter of 2003 that has materially
affected, or is reasonably likely to materially affect, the Corporation's
internal control over financial reporting.
37
GLOSSARY OF TERMS
Accounting/administration net assets - Domestic and foreign assets for which PNC
provides accounting and administration services. These assets are not included
in PNC's balance sheet.
Adjusted average total assets - Primarily comprised of total average quarterly
assets plus (less) unrealized losses (gains) on available-for-sale debt
securities, less goodwill and certain other intangible assets.
Annualized - Adjusted to reflect a full year of activity.
Assets under management - Assets held by PNC in a fiduciary capacity for
customers/clients. These assets are not included in PNC's balance sheet.
Assigned capital - Economic capital assignments based on management's assessment
of inherent risks and equity levels at independent companies providing similar
products and services in order to present, to the extent practicable, the
financial results of each business as if the business operated on a stand-alone
basis.
Charge-off - Process of removing a loan or portion of a loan from a bank's
balance sheet because the loan is considered uncollectible. A charge-off also is
recorded when a loan is transferred to held for sale and the loan's market value
is less than its carrying amount prior to the transfer. This difference is a
charge-off.
Common shareholders' equity to total assets - Common shareholders' equity
divided by total assets. Common shareholders' equity equals total shareholders'
equity less preferred stock and the portion of capital surplus and retained
interest related to the preferred stock.
Custody assets - Assets held on behalf of clients under a safekeeping
arrangements. Such assets are not reported in PNC's balance sheet. Assets held
in custody accounts at other institutions on behalf of PNC are included in the
appropriate asset categories as if held in the physical custody of PNC.
Earning assets - Assets that generate income, which include: short-term
investments; loans held for sale; loans, net of unearned income; securities;
federal funds sold and certain other assets.
Efficiency ratio - Noninterest expense divided by the sum of net interest income
and noninterest income.
Institutional lending repositioning - A 2001 PNC strategic action taken to build
a more diverse and valuable business mix designed to create shareholder value
over time by reducing lending leverage and improving the risk/return
characteristics of the banking business.
Leverage ratio - Tier 1 risk-based capital divided by adjusted average total
assets.
Net interest margin - Annualized taxable-equivalent net interest income divided
by average earning assets.
Noninterest income to total revenue - Total noninterest income divided by total
revenue. Total noninterest income includes asset management, fund servicing,
service charges on deposits, brokerage, consumer services, corporate services,
equity management, net securities gains (losses) and other noninterest income.
Total revenue includes total noninterest income plus net interest income.
Nonperforming assets - Nonperforming assets include nonaccrual loans, troubled
debt restructured loans, nonaccrual loans held for sale, foreclosed and other
assets.
Nonperforming loans - Nonperforming loans include nonaccrual loans to
commercial, lease financing, consumer, commercial real estate and residential
mortgage customers as well as troubled debt restructured loans. Nonperforming
loans do not include nonaccrual loans held for sale or foreclosed and other
assets.
Operating margin - Operating income divided by total revenue.
Return on assigned capital - Annualized net income divided by assigned capital.
Return on average assets - Annualized earnings divided by average assets.
Earnings can be from net income or continuing operations, as indicated in PNC's
disclosures.
Return on average equity - Annualized earnings divided by average shareholders'
equity. Earnings can be from net income or continuing operations, as indicated
in PNC's disclosures.
Risk-weighted assets - Primarily computed by the assignment of specific
risk-weights, as defined by The Board of Governors of the Federal Reserve
System, to assets and off-balance sheet instruments.
Securitization - The process by which financial assets are legally transformed
into securities.
Shareholders' equity to total assets - Total shareholders' equity divided by
total assets.
Taxable-equivalent interest - The interest income earned on certain earning
assets is completely or partially exempt from federal income tax. As such, these
tax-exempt instruments typically yield lower returns than a taxable investment.
In order to provide accurate comparisons of yields and margins for all earning
assets, the interest income earned on tax-exempt assets is increased to make
them fully equivalent to other taxable interest income investments.
Tier 1 and Total risk-based capital - Terms used by The Board of Governors of
the Federal Reserve System to describe the capital adequacy of a bank holding
company. Refer to the Risk-Based Capital section within the Shareholders' Equity
section of the Consolidated Balance Sheet Review of this Financial Review for
the components of risk-based capital.
Tier 1 risk-based capital ratio - Tier 1 risk-based capital divided by
risk-weighted assets.
Total assets serviced - Domestic and foreign assets for which PNC provides
mutual fund related services. These assets are not included in PNC's balance
sheet.
Total risk-based capital ratio - Total risk-based capital divided by
risk-weighted assets.
38
FORWARD-LOOKING STATEMENTS
This report contains, and other statements that the Corporation may make may
contain, forward-looking statements with respect to the Corporation's outlook or
expectations for earnings, revenues, expenses, capital levels, asset quality or
other future financial or business performance, strategies or expectations, or
the impact of legal, regulatory or supervisory matters on the Corporation's
business operations or performance. Forward-looking statements are typically
identified by words or phrases such as "believe," "feel," "expect,"
"anticipate," "intend," "outlook," "estimate," "forecast," "project,"
"position," "target," "assume," "achievable," "potential," "strategy," "goal,"
"objective," "plan," "aspiration," "outcome," "continue," "remain," "maintain,"
"seek," "strive," "trend" and variations of such words and similar expressions,
or future or conditional verbs such as "will," "would," "should," "could,"
"might," "can," "may" or similar expressions.
The Corporation cautions that forward-looking statements are subject to numerous
assumptions, risks and uncertainties, which change over time. Forward-looking
statements speak only as of the date they are made, and the Corporation assumes
no duty and does not undertake to update forward-looking statements. Actual
results could differ materially from those anticipated in forward-looking
statements and future results could differ materially from historical
performance.
In addition to factors mentioned elsewhere in this report or previously
disclosed in the Corporation's SEC reports (accessible on PNC's website at
www.pnc.com and on the SEC's website at www.sec.gov), the following factors,
among others, could cause actual results to differ materially from those
anticipated in forward-looking statements or from historical performance:
(1) changes in political, economic or industry conditions, the interest rate
environment or financial and capital markets, which if adverse could result in:
a deterioration in credit quality, increased credit losses, and increased
funding of unfunded loan commitments and letters of credit; an adverse effect on
the allowances for credit losses and unfunded loan commitments and letters of
credit; a reduction in demand for credit or fee-based products and services; a
reduction in net interest income, value of assets under management and assets
serviced, value of private equity investments and of other debt and equity
investments, value of loans held for sale or value of other on-balance sheet and
off-balance sheet assets; or changes in the availability and terms of funding
necessary to meet PNC's liquidity needs;
(2) relative and absolute investment performance of assets under management;
(3) the introduction, withdrawal, success and timing of business initiatives and
strategies, decisions regarding further reductions in balance sheet leverage,
the timing and pricing of any sales of loans held for sale, and PNC's inability
to realize cost savings or revenue enhancements, or to implement integration
plans relating to or resulting from mergers, acquisitions, restructurings and
divestitures;
(4) customer borrowing, repayment, investment and deposit practices and their
acceptance of PNC's products and services;
(5) the impact of increased competition;
(6) how PNC chooses to redeploy available capital, including the extent and
timing of any share repurchases and acquisitions or other investments in PNC
businesses;
(7) the inability to manage risks inherent in PNC's business;
(8) the unfavorable resolution of legal proceedings or government inquiries; the
impact of increased litigation risk from recent regulatory and other
governmental developments; and the impact of reputational risk created by recent
regulatory and other governmental developments on such matters as business
generation and retention, the ability to attract and retain management,
liquidity and funding;
(9) the denial of insurance coverage for claims made by PNC;
(10) an increase in the number of customer or counterparty delinquencies,
bankruptcies or defaults that could result in, among other things, increased
credit and asset quality risk, a higher provision for credit losses and reduced
profitability;
(11) the impact, extent and timing of technological changes, the adequacy of
intellectual property protection and costs associated with obtaining rights in
intellectual property claimed by others;
(12) actions of the Federal Reserve Board;
(13) the impact of legislative and regulatory reforms and changes in accounting
policies and principles;
(14) the impact of the regulatory examination process, the Corporation's failure
to satisfy the requirements of written agreements with regulatory and other
governmental agencies, and regulators' future use of supervisory and enforcement
tools; and
(15) terrorist activities and international hostilities which may adversely
affect the general economy, financial and capital markets, specific industries,
and the Corporation.
Factors relating to credit risk, operational risk, liquidity risk, market risk
(including interest rate risk, equity management risk and trading risk),
financial and other derivatives, and off-balance sheet activities are discussed
in the Risk Management section of this Financial Review. Other risk factors are
described in the Risk Factors section and elsewhere in this report or in the
Business section of the Corporation's 2002 Form 10-K.
39
CONSOLIDATED STATEMENT OF INCOME
THE PNC FINANCIAL SERVICES GROUP, INC.
Three months ended June 30 Six months ended June 30
------------------------------- -------------------------------
In millions, except per share data 2003 2002 2003 2002
Unaudited
- ----------------------------------------------------------------------------------------------------------------------------------
INTEREST INCOME
Loans and fees on loans $495 $588 $1,002 $1,187
Securities 155 149 298 326
Loans held for sale 15 41 27 93
Other 27 26 57 56
- ----------------------------------------------------------------------------------------------------------------------------------
Total interest income 692 804 1,384 1,662
- ----------------------------------------------------------------------------------------------------------------------------------
INTEREST EXPENSE
Deposits 117 172 249 348
Borrowed funds 54 77 111 169
- ----------------------------------------------------------------------------------------------------------------------------------
Total interest expense 171 249 360 517
- ----------------------------------------------------------------------------------------------------------------------------------
Net interest income 521 555 1,024 1,145
Provision for credit losses 57 89 93 171
- ----------------------------------------------------------------------------------------------------------------------------------
Net interest income less provision for credit losses 464 466 931 974
- ----------------------------------------------------------------------------------------------------------------------------------
NONINTEREST INCOME
Asset management 209 230 416 451
Fund servicing 188 217 381 429
Service charges on deposits 60 55 117 109
Brokerage 46 55 87 110
Consumer services 64 61 123 116
Corporate services 114 149 230 267
Equity management (17) (13) (21) (15)
Net securities gains 26 16 82 20
Other 86 100 156 173
- ----------------------------------------------------------------------------------------------------------------------------------
Total noninterest income 776 870 1,571 1,660
- ----------------------------------------------------------------------------------------------------------------------------------
NONINTEREST EXPENSE
Staff expense 446 441 884 871
Net occupancy 64 59 154 117
Equipment 69 67 138 135
Marketing 18 13 33 26
Distributions on capital securities 14 14 28 29
Other 324 245 554 468
- ----------------------------------------------------------------------------------------------------------------------------------
Total noninterest expense 935 839 1,791 1,646
- ----------------------------------------------------------------------------------------------------------------------------------
Income before minority interest and income taxes 305 497 711 988
Minority interest in income of consolidated entities 13 12 24 22
Income taxes 108 165 241 329
- ----------------------------------------------------------------------------------------------------------------------------------
Net income $184 $320 $446 $637
==================================================================================================================================
EARNINGS PER COMMON SHARE
Basic $.65 $1.13 $1.58 $2.25
Diluted $.65 $1.12 $1.57 $2.23
AVERAGE COMMON SHARES OUTSTANDING
Basic 281 283 282 283
Diluted 282 285 283 285
==================================================================================================================================
See accompanying Notes to Consolidated Financial Statements.
40
CONSOLIDATED BALANCE SHEET
THE PNC FINANCIAL SERVICES GROUP, INC.
In millions, except par value June 30 December 31
Unaudited 2003 2002
- ---------------------------------------------------------------------------------------------------------------------------------
ASSETS
Cash and due from banks $3,797 $3,201
Federal funds sold 850 1,847
Other short-term investments 1,554 1,811
Loans held for sale 1,475 1,607
Securities 16,017 13,763
Loans, net of unearned income of $1,018 and $1,075 34,534 35,450
Allowance for credit losses (673) (673)
- ---------------------------------------------------------------------------------------------------------------------------------
Net loans 33,861 34,777
Goodwill 2,356 2,313
Other intangible assets 316 333
Other 7,036 6,725
- ---------------------------------------------------------------------------------------------------------------------------------
Total assets $67,262 $66,377
=================================================================================================================================
LIABILITIES
Deposits
Noninterest-bearing $13,368 $10,563
Interest-bearing 33,326 34,419
- ---------------------------------------------------------------------------------------------------------------------------------
Total deposits 46,694 44,982
Borrowed funds
Federal funds purchased 36 38
Repurchase agreements 1,015 814
Bank notes and senior debt 3,306 4,400
Federal Home Loan Bank borrowings 1,134 1,256
Subordinated debt 2,260 2,423
Other borrowed funds 152 185
- ---------------------------------------------------------------------------------------------------------------------------------
Total borrowed funds 7,903 9,116
Allowance for unfunded loan commitments and letters of credit 78 84
Accrued expenses 2,269 2,046
Other 2,435 2,172
- ---------------------------------------------------------------------------------------------------------------------------------
Total liabilities 59,379 58,400
- ---------------------------------------------------------------------------------------------------------------------------------
Minority interest 261 270
Mandatorily redeemable capital securities of subsidiary trusts 848 848
SHAREHOLDERS' EQUITY
Common stock - $5 par value
Authorized 800 shares, issued 353 shares 1,764 1,764
Capital surplus 1,100 1,101
Retained earnings 7,360 7,187
Deferred benefit expense (28) (9)
Accumulated other comprehensive income 305 321
Common stock held in treasury at cost: 73 and 68 shares (3,727) (3,505)
- ---------------------------------------------------------------------------------------------------------------------------------
Total shareholders' equity 6,774 6,859
- ---------------------------------------------------------------------------------------------------------------------------------
Total liabilities, minority interest, capital securities and
shareholders' equity $67,262 $66,377
=================================================================================================================================
See accompanying Notes to Consolidated Financial Statements.
41
CONSOLIDATED STATEMENT OF CASH FLOWS
THE PNC FINANCIAL SERVICES GROUP, INC.
Six months ended June 30 - in millions
Unaudited 2003 2002
- ---------------------------------------------------------------------------------------------------------------------------------
OPERATING ACTIVITIES
Net income $446 $637
Adjustments to reconcile net income
to net cash provided by operating activities
Provision for credit losses 93 171
Depreciation, amortization and accretion 142 115
Deferred income taxes 106 226
Securities transactions (82) (20)
Valuation adjustments (7) 30
Change in
Loans held for sale 129 1,948
Other short-term investments 257 (460)
Other (184) 66
- ---------------------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 900 2,713
- ---------------------------------------------------------------------------------------------------------------------------------
INVESTING ACTIVITIES
Net change in
Loans 1,291 1,480
Federal funds sold 997 (1,100)
Repayment of securities 3,039 1,346
Sales
Securities 5,654 7,858
Loans 1
Foreclosed assets 7 5
Purchases
Securities (10,658) (7,181)
Loans (476) (22)
Net cash received (paid) for divestitures/acquisitions 7 (1,676)
Other (100) (118)
- ---------------------------------------------------------------------------------------------------------------------------------
Net cash (used) provided by investing activities (238) 592
- ---------------------------------------------------------------------------------------------------------------------------------
FINANCING ACTIVITIES
Net change in
Noninterest-bearing deposits 2,805 (897)
Interest-bearing deposits (1,093) (1,980)
Federal funds purchased (2) (130)
Repurchase agreements 201 17
Sales/issuances
Other borrowed funds 11,628 11,591
Common stock 65 72
Repayments/maturities
Bank notes and senior debt (1,105) (954)
Federal Home Loan Bank borrowings (122) (770)
Subordinated debt (187)
Other borrowed funds (11,661) (11,424)
Acquisition of treasury stock (322) (45)
Cash dividends paid (273) (273)
- ---------------------------------------------------------------------------------------------------------------------------------
Net cash used by financing activities (66) (4,793)
- ---------------------------------------------------------------------------------------------------------------------------------
INCREASE (DECREASE) IN CASH AND DUE FROM BANKS 596 (1,488)
Cash and due from banks at beginning of period 3,201 4,327
- ---------------------------------------------------------------------------------------------------------------------------------
Cash and due from banks at end of period $3,797 $2,839
=================================================================================================================================
CASH PAID FOR
Interest $368 $521
Income taxes 12 56
NON-CASH ITEMS
Transfer (to) from loans (from) to loans held for sale, net (10) 166
Transfer from loans to other assets 8 9
=================================================================================================================================
See accompanying Notes to Consolidated Financial Statements.
42
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THE PNC FINANCIAL SERVICES GROUP, INC.
BUSINESS
The PNC Financial Services Group, Inc. ("Corporation" or "PNC") is one of the
largest diversified financial services companies in the United States, operating
businesses engaged in regional community banking; wholesale banking including
corporate banking, real estate finance and asset-based lending; wealth
management; asset management and global fund processing services. The
Corporation provides certain products and services nationally and others in
PNC's primary geographic markets in Pennsylvania, New Jersey, Delaware, Ohio and
Kentucky. The Corporation also provides certain banking, asset management and
global fund processing services internationally. PNC is subject to intense
competition from other financial services companies and is subject to regulation
by various domestic and international authorities.
NOTE 1 ACCOUNTING POLICIES
BASIS OF FINANCIAL STATEMENT PRESENTATION
The unaudited consolidated interim financial statements ("consolidated financial
statements") include the accounts of PNC and its subsidiaries, most of which are
wholly owned, and certain general partnership interests. Such statements have
been prepared in accordance with accounting principles generally accepted in the
United States of America ("generally accepted accounting principles" or "GAAP").
All significant intercompany accounts and transactions have been eliminated.
Certain prior-period amounts have been reclassified to conform with the current
period presentation. These reclassifications did not impact the Corporation's
consolidated financial condition or results of operations.
In the opinion of management, the consolidated financial statements reflect all
adjustments of a normal recurring nature necessary for a fair statement of
results for the interim periods presented.
In preparing the consolidated financial statements, management is required to
make estimates and assumptions that affect the amounts reported. Actual results
may differ from such estimates and the differences may be material to the
consolidated financial statements.
The notes included herein should be read in conjunction with the audited
consolidated financial statements included in PNC's 2002 Annual Report on Form
10-K ("2002 Form 10-K").
INVESTMENTS
PNC has interests in various types of investments. The accounting for these
investments is dependent on a number of factors including, but not limited to,
items such as marketability of the investment, ownership interest, PNC's intent
and the nature of the investment.
Venture capital investments, which include direct investments in companies,
interests in limited partnerships, and general partnership interests, are
reported at estimated fair values. These estimates are based upon available
information and may not necessarily represent amounts that will ultimately be
realized through distribution, sale or liquidation of the investment. The
valuation procedures applied to direct investments include techniques such as
multiples cash flow of the entity, independent appraisals of the entity or the
pricing used to value the entity in a recent financing transaction. Limited
partnership investments are valued based on the financial statements received
from the general partner, an independent third party. All venture capital
investments are included in the consolidated balance sheet under other assets.
Changes in the fair value of these assets are recognized in noninterest income.
Venture capital investments are consolidated when PNC is the sole general
partner in a limited partnership and the determination has been made that PNC
has control.
Equity investments other than venture capital investments are accounted for
under one of the following methods:
- - Marketable equity securities are accounted for at fair value based on the
securities' quoted market prices from a national securities exchange. Those
purchased with the intention of recognizing short-term profits are placed
in the trading account, carried at market value and classified as
short-term investments. Gains and losses on trading securities are included
in noninterest income. Marketable equity securities not classified as
trading are designated as securities available for sale and are carried at
fair value with unrealized gains and losses, net of income taxes, reflected
in accumulated other comprehensive income or loss.
- - Investments in nonmarketable equity securities are recorded using the cost
or equity method of accounting. The cost method is used for those
investments in which PNC does not have significant influence over the
investee. Under this method, there is no change to the cost basis unless
there is an other than temporary decline in value. If the decline is
determined to be other than temporary, the cost basis of the investment is
written down to a new cost basis that represents realizable value and the
amount of the write-down is accounted for as a realized loss in the period
in which the decline occurs. Dividends received on cost investments are
included in noninterest income. The equity method is used for those
investments in which PNC can have significant influence over the operations
of the investee. Under the equity method, PNC records its equity ownership
share of the net income or loss of the investee in noninterest income. PNC
records its nonmarketable equity securities in other assets.
43
Investments in limited partnerships are accounted for under either the cost
method or the equity method as described above for nonmarketable equity
securities. The equity method is used if PNC's limited partner ownership
interest in the partnership is greater than 3% to 5%. For the remaining limited
partnership investments, the cost method is used. Limited partnership
investments are included in other assets.
Investments are consolidated when PNC is the sole general partner in a limited
partnership and the determination has been made that PNC has control.
Unconsolidated general partnership interests where the determination has been
made that PNC does not have control are accounted for under the equity method.
Debt securities are classified as securities and carried at amortized cost if
management has the positive intent and ability to hold the securities to
maturity. Debt securities purchased with the intention of recognizing
short-term profits are placed in the trading account, carried at market value
and classified as short-term investments. Gains and losses on these securities
are included in noninterest income. Debt securities not classified as held to
maturity or trading are designated as securities available for sale and carried
at fair value with unrealized gains and losses, net of income taxes, reflected
in accumulated other comprehensive income or loss.
Interest on debt securities, including amortization of premiums and accretion of
discounts using the interest method, is included in interest income. Gains and
losses realized on the sale of debt securities available for sale are computed
on a specific security basis and included in noninterest income.
SPECIAL PURPOSE ENTITIES
Special Purpose Entities ("SPEs") are broadly defined as legal entities
structured for a particular purpose. PNC utilizes SPEs in various legal forms to
conduct normal business activities including the sale or transfer of assets to
third parties. SPEs that meet the criteria for a Qualifying Special Purpose
Entity ("QSPE") as defined in Statement of Financial Accounting Standards
("SFAS") No. 140, "Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities," are not required to be consolidated. SPEs
that are not QSPEs are reviewed for consolidation based on each SPE's individual
structure and operations. General factors to be considered in making this
determination include whether the majority owner (or owners) of the SPE is
independent of PNC, has made a substantive capital investment in the SPE, has
control of the SPE, or possesses the substantive risks and rewards of ownership
of the SPE.
In response to demands to strengthen existing accounting guidance regarding the
consolidation of SPEs and other off-balance sheet entities, in January 2003 the
Financial Accounting Standards Board ("FASB") issued FASB Interpretation No.
("FIN") 46, "Consolidation of Variable Interest Entities".
In general, a variable interest entity ("VIE") is a corporation, partnership,
limited liability corporation, trust, grantor trust or any other legal
structure used to conduct activities or hold assets that either does not have
equity investors with voting rights that can directly or indirectly make
decisions about the entity's activities through those voting rights or similar
rights or has equity investors that do not provide sufficient financial
resources for the entity to support its activities. A VIE often holds financial
assets, including loans or receivables, real estate or other property.
FIN 46 requires a VIE to be consolidated if the entity is subject to a majority
of the risk of loss from the VIE's activities, is entitled to receive a
majority of the entity's residual returns or both. An entity that consolidates
the VIE is called the primary beneficiary. Upon consolidation, the
primary beneficiary generally must record all of the VIE's assets, liabilities
and noncontrolling interests at fair value with subsequent changes based upon
consolidation principles. FIN 46 also requires disclosures about VIEs that the
entity is not required to consolidate but in which it has a significant
variable interest.
The consolidation requirements of FIN 46 applied immediately to VIEs created
after January 31, 2003. For VIEs that existed prior to that date, the
consolidation requirements are effective as of July 1, 2003.
Based on a review of the provisions of FIN 46, it is reasonably possible that
PNC and/or BlackRock hold a significant variable interest in certain existing
entities currently classified as VIEs that will require the Corporation to
consolidate these entities effective as of July 1, 2003. However, the FASB staff
and representatives of the accounting profession and various industry groups
continue to discuss specific interpretative and implementation issues regarding
FIN 46. The results of these discussions could change management's assessment
and may eliminate the requirement to consolidate these entities in the third
quarter of 2003. A description of these entities follows:
- - PNC Bank, N.A. ("PNC Bank") provides credit enhancement, liquidity
facilities and certain administrative services to Market Street Funding
Corporation ("Market Street"), a multi-seller asset-backed commercial paper
conduit that is independently owned and managed. The activities of Market
Street are limited to the purchase of, or making of, loans secured by
interests primarily in pools of receivables from U.S. corporations that
desire access to the commercial paper market. Market Street funds the
purchases by issuing commercial paper. Market Street's commercial paper has
been rated A1/P1 by Standard & Poor's and Moody's. Market Street had total
assets of $2.7 billion and total liabilities of $2.7 billion at June 30,
2003. PNC Bank provides certain administrative
44
services, a portion of the program-level credit enhancement and the
majority of liquidity facilities to Market Street in exchange for fees
negotiated based on market rates. Credit enhancement is provided in part by
PNC Bank in the form of a cash collateral account which is funded by credit
loan facility with a five-year term expiring on December 31, 2004. At June
30, 2003, approximately $88 million was outstanding on this facility. An
additional $263 million was provided by a major insurer. Also at June 30,
2003, Market Street had committed liquidity facilities available supporting
individual pools of receivables totaling $3.5 billion, of which $2.7
billion was provided by PNC Bank. As Market Street's program administrator,
PNC received fees of $5.4 million for the six months ended June 30, 2003.
Commitment fees related to PNC's portion of the liquidity facilities
amounted to $1.6 million for the six months ended June 30, 2003. PNC holds
no ownership interest in Market Street.
- - BlackRock, Inc. ("BlackRock"), a majority-owned subsidiary of PNC, acts as
collateral asset manager for four collateralized bond obligation funds and
one collateralized loan obligation fund (collectively referred to as
"CBOs") organized as corporations or limited liability companies. The funds
invest in high yield securities and offer opportunity for high return and
are subject to greater risk than traditional investment products. These
funds are structured to take advantage of the yield differential between
their assets and liabilities and have terms to maturity from eight to
twelve years. At June 30, 2003, aggregate assets and debt in the CBOs were
approximately $2.3 billion and $2.0 billion, respectively. If such assets
and debt are required to be recorded, BlackRock would disclose that it
claims no title to the assets and such liabilities are without recourse to
BlackRock. In its role as collateral manager for the CBOs, BlackRock is not
exposed to risk of loss with respect to the CBOs' debts. BlackRock's equity
ownership in these fund was approximately $14.4 million at June 30, 2003.
BlackRock's maximum potential loss related to these VIEs is limited to the
amount of its respective equity ownership in each of these investment
vehicles and consequently BlackRock has no risk of loss with respect to the
debt of these investment vehicles. Additionally, BlackRock has neither
guaranteed nor is contractually liable for any of the VIEs' obligations.
In connection with the potential consolidation of the CBOs' assets,
liabilities and results of operations effective July 1, 2003, BlackRock
would record a charge to earnings in the third quarter 2003 representing
the difference between the carrying amounts of BlackRock's investments in
these entities accounted for under SFAS No. 115, "Accounting for Certain
Investments in Debt and Equity Securities," BlackRock's current accounting
treatment, and the requirements under FIN 46. The charge is not expected
to be material.
- - PNC Real Estate Finance makes equity investments in various limited
partnerships that sponsor affordable housing projects utilizing the Low
Income Housing Tax Credit ("LIHTC") pursuant to Section 42 of the Internal
Revenue Code. The purpose of these investments is to achieve a satisfactory
return on capital, to facilitate the sale of additional affordable housing
product offerings and to assist PNC in achieving goals associated with the
Community Reinvestment Act. The activities of the limited partnerships
include the identification, development and operation of multi-family
housing that is leased to qualifying residential tenants generally within
PNC's primary geographic region. The investments are funded through a
combination of debt and equity, with equity typically comprising 30% to 60%
of the total project capital. At June 30, 2003, PNC's maximum exposure to
loss resulting from those LIHTC investments in which PNC owns a 50% or
greater interest and which are subject to the provisions of FIN 46 was $147
million. This represents the combination of a recorded basis of $115
million and unfunded commitments of $32 million.
In addition to the equity investments in various limited partnerships
discussed above, PNC Real Estate Finance through PNC MultiFamily Capital is
a national syndicator of affordable housing equity. In these syndication
transactions, PNC creates funds in which PNC is the general partner, and in
some cases may also purchase a limited partnership interest in the fund.
The fund's limited partners can remove the general partner without cause at
any time. The purpose of this business is to generate income from the
syndication of these funds and to generate servicing fees from the
management of the funds. General partner activities include selecting,
evaluating, structuring, negotiating, and closing the fund's investments in
operating limited partnerships, as well as oversight of the ongoing
operations of the fund portfolio. Through June 30, 2003, the total proceeds
raised from the syndication of these funds was $945 million. At June 30,
2003, the net book value of PNC's partnership interests in these funds was
$61 million and unfunded commitments totaled $7 million. Accordingly, PNC's
maximum loss exposure to these funds was $68 million as of June 30, 2003.
- - Within the PNC Advisors' business segment, PNC GPI, Inc. ("GPI"), a wholly
owned subsidiary of the Corporation, is the general partner and in some
cases the commodity pool operator for, and PNC Bank is the investment
manager for, a number of private investment funds organized as limited
partnerships. In addition, PNC Bank is the investment manager for, and GPI
is the commodity pool operator for, two private investment funds organized
as offshore corporations. At June 30, 2003, the aggregate value of the
assets of these funds was $788 million. The value of GPI's ownership
interest at June 30, 2003 was $2.4 million, representing PNC's maximum loss
exposure to these funds.
45
As previously reported, beginning in 2003 BlackRock acts as trading adviser and
special member to an entity which has created a series of municipal securities
trusts in which it has retained interests. These trusts purchase fixed-rate,
long-term, highly rated, insured or escrowed municipal bonds financed by the
issuance of trust certificates. BlackRock management currently believes that
BlackRock is not the primary beneficiary of this entity and consolidation will
not be required as of July 1, 2003.
Management finalized changes to the equity ownership and/or control structure of
certain hedge funds, previously identified in the 2002 Form 10-K, that
management believes removed them from the scope of FIN 46.
Also, management currently believes that the private equity fund previously
identified in the 2002 Form 10-K for which a subsidiary of the Corporation acts
as the investment manager is not required to be consolidated under the
provisions of FIN 46.
DEPRECIATION AND AMORTIZATION
For financial reporting purposes, premises and equipment are depreciated
principally using the straight-line method over their estimated useful lives.
Accelerated methods are used for federal income tax purposes.
The estimated useful lives used for furniture and equipment range from one to 10
years, while buildings are depreciated over an estimated useful life of 39
years. Leasehold improvements are amortized over their estimated useful lives of
up to 10 years, or the respective lease terms, whichever is shorter.
STOCK-BASED COMPENSATION
Prior to January 2003, the Corporation accounted for employee stock-based
compensation plans under the recognition and measurement provisions of
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to
Employees," and related interpretations. No stock-based employee compensation
expense related to stock options was reflected in net income prior to 2003 as
all options to purchase PNC and subsidiary stock granted under these plans had
an exercise price equal to the market value of the underlying stock on the date
of grant. Effective January 1, 2003, the Corporation adopted the fair value
recognition provisions of SFAS No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123"), as amended by SFAS No. 148, "Accounting for
Stock-Based Compensation-Transition and Disclosure," prospectively to all
employee awards granted, modified or settled after January 1, 2003. Results for
prior years have not been restated. The cost related to stock-based employee
compensation included in net income for the three months and six months ended
June 30, 2003, is less than that which would have been recognized if the fair
value based method had been applied to all awards since the original effective
date of SFAS 123. The following table illustrates the effect on net income and
earnings per share if the Corporation had applied the fair value recognition
provisions of SFAS 123, as amended, to all outstanding and unvested awards in
each period.
PRO FORMA NET INCOME AND EARNINGS PER SHARE
Three months ended Six months ended
------------------ -----------------
In millions, except for June 30 June 30 June 30 June 30
per share data 2003 2002 2003 2002
- ----------------------------------------------------------------------------
Net income as reported $184 $320 $446 $637
Add: Stock-based
employee compensation
expense included in
reported net income, net
of related tax effects 5 1 10 4
Deduct: Total stock-based
employee compensation
expense determined under
the fair value method for
all awards, net of
related tax effects (12) (12) (24) (26)
- -----------------------------------------------------------------------------
Pro forma net income $177 $309 $432 $615
- -----------------------------------------------------------------------------
Earnings per share
Basic-as reported $.65 $1.13 $1.58 $2.25
Basic-pro forma $.63 $1.09 $1.53 $2.17
Diluted-as reported $.65 $1.12 $1.57 $2.23
Diluted-pro forma $.63 $1.08 $1.53 $2.16
=============================================================================
For purposes of computing the 2003 stock option expense and pro forma results,
the Corporation estimated the fair value of stock options and employee stock
purchase plan shares using the Black-Scholes option pricing model. The model
requires the use of numerous assumptions, many of which are highly subjective in
nature. Therefore, the pro forma results are estimates of results of operations
as if compensation expense had been recognized for all stock-based compensation
awards and are not indicative of the impact on future periods. The following
assumptions were used in the option pricing model for purposes of estimating pro
forma results as well as 2003 stock option expense.
OPTION PRICING ASSUMPTIONS
- ---------------------------------------------------------------
Weighted-average for the six months
ended June 30 2003 2002
- ---------------------------------------------------------------
Risk-free interest rate 2.9% 4.6%
Dividend yield 3.5% 3.5%
Volatility 26.6% 26.5%
Expected life 5 yrs. 5 yrs.
===============================================================
46
NOTE 2 NBOC ACQUISITION
In January 2002, PNC Business Credit acquired a portion of National Bank of
Canada's ("NBOC") U.S. asset-based lending business in a purchase business
combination. With this acquisition, PNC Business Credit established six new
marketing offices. The transaction was designed to allow PNC to acquire the
higher-quality portion of the portfolio, and provide NBOC a means for the
orderly liquidation and exit of the remaining portfolio.
PNC acquired 245 lending customer relationships representing approximately $2.6
billion of credit exposure including $1.5 billion of loans outstanding with the
balance representing unfunded loan commitments. PNC also acquired certain other
assets and assumed liabilities resulting in a total acquisition cost of
approximately $1.8 billion that was paid primarily in cash. Goodwill recorded
was approximately $277 million, of which approximately $101 million is
non-deductible for federal income tax purposes. The results of the acquired
business have been included in results of operations for PNC Business Credit
since the acquisition date.
NBOC retained a portfolio ("Serviced Portfolio") totaling approximately $662
million of credit exposure including $463 million of outstandings, which was
serviced by PNC for an 18-month term. The Serviced Portfolio retained by NBOC
primarily represented the portion of NBOC's U.S. asset-based loan portfolio with
the highest risk. The loans were either to borrowers with deteriorating trends
or with identified weaknesses which, if not corrected, could jeopardize full
satisfaction of the loans or in industries to which PNC Business Credit wants to
limit its exposure. Approximately $138 million of the Serviced Portfolio
outstandings were nonperforming on the acquisition date. At the end of the
servicing term, NBOC had the right to transfer the then remaining Serviced
Portfolio to PNC ("Put Option"). NBOC's and PNC's strategy has been to
aggressively liquidate the Serviced Portfolio during the servicing term. During
the first quarter of 2003, NBOC notified PNC of its exercise of the Put Option
effective July 15, 2003 as further discussed below.
NBOC retained significant risks and rewards of owning the Serviced Portfolio,
including realized credit losses, during the servicing term as described below.
NBOC assigned $24 million of specific reserves to certain of the loans in the
Serviced Portfolio. Additionally, NBOC absorbs realized credit losses on the
Serviced Portfolio in addition to the specific reserves on individual identified
loans. During the servicing term, the realized credit losses in the Serviced
Portfolio exceeded $50 million plus the specific reserves, and PNC Business
Credit advanced cash to NBOC for these excess losses net of recoveries ("Excess
Loss Payments").
As part of the allocation of the purchase price for the business acquired, PNC
Business Credit established a liability of $112 million to reflect its
obligation under the Put Option. An independent third party valuation firm
valued the Put Option by estimating the difference between the anticipated fair
value of loans from the Serviced Portfolio expected to be outstanding at the put
date and the anticipated Put Option purchase price. At June 30, 2003, the Put
Option liability was approximately $43 million, a decline of $14 million from
December 31, 2002. A $7 million reduction from the acquisition date amount has
been recognized in earnings for the first six months of 2003 as other
noninterest income. In addition, $7 million was paid to NBOC as Excess Loss
Payments during the six months ended June 30, 2003.
Prior to closing of the acquisition, PNC Business Credit transferred $49 million
of nonperforming loans to NBOC in a transaction accounted for as a financing.
Those loans are subject to the terms of the servicing agreement and are included
in the Serviced Portfolio amounts set forth above. The loans were transferred to
loans held for sale on PNC's balance sheet at a loss of $9.9 million, which was
recognized as a charge-off in the first quarter of 2002. The carrying amount of
those loans held for sale was zero at June 30, 2003. Excluding these loans, the
Serviced Portfolio in January 2002 was $608 million of credit exposure including
$414 million of outstandings of which $88 million was nonperforming. At June 30,
2003, comparable amounts were $169 million, $126 million and $42 million,
respectively. Credit exposure and outstandings have declined over 70% since the
acquisition date.
NBOC exercised the Put Option effective July 15, 2003. The loans were recorded
at the purchase price of $121 million net of the remaining Put Option liability
of $43 million as determined by an independent third party. The net recorded
amount of $78 million equaled the fair value of the loans on July 15, 2003. This
amount was comparable to the fair value at June 30, 2003, and represented
approximately 65% of the purchase price of the loans. PNC recorded the loans in
the exit portfolio and will continue to liquidate these loans in an orderly
manner.
NOTE 3 RECENT ACCOUNTING PRONOUNCEMENTS
In January 2003, the FASB issued FIN 46. See the Special Purpose Entities
section of Note 1 Accounting Policies for further information.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." This statement amends and
clarifies SFAS No. 133 for derivatives, including certain derivative instruments
embedded in other contracts, and for hedging activities under SFAS No. 133.
Except for certain specific implementation issues and provisions, the statement
is effective for contracts entered into or modified after (and for hedging
relationships designated after) June 30, 2003. The Corporation plans to adopt
SFAS No. 149 prospectively as of July 1, 2003 and it is not expected to have a
material impact on PNC's consolidated financial statements.
47
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity." This statement
requires that certain financial instruments, which under prior GAAP could be
designated as equity, be classified as liabilities on the balance sheet. SFAS
No. 150 is effective for certain financial instruments entered into or modified
after May 31, 2003, and otherwise is effective July 1, 2003 for PNC.
The Corporation currently classifies its mandatorily redeemable capital
securities of subsidiary trusts in the mezzanine section of the Consolidated
Balance Sheet. These securities will be reclassified as debt under the
provisions of SFAS No. 150 effective July 1, 2003. Additionally, the related
dividends will be reclassified and included in interest expense in the
Consolidated Statement of Income. While the adoption of SFAS No. 150 is not
expected to have a material effect on PNC's consolidated financial statements,
the effect of reclassifying dividends to interest expense will decrease the
Corporation's net interest margin by approximately 10 basis points.
NOTE 4 CASH FLOWS
During the first six months of 2003, divestiture activity that affected cash
flows included a cash receipt of $20 million related to the January 2003
settlement of all issues in dispute between the Corporation and Washington
Mutual, FA, in connection with the 2001 sale of the Corporation's residential
mortgage banking business. The settlement was reported in PNC's fourth quarter
2002 results as a $16 million after-tax loss from discontinued operations. Also
during the first quarter of 2003, PNC purchased the minority interests in PFPC,
representing approximately 2% of PFPC outstanding common stock, from other PFPC
shareholders and cashed out or converted all outstanding PFPC stock options. Net
cash outflows during the first six months of 2003 related to the PFPC actions
totaled $42 million. During the second quarter of 2003, BlackRock entered into a
binding agreement with an investment manager of a fund of hedge funds to
purchase 80% of its outstanding equity for approximately $4 million in cash. On
June 30, 2003, PFPC completed the previously announced agreement to sell its
retirement services business to Wachovia Corp. which resulted in net cash
proceeds of $33 million.
During the first six months of 2002, acquisition activity that affected cash
flows consisted of $1.736 billion of acquired assets and $60 million of acquired
liabilities, resulting in net cash disbursements of $1.676 billion. This
activity consisted solely of the NBOC acquisition as described in Note 2.
NOTE 5 TRADING ACTIVITIES
Most of PNC's trading activities are designed to provide capital markets
services to customers and not to position the Corporation's portfolio for gains
from market movements. PNC participates in derivatives and foreign exchange
trading as well as underwriting and "market making" in equity securities as an
accommodation to customers. PNC also engages in trading activities as part of
risk management strategies.
Net trading income for the first six months of 2003 totaled $60 million compared
with $53 million for the prior-year period and was included in noninterest
income as follows:
DETAILS OF TRADING ACTIVITIES
Six months ended June 30 - in millions 2003 2002
- ---------------------------------------------------------------
Other noninterest income
Securities underwriting and trading $37 $30
Derivatives trading 10 10
Foreign exchange 13 13
- ---------------------------------------------------------------
Net trading income $60 $53
===============================================================
NOTE 6 LEGAL PROCEEDINGS
On June 2, 2003, PNC ICLC Corp. ("PNCICLC"), an indirect non-bank subsidiary of
the Corporation, entered into a Deferred Prosecution Agreement (the "Deferred
Prosecution Agreement") with the United States Department of Justice, Criminal
Division, Fraud Section (the "Department of Justice"). A copy of the Deferred
Prosecution Agreement is attached as Exhibit 99.1 to the Current Report on Form
8-K filed by the Corporation on June 2, 2003 (the "Form 8-K"). Pursuant to the
terms of the Deferred Prosecution Agreement, the United States filed a criminal
complaint in the United States District Court for the Western District of
Pennsylvania charging PNCICLC with conspiracy to commit securities fraud, in
violation of Title 18, United States Code, Section 371. The Deferred Prosecution
Agreement relates to the three 2001 transactions (the "PAGIC transactions") that
gave rise to a financial statement restatement announced by the Corporation on
January 29, 2002 and that were the subject of a July 2002 consent order between
the Corporation and the United States Securities and Exchange Commission.
The Department of Justice has recommended to the District Court that the
prosecution of PNCICLC be deferred for a period of twelve months in light of
PNCICLC's exceptional remedial actions to date and its willingness to
acknowledge responsibility for its behavior, continue its cooperation with the
Department of Justice and other governmental regulatory agencies, demonstrate
its future good faith conduct and full compliance with the securities laws and
generally accepted accounting principles and consent to the establishment of a
$90 million restitution fund and the assessment of a $25 million monetary
penalty. The Department of Justice has further agreed that if PNCICLC is in full
compliance with all of its obligations under the Deferred Prosecution Agreement,
the Department of Justice will seek dismissal with prejudice of the complaint
within 30 days of the twelve month anniversary of the Deferred Prosecution
Agreement and at such time the Deferred Prosecution Agreement will be
terminated. PNCICLC has timely paid the monetary penalty and established the
restitution fund. The $90 million restitution fund will be
48
available to satisfy claims, including for the settlement of the pending
securities law litigation. The restitution fund will be administered by Louis W.
Fryman, chairman of Fox Rothschild LLP in Philadelphia, Pennsylvania.
The Form 8-K, together with its exhibits, contains a more complete description
of the Deferred Prosecution Agreement and its impact on PNCICLC and the
Corporation.
There are several pending judicial or administrative proceedings or other
matters arising out of the PAGIC transactions. The impact of the final
disposition of these matters cannot be assessed at this time. The Corporation
intends to defend vigorously each of the lawsuits described below.
The several putative class action complaints filed during 2002 have been
consolidated in a consolidated class action complaint brought on behalf of
purchasers of the Corporation's common stock between July 19, 2001 and July 18,
2002 (the "Class Period"). The consolidated class action complaint names the
Corporation, the Chairman and Chief Executive Officer, the former Chief
Financial Officer, the Controller, and the Corporation's independent auditors
for 2001 as defendants and seeks unquantified damages, interest, attorneys' fees
and other expenses. The consolidated class action complaint alleges violations
of federal securities laws related to disclosures regarding the PAGIC
transactions and related matters. The Corporation and all other defendants have
filed a motion to dismiss this lawsuit.
In August 2002, the United States Department of Labor began a formal
investigation of the Administrative Committee of the Corporation's Incentive
Savings Plan ("Plan") in connection with the Committee's conduct relating to the
Corporation's common stock held by the Plan and the Corporation's restatement of
earnings for 2001. Both the Administrative Committee and the Corporation are
cooperating fully with the investigation. In June 2003, the Administrative
Committee retained Independent Fiduciary Services, Inc. ("IFS") to serve as an
independent fiduciary charged with the exclusive authority and responsibility to
act on behalf of the Plan in connection with the consolidated class action
referred to above and to evaluate any legal rights the Plan might have against
any parties relating to the PAGIC transactions. This authority will include
representing the Plan's interests in connection with the $90 million restitution
fund set up under the Deferred Prosecution Agreement. The Department of Labor
has been advised of the appointment of IFS.
In July 2003, a former employee brought a putative class action lawsuit under
ERISA in the United States District Court for the Western District of
Pennsylvania against the Corporation, its Chairman and Chief Executive Officer,
its former Chief Financial Officer, the Plan administrator and certain past and
present members of the Administrative Committee of the Plan. The complaint,
brought on behalf of the Plan and all Plan participants for whose individual
accounts the Plan purchased and/or held shares of the Corporation during the
Class Period, alleges that the defendants breached their fiduciary duties
related to disclosures regarding the PAGIC transactions and related matters and
also breached their fiduciary duties by permitting the Plan to purchase and hold
stock of the Corporation. The complaint seeks, among other things, unquantified
damages, declaratory and injunctive relief, and attorneys' fees and costs.
The Corporation received a letter in June 2003 on behalf of an alleged
shareholder of the Corporation demanding that the Corporation take appropriate
legal action against the Chairman and Chief Executive Officer, the former Chief
Financial Officer, and the Controller, as well as any other individuals or
entities allegedly responsible for causing damage to the Corporation as a result
of the PAGIC transactions. The Board has referred this matter to a special
committee of the Board for evaluation.
In July 2003, the lead underwriter on the Corporation's Executive Blended Risk
insurance coverage filed a lawsuit for a declaratory judgment against the
Corporation and PNCICLC in the United States District Court for the Western
District of Pennsylvania. The complaint seeks a determination that the
defendants breached the terms and conditions of the policy and, as a result, the
policy does not provide coverage for any loss relating to or arising out of the
Department of Justice investigation or the PAGIC transactions. Alternatively,
the complaint seeks a determination that the policy does not provide coverage
for the payments made pursuant to the Deferred Prosecution Agreement. The
complaint also seeks attorneys' fees and costs.
In addition to the proceedings or other matters arising out of the PAGIC
transactions, the Corporation and persons to whom the Corporation may have
indemnification obligations, in the normal course of business, are subject to
various other pending and threatened legal proceedings in which claims for
monetary damages and other relief are asserted. Management does not anticipate
that the ultimate aggregate liability, if any, arising out of such other legal
proceedings will have a material adverse effect on the Corporation's financial
position. However, at the present time, management is not in a position to
determine whether any of such other pending or threatened legal proceedings will
have a material adverse effect on the Corporation's results of operations in any
future reporting period.
49
NOTE 7 ALLOWANCES FOR CREDIT LOSSES AND UNFUNDED LOAN COMMITMENTS AND LETTERS OF
CREDIT Changes in the allowance for credit losses were as follows:
In millions 2003 2002
- ----------------------------------------------------------------
Allowance at January 1 $673 $560
Charge-offs
Commercial (59) (105)
Commercial real estate (2) (2)
Consumer (20) (20)
Residential mortgage (1) (2)
Lease financing (37) (10)
- ----------------------------------------------------------------
Total charge-offs (119) (139)
- ---------------------------------------------------------------
Recoveries
Commercial 12 14
Commercial real estate
Consumer 6 8
Residential mortgage 1
Lease financing 2 1
- ---------------------------------------------------------------
Total recoveries 20 24
- ---------------------------------------------------------------
Net charge-offs
Commercial (47) (91)
Commercial real estate (2) (2)
Consumer (14) (12)
Residential mortgage (1) (1)
Lease financing (35) (9)
- ---------------------------------------------------------------
Total net charge-offs (99) (115)
- ---------------------------------------------------------------
Provision for credit losses 93 171
Acquired allowance (NBOC acquisition) 41
Net change in allowance for unfunded loan
commitments and letters of credit 6 (3)
- ---------------------------------------------------------------
Allowance at June 30 $673 $654
===============================================================
Changes in the allowance for unfunded loan commitments and letters of credit
were as follows:
In millions 2003 2002
- ---------------------------------------------------------------
Allowance at January 1 $84 $70
Net change in allowance for unfunded
loan commitments and letters of credit (6) 3
- ---------------------------------------------------------------
Allowance at June 30 $78 $73
===============================================================
NOTE 8 NONPERFORMING ASSETS
Nonperforming assets were as follows:
June 30 December 31
In millions 2003 2002
- -------------------------------------------------------------------
Nonperforming loans (a) $327 $309
Nonperforming loans held for sale (b) 45 97
Foreclosed assets 32 12
- -------------------------------------------------------------------
Total nonperforming assets (c) $404 $418
===================================================================
(a) Includes a troubled debt restructured loan of $1 million as of June 30,
2003 and December 31, 2002.
(b) Includes troubled debt restructured loans held for sale of $11 million and
$17 million as of June 30, 2003 and December 31, 2002, respectively.
(c) Excludes equity management assets carried at estimated fair value of $39
million and $40 million as of June 30, 2003 and December 31, 2002,
respectively. These amounts include troubled debt restructured assets of $3
million and $12 million, respectively.
50
NOTE 9 SECURITIES
Amortized Unrealized Fair
-------------------------------------
In millions Cost Gains Losses Value
- ----------------------------------------------------------------------------------------------------------------------------------
JUNE 30, 2003
SECURITIES AVAILABLE FOR SALE
Debt securities
U.S. Treasury and government agencies $1,005 $12 $1,017
Mortgage-backed 10,353 230 $(4) 10,579
Asset-backed 3,714 52 (4) 3,762
State and municipal 64 2 (2) 64
Other debt 54 3 57
- ----------------------------------------------------------------------------------------------------------------------------------
Total debt securities 15,190 299 (10) 15,479
Corporate stocks and other 531 10 (3) 538
- ----------------------------------------------------------------------------------------------------------------------------------
Total securities available for sale $15,721 $309 $(13) $16,017
==================================================================================================================================
DECEMBER 31, 2002
SECURITIES AVAILABLE FOR SALE
Debt securities
U.S. Treasury and government agencies $813 $13 $826
Mortgage-backed 8,916 189 $(2) 9,103
Asset-backed 2,699 83 (2) 2,780
State and municipal 61 2 63
Other debt 58 3 61
- ----------------------------------------------------------------------------------------------------------------------------------
Total debt securities 12,547 290 (4) 12,833
Corporate stocks and other 597 1 (13) 585
- ----------------------------------------------------------------------------------------------------------------------------------
Total securities available for sale $13,144 $291 $(17) $13,418
==================================================================================================================================
SECURITIES HELD TO MATURITY
Debt securities
U.S. Treasury and government agencies $276 $33 $309
Asset-backed 8 8
Other debt 61 61
- ----------------------------------------------------------------------------------------------------------------------------------
Total debt securities 345 33 378
- ----------------------------------------------------------------------------------------------------------------------------------
Total securities held to maturity $345 $33 $378
==================================================================================================================================
Total securities at June 30, 2003 were $16.0 billion compared with $13.8 billion
at December 31, 2002. Securities represented 24% of total assets at June 30,
2003 compared with 21% at December 31, 2002. The increase in total securities
compared with December 31, 2002 was primarily due to purchases during the first
six months of 2003 of mortgage-backed and asset-backed securities partially
offset by the sale of securities classified as held to maturity at December 31,
2002.
The expected weighted-average life of securities available for sale was 2 years
and 5 months at June 30, 2003 and 2 years and 8 months at December 31, 2002.
The securities classified as held to maturity at December 31, 2002 were carried
at amortized cost and were owned by companies formed with AIG that were
consolidated in PNC's financial statements. In January 2003, these securities
were sold and these companies were liquidated.
The expected weighted-average life of securities held to maturity was 20 years
and 2 months at December 31, 2002.
At June 30, 2003, the securities available for sale balance included a net
unrealized gain of $296 million, which represented the difference between fair
value and amortized cost. The comparable amount at December 31, 2002 was a
net unrealized gain of $274 million. Changes in the fair value of securities
available for sale reflect an inverse relationship with changes in interest
rates. The rise in interest rates subsequent to June 30, 2003, if sustained,
will adversely impact the fair value of securities available for sale at
September 30, 2003 compared with the balance at June 30, 2003. Net unrealized
gains and losses in the securities available for sale portfolio are included in
shareholders' equity as accumulated other comprehensive income or loss, net of
tax.
Net securities gains were $82 million for the first six months of 2003,
including $25 million of gains related to the liquidation of the entities formed
in 2001 in transactions with AIG, compared with $20 million for the first six
months of 2002.
Information relating to securities sold is set forth in the following table:
SECURITIES SOLD
Six months
ended June 30 Gross Gross Net Income
In millions Proceeds Gains Losses Gains Taxes
- ---------------------------------------------------------------
2003 $5,654 $92 $10 $82 $29
2002 7,858 31 11 20 7
===============================================================
51
NOTE 10 GOODWILL AND OTHER INTANGIBLE ASSETS
In accordance with SFAS No. 142, "Goodwill and Other Intangible Assets" ("SFAS
142"), the Corporation plans to conduct its annual goodwill impairment test on
its reporting units during the fourth quarter of 2003, using data as of
September 30, 2003. Additionally, the Corporation will perform interim
impairment testing as needed based on the occurrence of adverse triggering
events as required by SFAS 142. The fair value of PNC's reporting units is
determined by using discounted cash flow and market comparability methodologies.
A summary of the changes in goodwill by business for the six months ended June
30, 2003 follows:
GOODWILL
Dec 31 Goodwill June 30
In millions 2002 Acquired Sales 2003
- ---------------------------------------------------------------
Regional Community
Banking $438 $438
Corporate Banking 39 39
PNC Real Estate
Finance 302 302
PNC Business Credit 298 298
PNC Advisors 152 $1 153
BlackRock 175 3 178
PFPC 909 43 $(4) 948
- ---------------------------------------------------------------
Total $2,313 $47 $(4) $2,356
===============================================================
During the first quarter of 2003, PNC purchased the minority interests,
representing approximately 2% of PFPC outstanding common stock, from other PFPC
shareholders and cashed out or converted all outstanding PFPC stock options.
This transaction resulted in the recognition of goodwill of $43 million during
the first quarter of 2003, as the purchase price exceeded the book value of the
shares acquired.
During the second quarter of 2003, PFPC completed the sale of its retirement
services unit. This transaction resulted in a reduction of goodwill of
approximately $4 million and a reduction in customer-related intangibles of
approximately $14 million.
The gross carrying amount, accumulated amortization and net carrying amount of
other intangible assets by major category consisted of the following:
OTHER INTANGIBLE ASSETS
June 30 December 31
In millions 2003 2002
- -------------------------------------------------------------
Customer-related intangibles
Gross carrying amount $186 $199
Accumulated amortization (69) (67)
- -------------------------------------------------------------
Net carrying amount $117 $132
- -------------------------------------------------------------
Mortgage and other loan
servicing rights
Gross carrying amount $324 $313
Accumulated amortization (125) (112)
- -------------------------------------------------------------
Net carrying amount $199 $201
- -------------------------------------------------------------
Total $316 $333
=============================================================
The majority of the Corporation's other intangible assets have finite lives and
are amortized primarily on a straight-line basis or, in the case of mortgage and
other loan servicing rights, on an accelerated basis. As of June 30, 2003, the
Corporation had three indefinite-lived other intangible assets: two investment
management contracts held by BlackRock and an intangible asset recorded pursuant
to SFAS No. 87, "Employers' Accounting for Pensions."
For customer-related intangibles, the estimated remaining useful lives range
from less than one year to fifteen years, with a weighted-average remaining
useful life of approximately seven years. The Corporation's mortgage and other
loan servicing rights are amortized primarily over a period of seven to ten
years using the net present value of the cash flows received from servicing the
related loans.
The changes in the carrying amount of goodwill and net other intangible assets
for the six months ended June 30, 2003, are as follows:
CHANGES IN GOODWILL AND OTHER INTANGIBLES
Customer- Servicing
In millions Goodwill Related Rights
- --------------------------------------------------------------------------
Balance at December 31, 2002 $2,313 $132 $201
Additions/adjustments 47 9 11
Sales (4) (14)
Amortization (10) (13)
- --------------------------------------------------------------------------
Balance at June 30, 2003 $2,356 $117 $199
==========================================================================
Amortization expense on intangible assets for the second quarter and the first
six months of 2003 was approximately $12 million and $23 million, respectively.
Amortization expense on existing intangible assets for the remainder of 2003 and
for 2004, 2005, 2006, 2007 and 2008 is estimated to be $24 million, $43 million,
$40 million, $37 million, $36 million and $33 million, respectively.
52
NOTE 11 EARNINGS PER SHARE
The following table sets forth basic and diluted earnings per share
calculations.
Three months ended June 30 Six months ended June 30
------------------------------------------------------------
In millions, except share and per share data 2003 2002 2003 2002
- ------------------------------------------------------------------------------------------------------------------------------------
CALCULATION OF BASIC EARNINGS PER COMMON SHARE
Net income $184 $320 $446 $637
Less: Preferred dividends declared 1 1 1 1
- ------------------------------------------------------------------------------------------------------------------------------------
Net income applicable to basic earnings per common share $183 $319 $445 $636
Basic weighted-average common shares outstanding (in thousands) 280,564 283,116 281,643 282,944
- ------------------------------------------------------------------------------------------------------------------------------------
Basic earnings per common share $.65 $1.13 $1.58 $2.25
====================================================================================================================================
CALCULATION OF DILUTED EARNINGS PER COMMON SHARE
Net income $184 $320 $446 $637
Less: BlackRock adjustment for common stock equivalents 1 1 1 1
- ------------------------------------------------------------------------------------------------------------------------------------
Net income applicable to diluted earnings per common share $183 $319 $445 $636
Basic weighted-average common shares outstanding (in thousands) 280,564 283,116 281,643 282,944
Conversion of preferred stock Series A and B 92 99 92 100
Conversion of preferred stock Series C and D 734 802 744 812
Conversion of debentures 14 16 14 16
Exercise of stock options 337 858 292 973
Incentive share awards 476 423 459 423
- ------------------------------------------------------------------------------------------------------------------------------------
Diluted weighted-average common shares outstanding (in thousands) 282,217 285,314 283,244 285,268
- ------------------------------------------------------------------------------------------------------------------------------------
Diluted earnings per common share $.65 $1.12 $1.57 $2.23
====================================================================================================================================
53
NOTE 12 SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME
The following table sets forth the activity in shareholders' equity for the
first six months of 2003. The value of the Corporation's preferred stock
outstanding as of June 30, 2003 and December 31, 2002 was less than $.5 million
at each date and, therefore, is excluded from the following table.
Shares
Outstanding Deferred Accumulated Other
Common Common Capital Retained Benefit Comprehensive Treasury
In millions, except per share data Stock Stock Surplus Earnings Expense Income (Loss)(a) Stock Total
- ------------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2002 285 $1,764 $1,101 $7,187 $(9) $321 $(3,505) $6,859
Net income 446 446
Other comprehensive income, net
of tax (a)
Net unrealized securities gains 14 14
Net unrealized losses on cash
flow hedge derivatives (31) (31)
- ------------------------------------------------------------------------------------------------------------------------------------
Comprehensive income 429
- ------------------------------------------------------------------------------------------------------------------------------------
Cash dividends declared
Common ($.96 per share) (273) (273)
Treasury stock activity (5) (4) (222) (226)
Tax benefit of stock option plans 4 4
Stock options granted 5 5
Subsidiary stock transactions (6) (6)
Deferred benefit expense (18) (18)
- ------------------------------------------------------------------------------------------------------------------------------------
Balance at June 30, 2003 280 $1,764 $1,100 $7,360 $(27) $304 $(3,727) $6,774
====================================================================================================================================
(a) A summary of the components of other comprehensive income follows:
Six months ended June 30, 2003 Tax Benefit
In millions Pretax amount (Expense) After-tax Amount
- ------------------------------------------------------------------------------------------------------------------------------------
Unrealized securities gains $89 $(31) $58
Less: Reclassification adjustment for gains realized in net income 67 (23) 44
- ------------------------------------------------------------------------------------------------------------------------------------
Net unrealized securities gains 22 (8) 14
- ------------------------------------------------------------------------------------------------------------------------------------
Unrealized losses on cash flow hedge derivatives (12) 4 (8)
Less: Reclassification adjustment for gains realized in net income 36 (13) 23
- ------------------------------------------------------------------------------------------------------------------------------------
Net unrealized losses on cash flow hedge derivatives (48) 17 (31)
- ------------------------------------------------------------------------------------------------------------------------------------
Other comprehensive income $(26) $9 $(17)
====================================================================================================================================
The accumulated balances related to each component of other comprehensive income
are as follows:
June 30, 2003 December 31, 2002
In millions Pretax After-tax Pretax After-tax
- ---------------------------------------------------------------------------------------------------------------
Net unrealized securities gains $296 $193 $274 $179
Net unrealized gains on cash flow hedge
derivatives 160 104 208 135
Other 11 7 11 7
- ---------------------------------------------------------------------------------------------------------------
Accumulated other comprehensive income $467 $304 $493 $321
===============================================================================================================
(b) Consists of interest-only strip valuation adjustments, foreign currency
translation adjustments and minimum pension liability adjustments.
54
NOTE 13 SEGMENT REPORTING
PNC operates seven major businesses engaged in regional community banking;
wholesale banking, including corporate banking, real estate finance and
asset-based lending; wealth management; asset management and global fund
processing services. Assets, revenue and earnings attributable to foreign
activities were not material in the periods presented.
Results of individual businesses are presented based on PNC's management
accounting practices and the Corporation's management structure. There is no
comprehensive, authoritative body of guidance for management accounting
equivalent to generally accepted accounting principles; therefore, the financial
results of individual businesses are not necessarily comparable with similar
information for any other company. Financial results are presented, to the
extent practicable, as if each business operated on a stand-alone basis. Also,
certain amounts for 2002 have been reclassified to conform with the 2003
presentation.
The management accounting process uses various balance sheet and income
statement assignments and transfers to measure performance of the businesses.
Methodologies are refined from time to time as management accounting practices
are enhanced and businesses change. There were no significant changes to the
measurement methods during the second quarter of 2003. Securities or borrowings
and related net interest income are assigned based on the net asset or liability
position of each business. Capital is assigned based on management's assessment
of inherent risks and equity levels at independent companies providing similar
products and services. The allowance for credit losses is allocated based on
management's assessment of risk inherent in the loan portfolios. The costs
incurred by support areas not directly aligned with the businesses are allocated
primarily based on the utilization of services.
Total business financial results differ from consolidated results. The impact of
these differences is reflected in the "Intercompany eliminations" and "Other"
categories. "Intercompany eliminations" reflects activities conducted among
PNC's businesses that are eliminated in the consolidated results. "Other"
includes differences between management accounting practices and generally
accepted accounting principles, such as economic capital assignments rather than
legal entity shareholders' equity, unit cost allocations rather than actual
expense assignments, and policies that do not fully allocate holding company
expenses; minority interest in income of consolidated entities; and other
corporate items. "Other" also includes equity management activities and residual
asset and liability management activities which do not meet the criteria for
disclosure as a separate reportable business.
BUSINESS SEGMENT PRODUCTS AND SERVICES
Regional Community Banking provides deposit, lending, cash management and
investment services to two million consumer and small business customers within
PNC's geographic region.
Wholesale Banking includes the results for Corporate Banking, PNC Real Estate
Finance and PNC Business Credit.
Corporate Banking provides credit, equipment leasing, treasury management and
capital markets products and services to mid-sized corporations, government
entities and selectively to large corporations primarily within PNC's geographic
region. Treasury management activities, which include cash and investment
management, receivables management, disbursement services and global trade
services; capital markets products, which include foreign exchange, derivatives
trading and loan syndications; and equipment leasing products offered through
Corporate Banking are marketed by several businesses across the Corporation.
PNC Real Estate Finance specializes in financial solutions for the acquisition,
development, permanent financing and operation of commercial real estate
nationally. PNC Real Estate Finance offers treasury and investment management,
access to the capital markets, commercial mortgage loan servicing and other
products and services to clients that develop, own, manage or invest in
commercial real estate. PNC's commercial real estate financial services platform
provides processing services through Midland Loan Services, Inc., a leading
third-party provider of loan servicing and technology to the commercial real
estate finance industry. PNC Real Estate Finance also includes PNC MultiFamily
Capital, a national provider of financial services for the multi-family housing
industry, particularly affordable, senior and healthcare housing.
PNC Business Credit provides asset-based lending, treasury management and
capital markets products and services to middle market customers nationally. PNC
Business Credit's lending services include loans secured by accounts receivable,
inventory, machinery and equipment, and other collateral, and its customers
include manufacturing, wholesale, distribution, retailing and service industry
companies.
PNC Advisors provides a full range of tailored investment, trust and private
banking products and services to affluent individuals and families, including
full-service brokerage through J.J.B. Hilliard, W.L. Lyons, Inc. and investment
consulting and trust services to the ultra-affluent through Hawthorn. PNC
Advisors also serves as investment manager and trustee for employee benefit
plans and charitable and endowment assets and provides defined contribution plan
services and investment options through its Vested Interest(R) product. PNC
Advisors provides services to individuals and corporations primarily within
PNC's geographic region.
BlackRock is one of the largest publicly traded investment management firms in
the United States with approximately $286 billion of assets under management at
June 30, 2003. BlackRock manages assets on behalf of institutions and
individuals worldwide through a variety of fixed income, liquidity and equity
mutual funds, separate accounts and alternative investment products. Mutual
funds include the flagship fund families, BlackRock Funds and BlackRock
Provident Institutional Funds. In addition, BlackRock provides risk management
and investment system services to institutional investors under the BlackRock
Solutions(R) brand name.
PFPC is the largest full-service mutual fund transfer agent and second largest
provider of mutual fund accounting and administration services in the United
States, offering a wide range of fund services to the investment management
industry and providing processing solutions to the international marketplace
through its Ireland and Luxembourg operations.
55
RESULTS OF BUSINESSES
Regional PNC PNC
Three months ended June 30 Community Corporate Real Estate Business PNC
In millions Banking Banking Finance Credit Advisors
- -----------------------------------------------------------------------------------------------
2003 INCOME STATEMENT
Net interest income $332 $70 $28 $34 $21
Noninterest income 203 88 34 12 133
- -----------------------------------------------------------------------------------------------
Total revenue 535 158 62 46 154
Provision for credit losses 13 25 (1) 21 1
Depreciation and amortization 9 2 3 3
Other noninterest expense 273 82 41 15 118
- -----------------------------------------------------------------------------------------------
Earnings before minority
interest and income taxes 240 49 19 10 32
Minority interest in income of
consolidated entities (2)
Income taxes 81 16 (3) 4 12
- -----------------------------------------------------------------------------------------------
Earnings $159 $33 $24 $6 $20
===============================================================================================
Inter-segment revenue $6 $2 $7
===============================================================================================
AVERAGE ASSETS (a) $38,435 $11,354 $4,765 $3,777 $2,856
===============================================================================================
2002 INCOME STATEMENT
Net interest income $356 $87 $29 $33 $26
Noninterest income 186 129 35 12 145
- -----------------------------------------------------------------------------------------------
Total revenue 542 216 64 45 171
Provision for credit losses 11 49 29 1
Depreciation and amortization 9 3 2 3
Other noninterest expense 254 83 36 13 119
- -----------------------------------------------------------------------------------------------
Earnings before minority
interest and income taxes 268 81 26 3 48
Minority interest in income of
consolidated entities
Income taxes 92 27 1 17
- -----------------------------------------------------------------------------------------------
Earnings $176 $54 $26 $2 $31
===============================================================================================
Inter-segment revenue $2 $2 $10
===============================================================================================
AVERAGE ASSETS (a) $39,089 $14,291 $4,989 $3,978 $3,016
===============================================================================================
Six months ended June 30
In millions
2003 INCOME STATEMENT
Net interest income $648 $145 $56 $66 $42
Noninterest income 404 201 62 24 259
- -----------------------------------------------------------------------------------------------
Total revenue 1,052 346 118 90 301
Provision for credit losses 21 40 7 28 1
Depreciation/amortization 18 5 4 1 5
Other noninterest expense 542 188 78 28 238
- -----------------------------------------------------------------------------------------------
Earnings before minority
interest and income taxes 471 113 29 33 57
Minority interest in income of
consolidated entities (2)
Income taxes 160 38 (9) 13 21
- -----------------------------------------------------------------------------------------------
Earnings $311 $75 $40 $20 $36
===============================================================================================
Inter-segment revenue $12 $3 $13
===============================================================================================
AVERAGE ASSETS (a) $38,710 $11,501 $4,766 $3,703 $2,863
===============================================================================================
2002 INCOME STATEMENT
Net interest income $738 $181 $59 $66 $52
Noninterest income 353 228 56 24 302
- -----------------------------------------------------------------------------------------------
Total revenue 1,091 409 115 90 354
Provision for credit losses 23 95 (5) 57 1
Depreciation and amortization 18 5 3 5
Other noninterest expense 511 178 71 27 247
- -----------------------------------------------------------------------------------------------
Earnings before minority
interest and income taxes 539 131 46 6 101
Minority interest in income of
consolidated entities
Income taxes 186 44 (2) 2 37
- -----------------------------------------------------------------------------------------------
Earnings $353 $87 $48 $4 $64
===============================================================================================
Inter-segment revenue $7 $4 $23
===============================================================================================
AVERAGE ASSETS (a) $38,920 $14,752 $5,081 $3,898 $3,029
===============================================================================================
Three months ended June 30 Intercompany
In millions BlackRock PFPC Other Eliminations Consolidated
- ----------------------------------------------------------------------------------------------
2003 INCOME STATEMENT
Net interest income $8 $(16) $44 $521
Noninterest income 144 187 $(25) 776
- ----------------------------------------------------------------------------------------------
Total revenue 152 171 44 (25) 1,297
Provision for credit losses (2) 57
Depreciation and amortization 5 6 19 47
Other noninterest expense 84 141 157 (23) 888
- ----------------------------------------------------------------------------------------------
Earnings before minority
interest and income taxes 63 24 (130) (2) 305
Minority interest in income of
consolidated entities 15 13
Income taxes 24 9 (34) (1) 108
- ----------------------------------------------------------------------------------------------
Earnings $39 $15 $(111) $(1) $184
==============================================================================================
Inter-segment revenue $5 $2 $3 $(25)
==============================================================================================
AVERAGE ASSETS (a) $901 $1,891 $3,481 $(1,895) $65,565
==============================================================================================
2002 INCOME STATEMENT
Net interest income $4 $(18) $38 $555
Noninterest income 157 216 13 $(23) 870
- ----------------------------------------------------------------------------------------------
Total revenue 161 198 51 (23) 1,425
Provision for credit losses (1) 89
Depreciation and amortization 5 3 16 41
Other noninterest expense 97 160 58 (22) 798
- ----------------------------------------------------------------------------------------------
Earnings before minority
interest and income taxes 59 35 (22) (1) 497
Minority interest in income of
consolidated entities 12 12
Income taxes 24 14 (10) 165
- ----------------------------------------------------------------------------------------------
Earnings $35 $21 $(24) $(1) $320
==============================================================================================
Inter-segment revenue $4 $2 $3 $(23)
==============================================================================================
AVERAGE ASSETS (a) $734 $1,932 $494 $(2,063) $66,460
==============================================================================================
Six months ended June 30
In millions
2003 INCOME STATEMENT
Net interest income $11 $(30) $86 $1,024
Noninterest income 287 379 2 $(47) 1,571
- ----------------------------------------------------------------------------------------------
Total revenue 298 349 88 (47) 2,595
Provision for credit losses (4) 93
Depreciation/amortization 10 10 39 92
Other noninterest expense 168 295 203 (41) 1,699
- ----------------------------------------------------------------------------------------------
Earnings before minority
interest and income taxes 120 44 (150) (6) 711
Minority interest in income of
consolidated entities 26 24
Income taxes 46 17 (42) (3) 241
- ----------------------------------------------------------------------------------------------
Earnings $74 $27 $(134) $(3) $446
==============================================================================================
Inter-segment revenue $9 $4 $6 $(47)
==============================================================================================
AVERAGE ASSETS (a) $901 $1,878 $3,343 $(1,906) $65,759
==============================================================================================
2002 INCOME STATEMENT
Net interest income $6 $(36) $79 $1,145
Noninterest income 303 427 19 $(52) 1,660
- ----------------------------------------------------------------------------------------------
Total revenue 309 391 98 (52) 2,805
Provision for credit losses 171
Depreciation and amortization 10 4 35 80
Other noninterest expense 188 323 68 (47) 1,566
- ----------------------------------------------------------------------------------------------
Earnings before minority
interest and income taxes 111 64 (5) (5) 988
Minority interest in income of
consolidated entities 22 22
Income taxes 45 26 (7) (2) 329
- ----------------------------------------------------------------------------------------------
Earnings $66 $38 $(20) $(3) $637
==============================================================================================
Inter-segment revenue $8 $4 $6 $(52)
==============================================================================================
AVERAGE ASSETS (a) $734 $1,890 $1,069 $(2,033) $67,340
==============================================================================================
(a) Period-end balances for BlackRock.
56
Certain revenue and expense amounts shown in the preceding table differ from
amounts included in the "Review of Businesses" section of the Financial Review
of this Form 10-Q due to the presentation in the Financial Review of business
revenues on a taxable-equivalent basis (except for BlackRock and PFPC) and
classification differences related to BlackRock and PFPC. BlackRock income
classified as net interest income in the preceding table is classified as
nonoperating income in the "Review of Businesses" section. PFPC income
classified as net interest income (expense) in the preceding table represents
the interest components of nonoperating income (net of nonoperating expense) and
debt financing as disclosed in the "Review of Businesses" section.
NOTE 14 COMMITMENTS AND GUARANTEES
EQUITY FUNDING COMMITMENTS
The Corporation has commitments to make additional equity investments in certain
equity management entities and affordable housing limited partnerships. These
commitments totaled $248 million at June 30, 2003.
STANDBY LETTERS OF CREDIT
PNC issues standby letters of credit and has risk participation in standby
letters of credit issued by other financial institutions, in each case to
support obligations of its customers to third parties. If the customer fails to
meet its financial or performance obligation to the third party under the terms
of the contract, then upon their request PNC would be obligated to make payment
to the guaranteed party. Standby letters of credit and risk participations in
standby letters of credit outstanding on June 30, 2003 had terms ranging from
less than 1 year to 7 years. The aggregate maximum amount of future payments PNC
could be required to make under outstanding standby letters of credit and risk
participations in standby letters of credit was $4.8 billion at June 30, 2003.
Assets valued, as of June 30, 2003, at approximately $1.6 billion secured
certain specifically identified standby letters of credit and letter of credit
risk participations having aggregate potential future payments of approximately
$1.6 billion. In addition, a portion of the remaining standby letters of credit
and letter of credit risk participations issued on behalf of specific customers
are also secured by collateral or guarantees which secure that customer's other
obligations to PNC.
LIQUIDITY FACILITIES AND STANDBY BOND PURCHASE AGREEMENTS
PNC enters into liquidity facilities primarily to support individual pools of
receivables acquired by commercial paper conduits including Market Street. At
June 30, 2003, the aggregate commitments under these facilities was $3.1
billion, of which $2.8 billion was related to Market Street. Collateral or third
party insurance secures PNC's exposure under these facilities. PNC also enters
into Standby Bond Purchase Agreements to support municipal bond obligations. At
June 30, 2003, the aggregate of PNC's commitments under these facilities was
$345 million.
INDEMNIFICATIONS
PNC is a party to numerous acquisition or divestiture agreements, under which it
has purchased or sold, or agreed to purchase or sell, various types of assets.
These agreements can cover the purchase or sale of entire businesses, loan
portfolios, branch banks, partial interests in companies, or other types of
assets. They generally include indemnification provisions under which PNC
indemnifies the other parties to these agreements against a variety of risks to
the other parties as a result of the transaction in question; when PNC is the
seller, the indemnification provisions will generally also provide protection
relating to the quality of the assets being sold and the extent of any
liabilities being assumed. Due to the nature of these indemnification
provisions, it is not possible to quantify the aggregate exposure to PNC
resulting from them.
PNC provides indemnification in connection with securities offering transactions
in which it is involved. When PNC is the issuer of the securities, it provides
indemnification to the underwriters or placement agents analogous to the
indemnification provided purchasers of businesses from it, as described above.
When PNC is an underwriter or placement agent, it provides a limited
indemnification to the issuer related to its actions in connection with the
offering and, if there are other underwriters, indemnification to the other
underwriters intended to result in an appropriate sharing of the risk of
participating in the offering. Due to the nature of these indemnification
provisions, it is not possible to quantify the aggregate exposure to PNC
resulting from them.
PNC enters into certain types of agreements such as (i) agreements relating to
providing various servicing and processing functions to third parties, (ii)
agreements relating to the creation of trusts or other legal entities to
facilitate leasing transactions, commercial mortgage-backed securities
transactions (loan securitizations) and certain other off-balance sheet
transactions, (iii) syndicated credit agreements, as a syndicate member, and
(iv) sales of individual loans, which provide indemnification to third parties.
Due to the nature of these indemnification provisions, it is not possible to
calculate aggregate potential exposure under them.
PNC enters into certain types of agreements, such as leases with tenants, in
which PNC indemnifies third parties for acts by PNC's agents. While PNC does not
believe these indemnification liabilities are material, either individually or
in the aggregate, it is not possible to calculate potential exposure.
PNC enters into contracts for the delivery of technology service in which PNC
indemnifies the other party against claims of patent infringement by third
parties. Due to the nature of these indemnification provisions, it is not
possible to calculate aggregate potential exposure under this type of
indemnification.
57
PNC engages in certain insurance activities which require its employees to be
bonded. PNC satisfies this requirement by issuing letters of credit in an
aggregate amount of approximately $5 million.
In the ordinary course of business PNC enters into contracts with third parties
pursuant to which the third parties provide services on behalf of PNC. In many
of the contracts PNC agrees to indemnify the third party service provider under
certain circumstances. The terms of the indemnity vary from contract to contract
and the amount of the indemnification liability, if any, cannot be determined.
PNC is a general or limited partner in certain asset management and investment
limited partnerships, many of which contain indemnification provisions which
would require PNC to make payments in excess of its remaining funding
commitments. While in certain of these partnerships the maximum liability to PNC
is limited to the sum of PNC's unfunded commitments and partnership
distributions received by PNC, in the others the indemnification liability is
unlimited. As a result, it is not possible to determine the aggregate potential
exposure for these indemnifications.
Pursuant to their bylaws, the Corporation and its subsidiaries provide
indemnification to directors, officers and, in some cases, employees and agents
against certain liabilities incurred as a result of their service on behalf of
or at the request of the Corporation and its subsidiaries and also advance on
behalf of covered individuals costs incurred in defending against certain
claims, subject to written undertakings by each such individual to repay all
amounts so advanced if it is ultimately determined that the individual is not
entitled to indemnification. The Corporation advanced such defense costs on
behalf of several such individuals with respect to pending litigation or
investigations during the first half of 2003. It is not possible to determine
the aggregate potential exposure resulting from the obligation to provide this
indemnity or to advance such costs.
In connection with the lending of securities held by its mutual fund processing
services business on behalf of certain of its clients, PNC provides
indemnification to those clients against the failure of the borrowers to return
the securities. The market value of the securities lent is fully secured on a
daily basis, and thus the exposure to the Corporation is limited to temporary
shortfalls in the collateral as a result of short-term fluctuations in trading
prices of the loaned securities. At June 30, 2003, the aggregate maximum
potential exposure as a result of these indemnity obligations was $7.6 billion,
although PNC held cash collateral at the time in excess of that amount.
CONTINGENT PAYMENTS IN CONNECTION WITH CERTAIN ACQUISITIONS
A number of the acquisition agreements to which PNC is a party and under which
it has purchased various types of assets, including the purchase of entire
businesses, partial interests in companies, or other types of assets, require
PNC to make additional payments in future years if certain predetermined goals,
such as revenue targets, are achieved or if other contingencies, such as
specified declines in the value of the consideration paid, occur within a
specified time. As certain of these provisions do not specify dollar
limitations, it is not possible to quantify the aggregate exposure to PNC
resulting from these agreements.
NBOC ACQUISITION PUT OPTION
See Note 2 NBOC Acquisition for a description of the Put Option. NBOC exercised
the Put Option effective July 15, 2003.
58
STATISTICAL INFORMATION
THE PNC FINANCIAL SERVICES GROUP, INC.
CONSOLIDATED AVERAGE BALANCE SHEET AND NET INTEREST ANALYSIS
Six months ended June 30
- -----------------------------------------------------------------------------------------------------
2003
Taxable-equivalent basis Average Interest Average
Dollars in millions Balances Income/Expense Yields/Rates
- -----------------------------------------------------------------------------------------------------
ASSETS
Interest-earning assets
Loans held for sale $1,768 $27 3.05%
Securities
Securities available for sale
U.S. Treasury and government agencies/corporations 3,456 73 4.25
Other debt 9,838 215 4.36
State and municipal 57 2 8.97
Corporate stocks and other 496 7 2.74
- -------------------------------------------------------------------------------------
Total securities available for sale 13,847 297 4.29
Securities held to maturity 33 2 7.98
- -------------------------------------------------------------------------------------
Total securities 13,880 299 4.30
Loans, net of unearned income
Commercial 15,007 432 5.72
Commercial real estate 2,217 52 4.66
Consumer 10,161 301 5.96
Residential mortgage 3,430 102 5.97
Lease financing 3,837 112 5.88
Other 362 7 3.71
- -------------------------------------------------------------------------------------
Total loans, net of unearned income 35,014 1,006 5.75
Federal funds sold 960 6 1.24
Other 2,003 51 5.16
- -------------------------------------------------------------------------------------
Total interest-earning assets/interest income 53,625 1,389 5.18
Noninterest-earning assets
Allowance for credit losses (677)
Cash and due from banks 2,687
Other assets 10,124
- ----------------------------------------------------------------------
Total assets $65,759
======================================================================
LIABILITIES, MINORITY INTEREST, CAPITAL SECURITIES AND
SHAREHOLDERS' EQUITY
Interest-bearing liabilities
Interest-bearing deposits
Demand and money market $22,107 87 .79
Savings 2,095 4 .38
Retail certificates of deposit 9,263 147 3.20
Other time 267 10 7.35
Deposits in foreign offices 213 1 1.11
- ------------------------------------------------------------------------------------
Total interest-bearing deposits 33,945 249 1.48
Borrowed funds
Federal funds purchased 366 3 1.31
Repurchase agreements 1,004 6 1.17
Bank notes and senior debt 3,909 42 2.14
Federal Home Loan Bank borrowings 1,174 (8) (1.30)
Subordinated debt 2,087 43 4.13
Other borrowed funds 161 25 31.21
- ------------------------------------------------------------------------------------
Total borrowed funds 8,701 111 2.54
- ------------------------------------------------------------------------------------
Total interest-bearing liabilities/interest
expense 42,646 360 1.69
Noninterest-bearing liabilities, minority interest,
capital securities and shareholders' equity
Demand and other noninterest-bearing deposits 10,213
Allowance for unfunded commitments and letters of
credit 80
Accrued expenses and other liabilities 4,955
Minority interest 251
Mandatorily redeemable capital securities of
subsidiary trusts 848
Shareholders' equity 6,766
======================================================================
Total liabilities, minority interest, capital
securities and shareholders' equity $65,759
- --------------------------------------------------------------------------------------------------
Interest rate spread 3.49
Impact of noninterest-bearing sources .34
- --------------------------------------------------------------------------------------------------
Net interest income/margin $1,029 3.83%
==================================================================================================
Six months ended June 30
- --------------------------------------------------------------------------------------------------
2002
Taxable-equivalent basis Average Interest Average
Dollars in millions Balances Income/Expense Yields/Rates
- ------------------------------------------------------------------------------------------------
ASSETS
Interest-earning assets
Loans held for sale $3,753 $93 4.95%
Securities
Securities available for sale
U.S. Treasury and government agencies/corporations 3,237 86 5.28
Other debt 7,906 222 5.63
State and municipal 61 3 9.21
Corporate stocks and other 450 8 3.35
- --------------------------------------------------------- ----------------------
Total securities available for sale 11,654 319 5.46
Securities held to maturity 364 8 4.66
- --------------------------------------------------------- ----------------------
Total securities 12,018 327 5.44
Loans, net of unearned income
Commercial 16,287 483 5.90
Commercial real estate 2,461 66 5.31
Consumer 9,395 314 6.74
Residential mortgage 5,365 183 6.83
Lease financing 4,285 138 6.45
Other 398 8 4.21
- --------------------------------------------------------- ----------------------
Total loans, net of unearned income 38,191 1,192 6.24
Federal funds sold 810 7 1.75
Other 1,856 49 5.31
- --------------------------------------------------------- ----------------------
Total interest-earning assets/interest income 56,628 1,668 5.89
Noninterest-earning assets
Allowance for credit losses (596)
Cash and due from banks 2,791
Other assets 8,517
- --------------------------------------------------------- ----------
Total assets $67,340
========================================================= ==========
LIABILITIES, MINORITY INTEREST, CAPITAL SECURITIES AND
SHAREHOLDERS' EQUITY
Interest-bearing liabilities
Interest-bearing deposits
Demand and money market $21,483 123 1.16
Savings 2,031 5 .49
Retail certificates of deposit 10,562 198 3.77
Other time 849 17 4.06
Deposits in foreign offices 519 5 1.76
- --------------------------------------------------------- -------------------------
Total interest-bearing deposits 35,444 348 1.98
Borrowed funds
Federal funds purchased 1,066 9 1.59
Repurchase agreements 947 7 1.42
Bank notes and senior debt 5,558 76 2.71
Federal Home Loan Bank borrowings 1,793 4 .50
Subordinated debt 2,209 50 4.59
Other borrowed funds 437 23 10.58
- --------------------------------------------------------- -------------------------
Total borrowed funds 12,010 169 2.81
- --------------------------------------------------------- -------------------------
Total interest-bearing liabilities/interest 47,454 517 2.19
expense
Noninterest-bearing liabilities, minority interest,
capital securities and shareholders' equity
Demand and other noninterest-bearing deposits 8,913
Allowance for unfunded commitments and letters of
credit 84
Accrued expenses and other liabilities 3,853
Minority interest 184
Mandatorily redeemable capital securities of
subsidiary trusts 848
Shareholders' equity 6,004
====================================================================
Total liabilities, minority interest, capital
securities and shareholders' equity $67,340
- ------------------------------------------------------------------------------------------------
Interest rate spread 3.70
Impact of noninterest-bearing sources .36
- ------------------------------------------------------------------------------------------------
Net interest income/margin $1,151 4.06%
================================================================================================
Nonaccrual loans are included in loans, net of unearned income. The impact of
financial derivatives used in interest rate risk management is included in the
interest income/expense and average yields/rates of the related assets and
liabilities. Basis adjustments related to hedged items are included in
noninterest-earning assets and noninterest-bearing liabilities. Average balances
of securities are based on amortized historical cost (excluding SFAS No. 115
adjustments to fair value which are included in other assets).
59
- -----------------------------------------------------------------------------------------------------------------------------------
Second Quarter 2003 First Quarter 2003 Second Quarter 2002
- -----------------------------------------------------------------------------------------------------------------------------------
Average Interest Average Average Interest Average Average Interest Average
Balances Income/Expense Yields/Rates Balances Income/Expense Yields/Rates Balances Income/Expense Yields/Rates
- -----------------------------------------------------------------------------------------------------------------------------------
$1,754 $15 3.45% $1,782 $12 2.65% $3,235 $41 5.07%
3,825 37 3.95 3,082 36 4.62 2,972 39 5.21
10,325 112 4.34 9,345 103 4.39 7,146 99 5.54
57 1 8.90 57 1 9.04 61 1 9.33
465 4 2.86 527 3 2.59 492 5 3.63
- ------------------------------- ----------------------------- ---------------------------
14,672 154 4.21 13,011 143 4.39 10,671 144 5.38
1 67 1 7.69 364 5 5.70
- ------------------------------- ----------------------------- ---------------------------
14,672 155 4.21 13,078 144 4.41 11,035 149 5.39
14,965 215 5.69 15,050 217 5.76 16,311 243 5.90
2,169 25 4.62 2,265 27 4.70 2,470 33 5.26
10,346 152 5.87 9,974 149 6.06 9,509 158 6.67
3,244 47 5.83 3,619 55 6.10 4,979 85 6.79
3,767 54 5.73 3,909 58 6.02 4,244 68 6.39
360 4 3.64 363 3 3.78 402 4 4.26
- ------------------------------- ----------------------------- ---------------------------
34,851 497 5.67 35,180 509 5.82 37,915 591 6.20
116 1.22 1,813 6 1.24 1,532 6 1.76
1,863 27 5.82 2,145 24 4.57 1,925 20 4.12
- ------------------------------- ----------------------------- ---------------------------
53,256 694 5.19 53,998 695 5.17 55,642 807 5.78
(671) (682) (625)
2,679 2,695 2,705
10,301 9,944 8,738
- ---------------- -------------- -----------
$65,565 $65,955 $66,460
================ ============== ===========
$22,141 41 .74 $22,073 46 .84 $21,625 63 1.18
2,131 2 .37 2,058 2 .39 2,067 3 .50
8,892 69 3.11 9,638 78 3.29 10,518 97 3.68
269 5 7.27 265 5 7.44 910 8 3.60
220 1.11 206 1 1.12 223 1 1.81
- ------------------------------- ----------------------------- ---------------------------
33,653 117 1.40 34,240 132 1.56 35,343 172 1.95
692 3 1.28 37 1.86 35 1.81
1,116 4 1.17 891 2 1.16 979 4 1.45
3,555 19 2.14 4,267 23 2.14 5,441 38 2.76
1,138 (5) (1.49) 1,210 (3) (1.11) 1,714 2 .52
2,025 20 4.01 2,151 23 4.24 2,210 25 4.58
175 13 29.55 146 12 33.23 483 8 6.66
- ------------------------------- ----------------------------- ---------------------------
8,701 54 2.46 8,702 57 2.63 10,862 77 2.83
- ------------------------------- ----------------------------- ---------------------------
42,354 171 1.61 42,942 189 1.77 46,205 249 2.16
10,278 10,146 8,986
77 84 98
4,980 4,928 4,027
252 251 192
848 848 848
6,776 6,756 6,104
- ---------------- -------------- -----------
$65,565 $65,955 $66,460
- -----------------------------------------------------------------------------------------------------------------------------------
3.58 3.40 3.62
.33 .36 .37
- -----------------------------------------------------------------------------------------------------------------------------------
$523 3.91% $506 3.76% $558 3.99%
===================================================================================================================================
Loan fees for the six months ended June 30, 2003 and June 30, 2002 were $53
million and $58 million, respectively. Loan fees for the three months ended June
30, 2003, March 31, 2003, December 31, 2002, September 30, 2002 and June 30,
2002 were $26 million, $27 million, $26 million, $22 million and $29 million,
respectively.
60
QUARTERLY REPORT ON FORM 10-Q
THE PNC FINANCIAL SERVICES GROUP, INC.
Securities and Exchange Commission
Washington, D.C. 20549
Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act
of 1934 for the quarterly period ended June 30, 2003.
Commission File Number 1-9718
THE PNC FINANCIAL SERVICES GROUP, INC.
Incorporated in the Commonwealth of Pennsylvania
IRS Employer Identification No. 25-1435979
Address of principal executive offices:
One PNC Plaza
249 Fifth Avenue
Pittsburgh, Pennsylvania 15222-2707
Telephone: (412) 762-2000
The PNC Financial Services Group, Inc. (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months, (2) has been subject to such filing requirements for the
past 90 days, and (3) is an accelerated filer (as defined in Rule 12b-2 of the
Exchange Act).
As of July 31, 2003, The PNC Financial Services Group, Inc. had 280,140,368
shares of common stock ($5 par value) outstanding.
PART I FINANCIAL INFORMATION
The following sections of the Consolidated Financial Highlights and Financial
Review set forth in the cross-reference index are incorporated in the Quarterly
Report on Form 10-Q for the quarterly period ended June 30, 2003.
Cross-reference Page(s)
- ---------- ------------------------------------------ ---------
PART I FINANCIAL INFORMATION
Item 1 Financial Statements
Consolidated Statement of Income for the
three months and six months ended June
30, 2003 and 2002 40
Consolidated Balance Sheet as of
June 30, 2003 and December 31, 2002 41
Consolidated Statement of Cash Flows for
the six months ended June 30, 2003 and
2002 42
Notes to Consolidated Financial
Statements 43-58
Consolidated Average Balance Sheet and
Net Interest Analysis 59-60
Item 2 Management's Discussion and Analysis of
Financial Condition and Results of
Operations 1-39
Item 3 Quantitative and Qualitative
Disclosures About Market Risk 23-36
Item 4 Controls and Procedures 37
- ---------- ---------------------------------------- -----------
PART II OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On June 2, 2003, PNC ICLC Corp. ("PNCICLC"), an indirect non-bank subsidiary of
the Corporation, entered into a Deferred Prosecution Agreement (the "Deferred
Prosecution Agreement") with the United States Department of Justice, Criminal
Division, Fraud Section (the "Department of Justice"). A copy of the Deferred
Prosecution Agreement is attached as Exhibit 99.1 to the Current Report on Form
8-K filed by the Corporation on June 2, 2003 (the "Form 8-K"). Pursuant to the
terms of the Deferred Prosecution Agreement, the United States filed a criminal
complaint in the United States District Court for the Western District of
Pennsylvania charging PNCICLC with conspiracy to commit securities fraud, in
violation of Title 18, United States Code, Section 371. The Deferred Prosecution
Agreement relates to the three 2001 transactions (the "PAGIC transactions") that
gave rise to a financial statement restatement announced by the Corporation on
January 29, 2002 and that were the subject of a July 2002 consent order between
the Corporation and the United States Securities and Exchange Commission.
The Department of Justice has recommended to the District Court that the
prosecution of PNCICLC be deferred for a period of twelve months in light of
PNCICLC's exceptional remedial actions to date and its willingness to
acknowledge responsibility for its behavior, continue its cooperation with the
Department of Justice and other governmental regulatory agencies, demonstrate
its future good faith conduct and full compliance with the securities laws and
generally accepted accounting principles and consent to the establishment of a
$90 million restitution fund and the assessment of a $25 million monetary
penalty. The Department of Justice has further agreed that if PNCICLC is in full
compliance with all of its obligations under the Deferred Prosecution Agreement,
the Department of Justice will seek dismissal with prejudice of the complaint
within 30 days of the twelve month anniversary of the Deferred Prosecution
Agreement and at such time the Deferred Prosecution Agreement will be
terminated. PNCICLC has timely paid the monetary penalty and established the
restitution fund. The $90 million restitution fund will be available to satisfy
claims, including for the settlement of the pending securities law litigation.
The restitution fund will be administered by Louis W. Fryman, chairman of Fox
Rothschild LLP in Philadelphia, Pennsylvania.
The Form 8-K, together with its exhibits, contains a more complete description
of the Deferred Prosecution Agreement and its impact on PNCICLC and the
Corporation.
61
There are several pending judicial or administrative proceedings or other
matters arising out of the PAGIC transactions. The impact of the final
disposition of these matters cannot be assessed at this time. The Corporation
intends to defend vigorously each of the lawsuits described below.
The several putative class action complaints filed during 2002 have been
consolidated in a consolidated class action complaint brought on behalf of
purchasers of the Corporation's common stock between July 19, 2001 and July 18,
2002 (the "Class Period"). The consolidated class action complaint names the
Corporation, the Chairman and Chief Executive Officer, the former Chief
Financial Officer, the Controller, and the Corporation's independent auditors
for 2001 as defendants and seeks unquantified damages, interest, attorneys' fees
and other expenses. The consolidated class action complaint alleges violations
of federal securities laws related to disclosures regarding the PAGIC
transactions and related matters. The Corporation and all other defendants have
filed a motion to dismiss this lawsuit.
In August 2002, the United States Department of Labor began a formal
investigation of the Administrative Committee of the Corporation's Incentive
Savings Plan ("Plan") in connection with the Committee's conduct relating to the
Corporation's common stock held by the Plan and the Corporation's restatement of
earnings for 2001. Both the Administrative Committee and the Corporation are
cooperating fully with the investigation. In June 2003, the Administrative
Committee retained Independent Fiduciary Services, Inc. ("IFS") to serve as an
independent fiduciary charged with the exclusive authority and responsibility to
act on behalf of the Plan in connection with the consolidated class action
referred to above and to evaluate any legal rights the Plan might have against
any parties relating to the PAGIC transactions. This authority will include
representing the Plan's interests in connection with the $90 million restitution
fund set up under the Deferred Prosecution Agreement. The Department of Labor
has been advised of the appointment of IFS.
In July 2003, a former employee brought a putative class action lawsuit under
ERISA in the United States District Court for the Western District of
Pennsylvania against the Corporation, its Chairman and Chief Executive Officer,
its former Chief Financial Officer, the Plan administrator and certain past and
present members of the Administrative Committee of the Plan. The complaint,
brought on behalf of the Plan and all Plan participants for whose individual
accounts the Plan purchased and/or held shares of the Corporation during the
Class Period, alleges that the defendants breached their fiduciary duties
related to disclosures regarding the PAGIC transactions and related matters and
also breached their fiduciary duties by permitting the Plan to purchase and hold
stock of the Corporation. The complaint seeks, among other things, unquantified
damages, declaratory and injunctive relief, and attorneys' fees and costs.
The Corporation received a letter in June 2003 on behalf of an alleged
shareholder of the Corporation demanding that the Corporation take appropriate
legal action against the Chairman and Chief Executive Officer, the former Chief
Financial Officer, and the Controller, as well as any other individuals or
entities allegedly responsible for causing damage to the Corporation as a result
of the PAGIC transactions. The Board has referred this matter to a special
committee of the Board for evaluation.
In July 2003, the lead underwriter on the Corporation's Executive Blended Risk
insurance coverage filed a lawsuit for a declaratory judgment against the
Corporation and PNCICLC in the United States District Court for the Western
District of Pennsylvania. The complaint seeks a determination that the
defendants breached the terms and conditions of the policy and, as a result, the
policy does not provide coverage for any loss relating to or arising out of the
Department of Justice investigation or the PAGIC transactions. Alternatively,
the complaint seeks a determination that the policy does not provide coverage
for the payments made pursuant to the Deferred Prosecution Agreement. The
complaint also seeks attorneys' fees and costs.
In addition to the proceedings or other matters arising out of the PAGIC
transactions, the Corporation and persons to whom the Corporation may have
indemnification obligations, in the normal course of business, are subject to
various other pending and threatened legal proceedings in which claims for
monetary damages and other relief are asserted. Management does not anticipate
that the ultimate aggregate liability, if any, arising out of such other legal
proceedings will have a material adverse effect on the Corporation's financial
position. However, at the present time, management is not in a position to
determine whether any of such other pending or threatened legal proceedings will
have a material adverse effect on the Corporation's results of operations in any
future reporting period.
62
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
The following exhibit index lists Exhibits filed, or in the case of Exhibits
32.1 and 32.2 furnished, with this Quarterly Report on Form 10-Q:
EXHIBIT INDEX
12.1 Computation of Ratio of Earnings to Fixed Charges
12.2 Computation of Ratio of Earnings to Fixed Charges and
Preferred Stock Dividends
31.1 Certification of Chairman and Chief Executive Officer
pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002
31.2 Certification of Vice Chairman and Chief Financial
Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002
32.1 Certification of Chairman and Chief Executive Officer
pursuant to 18 U.S.C. Section 1350
32.2 Certification of Vice Chairman and Chief Financial
Officer pursuant to 18 U.S.C. Section 1350
99.4 Deferred Prosecution Agreement between PNC ICLC Corp.
and the United States Department of Justice*
- -------------------------------------------------------------------
*Incorporated herein by reference to Exhibit 99.1 of the Corporation's Current
Report on Form 8-K dated June 2, 2003.
Copies of these Exhibits may be obtained electronically at the SEC's home page
at www.sec.gov or from the public reference section of the SEC, at prescribed
rates, at 450 Fifth Street NW, Washington, D.C. 20549. Copies may also be
obtained by any shareholder, without charge, upon written request addressed to
Computershare Investor Services, Post Office Box 3504, Chicago, Illinois
60690-3504, by calling (800) 982-7652 or via e-mail at
web.queries@computershare.com.
As described in PNC's Quarterly Report on Form 10-Q for the quarter ended March
31, 2003, the Corporation filed Current Reports on Form 8-K on April 17, 2003
(two reports), April 24, 2003 and May 1, 2003. In addition, the Corporation
filed the following Reports on Form 8-K during and subsequent to the second
quarter of 2003 through the date of this Quarterly Report on Form 10-Q on the
dates indicated:
June 2, 2003
Item 5, Other Events and Regulation FD Disclosure, related to the entry by PNC
ICLC Corp., an indirect, non-bank subsidiary of the Corporation, into a Deferred
Prosecution Agreement with the United States Department of Justice. Copies of
the Deferred Prosecution Agreement, the Corporation's press release related to
said agreement, and a related question and answer sheet were furnished as
Exhibits to this Current Report on Form 8-K.
July 21, 2003
Item 12, Disclosure of Results of Operations and Financial Condition, regarding
the Corporation's release of second quarter 2003 earnings. A copy of the
Corporation's earnings press release was furnished as an Exhibit to this
Current Report on Form 8-K.
July 21, 2003
Item 12, Disclosure of Results of Operations and Financial Condition, regarding
supplementary financial information provided on the Corporation's website in
connection with its July 21, 2003 release of second quarter 2003 earnings and
related investor conference call. A copy of this supplementary financial
information was furnished as an Exhibit to this Current Report on Form 8-K.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on August 14, 2003, on its
behalf by the undersigned thereunto duly authorized and in the capacity
indicated.
THE PNC FINANCIAL SERVICES GROUP, INC.
/s/ William S. Demchak
William S. Demchak
Vice Chairman and Chief Financial Officer
(Principal Financial Officer)
63
CORPORATE INFORMATION
THE PNC FINANCIAL SERVICES GROUP, INC.
CORPORATE HEADQUARTERS
The PNC Financial Services Group, Inc.
One PNC Plaza
249 Fifth Avenue
Pittsburgh, Pennsylvania 15222-2707
(412) 762-2000
STOCK LISTING
The PNC Financial Services Group, Inc. common stock is listed on the New York
Stock Exchange under the symbol PNC.
INTERNET INFORMATION
The PNC Financial Services Group, Inc.'s financial reports and information about
its products and services are available on the Internet at www.pnc.com.
FINANCIAL INFORMATION
PNC is subject to the reporting requirements of the Securities Exchange Act of
1934 and as such files annual, quarterly and current reports as well as proxy
materials with the Securities and Exchange Commission ("SEC"). Copies of these
and other filings, including exhibits thereto, may be obtained electronically at
the SEC's home page at www.sec.gov or at PNC's home page at www.pnc.com in the
Investors section. Copies may also be obtained without charge by contacting
Shareholder Services at (800) 982-7652 or via e-mail at
web.queries@computershare.com.
INQUIRIES
For financial services call 1-888-PNC-2265. Individual shareholders should
contact Shareholder Services at (800) 982-7652.
Analysts and institutional investors should contact William H. Callihan,
Director of Investor Relations, at (412) 762-8257 or via e-mail at
investor.relations@pnc.com.
News media representatives and others seeking general information should contact
Brian Goerke, Vice President, Corporate Communications, at (412) 762-4550 or via
e-mail at corporate.communications@pnc.com.
COMMON STOCK PRICES/DIVIDENDS DECLARED
The table below sets forth by quarter the range of high and low sale and
quarter-end closing prices for The PNC Financial Services Group, Inc. common
stock and the cash dividends declared per common share.
Cash
Dividends
High Low Close Declared
=================================================================
2003 QUARTER
- -----------------------------------------------------------------
First $45.950 $41.630 $42.380 $.48
Second 50.110 42.060 48.810 .48
- -----------------------------------------------------------------
Total $.96
=================================================================
2002 QUARTER
- -----------------------------------------------------------------
First $62.800 $52.500 $61.490 $.48
Second 61.490 49.600 52.280 .48
Third 52.750 32.700 42.170 .48
Fourth 44.230 36.020 41.900 .48
- -----------------------------------------------------------------
Total $1.92
- -----------------------------------------------------------------
DIVIDEND REINVESTMENT AND STOCK PURCHASE PLAN
The PNC Financial Services Group, Inc. Dividend Reinvestment and Stock Purchase
Plan enables holders of common and preferred stock to purchase additional shares
of common stock conveniently and without paying brokerage commissions or service
charges. A prospectus and enrollment card may be obtained by contacting
Shareholder Services at (800) 982-7652.
REGISTRAR AND TRANSFER AGENT
Computershare Investor Services, LLC
2 North LaSalle Street
Chicago, Illinois 60602
(800) 982-7652
64