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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2003
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from _________________to_________________
Commission file number 1-9718
THE PNC FINANCIAL SERVICES GROUP, INC.
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(Exact name of registrant as specified in its charter)
Pennsylvania 25-1435979
- ------------------------------------ --------------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
One PNC Plaza, 249 Fifth Avenue, Pittsburgh, Pennsylvania 15222-2707
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(Address of principal executive offices)
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(Zip Code)
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(412) 762-2000
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(Registrant's telephone number, including area code)
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(Former name, former address and former fiscal year, if changed since
last report)
Indicate by check mark whether the registrant: (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 (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No
---------------------- --------------------------
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act).
Yes X No
---------------------- --------------------------
As of October 31, 2003, there were 277,263,487 shares of the
registrant's common stock ($5 par value) outstanding.
THE PNC FINANCIAL SERVICES GROUP, INC.
CROSS-REFERENCE INDEX TO 2003 THIRD QUARTER FORM 10-Q
PART I - Financial Information Page(s)
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations. 1-46
Consolidated Financial Highlights 1
Financial Review
Overview 3
Review of Businesses 6
Consolidated Income Statement Review 16
Consolidated Balance Sheet Review 19
"Off-Balance Sheet" Activities 23
Risk Factors 26
Critical Accounting Policies and Judgments 26
Risk Management 29
Internal Controls and Disclosure Controls and Procedures 43
Glossary of Terms 44
Cautionary Statement Regarding Forward-Looking Information 45
Item 1. Financial Statements. 47-68
Consolidated Statement of Income 47
Consolidated Balance Sheet 48
Consolidated Statement of Cash Flows 49
Notes to Consolidated Financial Statements
Note 1 Accounting Policies 50
Note 2 Variable Interest Entities 52
Note 3 Acquisitions 54
Note 4 Recent Accounting Pronouncements 55
Note 5 Capital Securities Of Subsidiary Trusts 55
Note 6 Cash Flows 56
Note 7 Trading Activities 56
Note 8 Legal Proceedings 57
Note 9 Nonperforming Assets 58
Note 10 Allowances For Credit Losses And Unfunded
Loan Commitments And Letters Of Credit 58
Note 11 Securities 59
Note 12 Goodwill And Other Intangible Assets 60
Note 13 Earnings Per Share 61
Note 14 Shareholders' Equity And Comprehensive Income 62
Note 15 Segment Reporting 63
Note 16 Commitments And Guarantees 65
Statistical Information
Consolidated Average Balance Sheet And Net Interest Analysis 67
Item 3. Quantitative and Qualitative Disclosures About Market Risk. 29-43
Item 4. Controls and Procedures. 43
PART II - Other Information
Item 1. Legal Proceedings. 69-70
Item 6. Exhibits and Reports on Form 8-K. 70-71
Corporate Information 72
CONSOLIDATED FINANCIAL HIGHLIGHTS
THE PNC FINANCIAL SERVICES GROUP, INC.
Dollars in millions, except per share data Three months ended September 30 Nine months ended September 30
Unaudited 2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------------------------------
FINANCIAL PERFORMANCE
Revenue
Net interest income (taxable-equivalent basis) (a) $514 $532 $1,543 $1,683
Noninterest income 906 771 2,477 2,431
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Total revenue $1,420 $1,303 $4,020 $4,114
============================== ===========================
Net income $281 $285 $727 $922
------------------------------ ---------------------------
Per common share
Diluted earnings $1.00 $1.00 $2.57 $3.23
------------------------------ ---------------------------
Cash dividends declared $.48 $.48 $1.44 $1.44
- ---------------------------------------------------------------------------------------------------------------------------
SELECTED RATIOS
Return on
Average common shareholders' equity 17.06% 17.49% 14.53% 20.01%
Average assets 1.56 1.72 1.44 1.84
Net interest margin 3.49 3.88 3.71 4.00
Noninterest income to total revenue(b) 64 59 62 59
Efficiency(c) 59 61 65 59
===========================================================================================================================
Certain prior period amounts included in these Consolidated Financial Highlights
have been reclassified to conform to the current period presentation. Also, see
Early Adoption of FIN 46 in the "Off-Balance Sheet Activities" section of this
Financial Review, Note 2 Variable Interest Entities and Note 5 Capital
Securities Of Subsidiary Trusts in the Notes to Consolidated Financial
Statements for further information regarding the impact of the adoption of new
accounting pronouncements during the third quarter of 2003 on certain items
included in these Consolidated Financial Highlights. See page 44 of this
Financial Review for a glossary of 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 September 30 Nine months ended September 30
2003 2002 2003 2002
-------------- ------------ ------------- ------------
Net interest income, GAAP basis $512 $528 $1,536 $1,673
Taxable-equivalent adjustment 2 4 7 10
-------------- ------------ ------------- ------------
Net interest income, taxable-equivalent basis $514 $532 $1,543 $1,683
============== ============ ============= ============
(b) Computed as total noninterest income divided by the sum of net interest
income and noninterest income. For the nine months ended September 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 with the current period presentation.
(c) The efficiency ratio for all periods presented is computed as noninterest
expense divided by the sum of net interest income and noninterest income.
For the nine months ended September 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 with the current period presentation.
1
September 30 December 31 September 30
Unaudited 2003 2002 2002
- ------------------------------------------------------------------------------------------------------------------------------------
BALANCE SHEET DATA (dollars in millions, except per share data)
Assets $72,284 $66,377 $67,659
Earning assets 58,647 54,833 55,650
Loans, net of unearned income 34,514 35,450 35,917
Allowance for credit losses 648 673 648
Securities 14,889 13,763 12,536
Loans held for sale 1,531 1,607 1,989
Deposits 45,523 44,982 44,960
Borrowed funds 13,863 9,116 9,947
Allowance for unfunded loan commitments and letters of credit 89 84 79
Shareholders' equity 6,637 6,859 6,717
Common shareholders' equity 6,628 6,849 6,707
Book value per common share 23.93 24.03 23.62
Loans to deposits 76% 79% 80%
ASSETS UNDER MANAGEMENT (billions) $336 $313 $285
FUND ASSETS SERVICED (billions)
Accounting/administration net assets $634 $510 $489
Custody assets $384 $336 $311
CAPITAL RATIOS
Tier 1 Risk-based 8.2% 8.8% 8.8%
Total Risk-based 11.3 12.5 12.5
Leverage 7.3 8.1 7.8
Shareholders' equity to assets 9.18 10.33 9.93
Common shareholders' equity to assets 9.17 10.32 9.91
ASSET QUALITY RATIOS
Nonperforming assets to loans,
loans held for sale and foreclosed assets 1.10% 1.13% 1.08%
Nonperforming loans to loans .94 .87 .75
Net charge-offs to average loans (for the three months ended) .73 .39 .79
Allowance for credit losses to loans 1.88 1.90 1.80
Allowance for credit losses to nonperforming loans 200 218 239
===================================================================================================================================
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
unaudited Statistical Information included in the Corporation's 2002 Annual
Report on Form 10-K, as amended ("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 Cautionary Statement Regarding Forward-Looking
Information and Critical Accounting Policies And Judgments sections in this
Financial Review for certain other factors that could cause actual results or
future events to differ materially from those anticipated in forward-looking
statements or from historical performance. See page 44 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 nine months of 2003 was $727 million, or
$2.57 per diluted share, compared with net income of $922 million, or $3.23 per
diluted share, for the first nine months of 2002. Return on average common
shareholders' equity was 14.53% for the first nine months of 2003 compared with
20.01% for the first nine months of 2002. Return on average assets was 1.44% for
the first nine months of 2003 compared with 1.84% for the first nine months of
2002.
Consolidated net income for the third quarter of 2003 was $281 million, or $1.00
per diluted share, compared with $285 million, or $1.00 per diluted share, for
the third quarter of 2002. Return on average common shareholders' equity was
17.06% for the third quarter of 2003 compared with 17.49% for the third quarter
of 2002. Return on average assets was 1.56% for the third quarter of 2003
compared with 1.72% for the third quarter of 2002.
Results for the first nine months of 2003 included expenses totaling $87 million
after taxes, or $.31 per diluted share, recognized during the second quarter of
2003 in connection with the Corporation's previously announced agreement with
the United States Department of Justice ("DOJ"), including related legal and
consulting costs. The impact of these expenses was reflected in the return on
average common shareholders' equity and in the return on average assets for the
first nine months of 2003.
The returns on average assets for the first nine months and third quarter of
2003 were also adversely impacted by the Corporation's early adoption of FASB
Interpretation No. ("FIN") 46, "Consolidation of Variable Interest Entities."
The adoption of FIN 46 resulted in increases in total assets and total
liabilities of $6.5 billion and $5.1 billion, respectively, at September 30,
2003. Several income statement line items changed significantly with the
inclusion of the results of the variable interest entities that were
consolidated, but the impact on consolidated net income was minimal. See Early
Adoption of FIN 46 in the "Off-Balance Sheet Activities" section of this
Financial Review and Note 2 Variable Interest Entities in the Notes to
Consolidated Financial Statements for further information.
The Corporation's progress during the first nine months and third quarter of
2003 in addressing several of the challenges referred to in the 2002 Form 10-K
included the following:
Asset quality remained stable.
- The provision for credit losses was $143 million for the first nine
months of 2003 compared with $244 million for the first nine months of
2002. The provision for credit losses was $50 million for the third
quarter of 2003 compared with $73 million for the third quarter of
2002.
- Total nonperforming assets declined $22 million, or 5%, to $396
million at September 30, 2003, despite a $15 million increase in
nonperforming loans from December 31, 2002.
Total revenues declined $91 million in the first nine months of 2003 and
increased $119 million in the third quarter of 2003 compared with the same
periods in 2002. Revenues for the third quarter and first nine months of 2003
included $117 million due to the adoption of FIN 46. Apart from the impact of
FIN 46, total revenues for the first nine months and third quarter of 2003
compared with the corresponding 2002 periods reflected the effects of a lower
interest rate environment, declines in average interest-earning assets and
comparatively weaker equity markets in
3
2003. However, growth in certain facets of the business included the following:
- Third quarter earnings from BlackRock improved 21% compared with the
third quarter of 2002 and earnings for the first nine months of 2003
increased 15% compared with the corresponding 2002 period.
- Regional Community Banking grew home equity loans 15% on average for
the first nine months of 2003 and 17% for the third quarter of 2003
compared with the corresponding prior year periods. Demand deposits
grew 7% on average compared with the first nine months of 2002 and 10%
on average compared with the third quarter of 2002.
PNC's development of value-added customer relationships was evidenced by the
following:
- The number of Regional Community Banking checking relationships at
September 30, 2003 reflected growth of 4% compared with both December
31, 2002 and September 30, 2002.
- PFPC provided accounting/administration services for $634 billion of
pooled investment assets at September 30, 2003, up from $510 billion
at December 31, 2002 and $489 billion at September 30, 2002. These
increases from prior periods resulted from net new business activity
and positive equity market performance during the second and third
quarters of 2003.
Other strategic initiatives and key developments included:
- In August 2003, the Corporation signed a definitive agreement to
acquire United National Bancorp for approximately $320 million in
cash and 6.55 million shares of PNC common stock, and announced an
alliance with The Stop & Shop Supermarket Company to become the
exclusive bank in all new Stop & Shop stores located in New Jersey
going forward.
- In September 2003, the Federal Reserve Bank of Cleveland and the
Office of the Comptroller of the Currency lifted their formal written
agreements with PNC and PNC Bank, N.A. ("PNC Bank"), respectively.
- The Corporation's $100 million efficiency initiative is on track and
has resulted in expense savings, prior to reinvestment, of
approximately $66 million for the first nine months of 2003, including
$29 million in the third quarter.
- PNC repurchased 9.8 million common shares under its 35 million share
repurchase program during the first nine months of 2003, including 3.2
million shares during the third quarter of 2003.
Results for the first nine months of 2003 included a $94 million, or 2%, decline
in total taxable-equivalent revenue compared with the first nine months of 2002,
representing a $140 million decline in taxable-equivalent net interest income
and a $46 million increase in noninterest income. Results for the third quarter
of 2003 reflected a $117 million increase in total taxable-equivalent revenue
compared with the third quarter of 2002, comprised of a $135 million increase in
noninterest income and an $18 million decline in taxable-equivalent net interest
income.
The adoption of FIN 46 increased taxable-equivalent net interest income by $29
million for both 2003 periods. 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").
Total noninterest income was $2.477 billion for the first nine months of 2003
compared with $2.431 billion for the first nine months of 2002. Noninterest
income totaled $906 million for the third quarter of 2003, an increase of $135
million compared with the third quarter of 2002. The adoption of FIN 46 resulted
in an $88 million increase in noninterest income for the third quarter and first
nine months of 2003. A lower level of equity management losses and higher asset
management fees, net gains on sales of commercial mortgages and corporate
services revenue more than offset lower net securities gains in the third
quarter of 2003 compared with the corresponding 2002 period.
Total noninterest expense increased $190 million for the first nine months of
2003 compared with the first nine months of 2002 and increased $45 million in
the third quarter of 2003 compared with the third quarter of 2002. Noninterest
expense for the first nine months of 2003 included DOJ-related expenses of $120
million. The adoption of FIN 46 increased noninterest expense for both the first
nine months and third quarter of 2003 by $28 million.
Management expects that the remainder of 2003 will continue to be a challenge
for 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
4
Cautionary Statement Regarding Forward-Looking Information sections of this
Financial Review.
BALANCE SHEET HIGHLIGHTS
Total assets were $72.3 billion at September 30, 2003 compared with $66.4
billion at December 31, 2002 and $67.7 billion at September 30, 2002. The
Corporation's adoption of FIN 46 effective July 1, 2003 resulted in increases in
total assets and total liabilities of $6.5 billion and $5.1 billion,
respectively, at September 30, 2003. See Early Adoption of FIN 46 in the
"Off-Balance Sheet Activities" section of this Financial Review and Note 2
Variable Interest Entities in the Notes to Consolidated Financial Statements for
further information.
Average interest-earning assets for the first nine months of 2003 were $55.2
billion, down slightly compared with the first nine months of 2002. Average
interest-earning assets increased $1.6 billion during the first nine months of
2003 due to the adoption of FIN 46. Apart from the impact of FIN 46, declines in
average loans of $2.9 billion and average loans held for sale of $1.5 billion
were partially offset by an increase of $2.6 billion in average securities.
Average loans for the first nine months of 2003 were $34.8 billion compared with
$37.7 billion for the first nine months of 2002. Average loans represented 63%
of total average interest-earning assets for the first nine months of 2003
compared with 68% for the first nine months of 2002. Declines in average
residential mortgage and commercial loans drove the decline compared with the
prior year period, 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 nine months of 2003 were $14.4 billion,
compared with $11.7 billion for the first nine months of 2002. Securities
represented 26% of average total interest-earning assets for the first nine
months of 2003 compared with 21% for the first nine months of 2002.
Average deposits represented 66% of total sources of funds for both the first
nine months of 2003 and the first nine months of 2002, with the remainder
primarily comprised of wholesale funding obtained at prevailing market rates.
Average interest-bearing demand and money market deposits totaled $22.2 billion
for the first nine months of 2003, up slightly compared with the first nine
months of 2002. Average borrowed funds were $10.5 billion for the first nine
months of 2003, down slightly compared with the first nine months of 2002. This
decline is consistent with the decline in average total interest-earning assets
in the first nine months 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.
5
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 third 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
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
BlackRock; 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 $142 million for the first nine months of 2003 compared
with a net loss of $52 million for the first nine months of 2002. "Other" for
the first nine months 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 15 Segment Reporting.
"Other Information" included in the tables that follow is presented as of period
end, except for 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)
--------------------------------------------------------------------------------------
Nine months ended September 30 - dollars
in millions 2003 2002 2003 2002 2003 2002 2003 2002
- -----------------------------------------------------------------------------------------------------------------------------------
Banking businesses
Regional Community Banking $449 $545 $1,558 $1,671 23% 28% $38,608 $39,010
Wholesale Banking
Corporate Banking 112 117 513 588 18 15 12,194 14,275
PNC Real Estate Finance 74 67 198 171 26 23 4,738 5,017
PNC Business Credit 26 12 137 133 14 6 3,778 3,870
- ---------------------------------------------------------------------------------------- ---------------------
Total wholesale banking 212 196 848 892 19 15 20,710 23,162
PNC Advisors 56 84 532 504 14 22 3,104 2,976
- ---------------------------------------------------------------------------------------- ---------------------
Total banking businesses 717 825 2,938 3,067 21 23 62,422 65,148
- ---------------------------------------------------------------------------------------- ---------------------
Asset management and processing businesses
BlackRock 114 99 512 447 22 24 3,484 790
PFPC 43 57 568 622 28 37 1,884 1,891
- ---------------------------------------------------------------------------------------- ---------------------
Total asset management and 157 156 1,080 1,069 24 28 5,368 2,681
processing businesses
- ---------------------------------------------------------------------------------------- ---------------------
Total business results 874 981 4,018 4,136 21 23 67,790 67,829
Intercompany eliminations (5) (7) (71) (79) (1,946) (2,005)
Other (142) (52) 73 57 1,777 1,017
- ---------------------------------------------------------------------------------------- ---------------------
Total consolidated(a) $727 $922 $4,020 $4,114 15 20 $67,621 $66,841
===================================================================================================================================
(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:
Nine months ended September 30 - in millions 2003 2002
================================================================================
Total consolidated revenue, book (GAAP) $4,013 $4,104
Taxable-equivalent adjustment 7 10
- --------------------------------------------------------------------------------
Total consolidated revenue, taxable-equivalent basis $4,020 $4,114
================================================================================
(b) Percentages for BlackRock reflect return on equity.
(c) Period-end balances for BlackRock.
6
REGIONAL COMMUNITY BANKING
Nine months ended September 30
Taxable-equivalent basis
Dollars in millions 2003 2002
- --------------------------------------------------------------------------------
INCOME STATEMENT
Net interest income $960 $1,078
Other noninterest income 521 509
Net securities gains 77 84
- --------------------------------------------------------------------------------
Total revenue 1,558 1,671
Provision for credit losses 32 37
Noninterest expense 842 797
- --------------------------------------------------------------------------------
Pretax earnings 684 837
Income taxes 235 292
- --------------------------------------------------------------------------------
Earnings $449 $545
================================================================================
AVERAGE BALANCE SHEET
Loans
Consumer
Home equity $8,069 $7,002
Indirect 466 569
Other consumer 522 649
- --------------------------------------------------------------------------------
Total consumer 9,057 8,220
Residential mortgage 2,941 4,435
Commercial 3,950 3,512
Vehicle leasing 1,163 1,750
Other 116 120
- --------------------------------------------------------------------------------
Total loans 17,227 18,037
Securities 13,844 10,855
Education and other loans held for sale 1,166 1,354
Assigned assets and other assets 6,371 8,764
- --------------------------------------------------------------------------------
Total assets $38,608 $39,010
================================================================================
Deposits
Noninterest-bearing demand $5,493 $4,980
Interest-bearing demand 6,216 6,012
Money market 12,358 12,311
- --------------------------------------------------------------------------------
Total transaction deposits 24,067 23,303
Savings 2,024 1,966
Certificates 8,749 10,177
- --------------------------------------------------------------------------------
Total deposits 34,840 35,446
Other liabilities 1,163 932
Assigned capital 2,605 2,632
- --------------------------------------------------------------------------------
Total funds $38,608 $39,010
================================================================================
PERFORMANCE RATIOS
Return on assigned capital 23% 28%
Noninterest income to total revenue 38 35
Efficiency 54 48
- --------------------------------------------------------------------------------
OTHER INFORMATION
Total nonperforming assets(a) $74 $65
Vehicle leasing outstandings,
net of unearned income(b) $872 $1,511
Net charge-offs $38 $41
Home equity portfolio credit statistics:
Percentage of first lien positions 50% 37%
Weighted average loan-to-value ratios 70% 70%
Weighted average FICO scores 712 708
Gains on sales of education loans $12 $13
Average FTEs 9,438 9,568
ATMs 3,664 3,450
Branches 715 714
Financial consultants 702 626
Business banking centers 208 188
Checking relationships 1,606,004 1,538,000
Online banking users 728,352 563,471
Deposit households using online banking 41.7% 34.7%
================================================================================
(a) Includes nonperforming loans of $63 million and $56 million at September
30, 2003 and 2002, respectively.
(b) At September 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 goal of Regional Community Banking 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 expanding relationships with these customers through cross-selling of other
products and services. Consistent with this strategy, in August 2003 the
Corporation signed a definitive agreement to acquire United National Bancorp
("United National") for approximately $320 million in cash and 6.55 million
shares of PNC common stock, subject to customary closing conditions. United
National is a bank holding company with over $3 billion in assets. A subsidiary
of United National, UnitedTrust Bank, provides a full range of commercial and
retail banking services through 45 branches in New Jersey and seven branches in
Pennsylvania. With this acquisition, PNC expects to increase its customer base
by more than 100,000 households and businesses. See Note 3 Acquisitions in the
Notes to Consolidated Financial Statements and Cautionary Statement Regarding
Forward-Looking Information for further information.
Also, PNC Bank announced in August 2003 an alliance with The Stop & 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 &
Shop's new and existing New Jersey stores over the next four years.
Regional Community Banking increased the number of checking relationships by 4%
compared with September 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 online banking services. This focus has resulted in a 29% increase in online
banking users since September 30, 2002.
Regional Community Banking earnings were $449 million for the first nine months
of 2003 compared with $545 million in the first nine months of 2002. Revenue was
negatively impacted by low interest rates in the first nine months of 2003 and
the downsizing of targeted lending activities. These factors, and an increase in
employee benefit costs, contributed to the decline in earnings. Accordingly, the
efficiency ratio declined in 2003 compared with the first nine months of 2002.
7
Total revenue was $1.6 billion for the first nine months of 2003 compared with
$1.7 billion in the first nine months of 2002. Taxable-equivalent net interest
income declined $118 million, or 11%, compared with the first nine months of
2002. The lower interest rate environment in 2003 contributed to an acceleration
in prepayments, lower yields and a $77 million decline in taxable-equivalent net
interest income generated from the mortgage loan and mortgage-backed securities
portfolios. An additional $27 million decline in taxable-equivalent net interest
income was attributable to lower yields on securities. The lower yields on
earning assets were partially offset by an increase of $21 million from higher
average home equity loan balances. Other noninterest income increased $12
million compared with the first nine months of 2002 as a $12 million improvement
in deposit-related fee revenue and an $11 million increase in ATM and debit card
fees more than offset declines in other income related to gains on sales of
assets in 2002. Net securities gains decreased $7 million for the first nine
months of 2003 compared with the prior year period.
The provision for credit losses for the first nine months of 2003 was $32
million, a decline of $5 million compared with the prior year period primarily
due to a decrease in required specific reserves.
Noninterest expense totaled $842 million in the first nine months of 2003, an
increase of $45 million compared with the first nine months of 2002. The
increase reflected higher pension cost, increases in net occupancy costs related
to additional offsite ATMs, investments in the branch network and marketing
costs.
Average total loans decreased 4% for the first nine months of 2003 compared with
the first nine 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 15% on average compared with the first nine months of
2002 driven by record levels of new loan volume fueled in part by refinancing
activity. As of September 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 which may not continue. Commercial loan outstandings
associated with lending to auto dealers to finance their inventory increased by
14% as new relationships were added and auto dealers expanded their inventories
during 2003. The overall decline in loans primarily resulted from residential
mortgage prepayments and the run-off of vehicle leases.
Average total deposits declined 2% in the first nine 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
deposit balance growth of 7% was primarily attributable to the growth in
checking relationships. Money market and savings balances experienced modest
growth as progress with cross-selling efforts was offset by the adverse impact
of aggressive competitor pricing on balances attracted and retained. The
certificate of deposit portfolio declined as higher-cost maturing certificates
were not targeted for aggressive retention offers and were allowed to run off or
were converted to fixed-rate annuities based on customer preferences.
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 42% since September 30, 2002 and is performing overall as expected. See
Loans in the Consolidated Balance Sheet Review section of this Financial Review
for additional information.
8
WHOLESALE BANKING - CORPORATE BANKING
Nine months ended September 30
Taxable-equivalent basis
Dollars in millions 2003 2002
- --------------------------------------------------------------------------------
INCOME STATEMENT
Net interest income $224 $271
Noninterest income 289 317
- --------------------------------------------------------------------------------
Total revenue 513 588
Provision for credit losses 63 139
Noninterest expense 278 272
- --------------------------------------------------------------------------------
Pretax earnings 172 177
Income tax 60 60
- --------------------------------------------------------------------------------
Earnings $112 $117
================================================================================
AVERAGE BALANCE SHEET
Loans $8,292 $9,698
Purchased customer receivables 841
Loans held for sale 213 1,674
Other assets 2,848 2,903
- --------------------------------------------------------------------------------
Total assets $12,194 $14,275
================================================================================
Deposits $5,106 $4,608
Commercial paper 843
Assigned funds and other liabilities 5,391 8,596
Assigned capital 854 1,071
- --------------------------------------------------------------------------------
Total funds $12,194 $14,275
================================================================================
PERFORMANCE RATIOS
Return on assigned capital 18% 15%
Noninterest income to total revenue 56 54
Efficiency 54 46
- --------------------------------------------------------------------------------
OTHER INFORMATION
Total nonperforming assets(a) $168 $158
Net charge-offs $78 $122
Average FTEs 1,893 1,919
INSTITUTIONAL LENDING REPOSITIONING
Loans held for sale
Credit exposure $126 $964
Outstandings $75 $415
Exit portfolio
Credit exposure $61 $611
Outstandings $10 $12
- --------------------------------------------------------------------------------
Net gains on loans held for sale(b) $47 $100
================================================================================
(a) Includes nonperforming loans of $118 million and $57 million at September
30, 2003 and 2002, respectively
(b) Included in Noninterest income above.
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. 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.
PNC, through the Corporate Banking line of business, administers Market Street
Funding Corporation ("Market Street"), a multi-seller asset-backed commercial
paper conduit. Effective July 1, 2003, PNC consolidated Market Street into its
financial statements in connection with the Corporation's early adoption of FIN
46. While the consolidation of Market Street had no impact on earnings for
Corporate Banking or on PNC's consolidated net income for the first nine months
of 2003, it increased taxable-equivalent net interest income by $4 million,
decreased noninterest income by $3 million and increased noninterest expense by
$1 million. In addition, the average balance sheet for Corporate Banking was
increased primarily by the addition of purchased customer receivables of $841
million and commercial paper of $843 million. See Early Adoption of FIN 46 in
the "Off-Balance Sheet Activities" section of this Financial Review and Note 2
Variable Interest Entities in the Notes to Consolidated Financial Statements for
further information.
Corporate Banking earnings were $112 million for the first nine months of 2003
compared with $117 million for the first nine 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 nine
months of 2002.
Total revenue of $513 million for the first nine months of 2003 decreased $75
million compared with the first nine months of 2002. Taxable-equivalent net
interest income for the first nine months of 2003 decreased $47 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 $28 million
compared with the first nine months of 2002. This decline reflected a $53
million reduction in net gains on loans held for sale compared with the first
nine months 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 declined $76 million in the first nine months of
2003 compared with the same period in 2002. The provision for credit losses for
the first nine months of 2002 reflected reserve allocations related to Market
Street matters.
Noninterest expense totaled $278 million in the first nine months of 2003
compared with $272 million for the first nine 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 and higher pension and
stock option costs, partially offset by lower servicing costs associated with
the reduction in average loans and average loans held for sale.
Nonperforming assets were $168 million at September 30, 2003 compared with $158
million at September 30, 2002. Nonperforming assets at September 30, 2003
included approximately $71 million in aggregate outstandings from two customers
in the manufacturing sector that were placed on nonaccrual status in 2003 and
$18 million from foreclosed lease assets primarily representing the repossession
of collateral related to a single airline industry credit during the second
quarter of 2003. Collectively, these items more than offset the reduction in
nonperforming assets associated with the Corporation's continued liquidation of
the institutional lending held for sale portfolio.
9
WHOLESALE BANKING - PNC REAL ESTATE FINANCE
Nine months ended September 30
Taxable-equivalent basis
Dollars in millions 2003 2002
- --------------------------------------------------------------------------------
INCOME STATEMENT
Net interest income $81 $87
Noninterest income
Net commercial mortgage banking
Net gains on loan sales 38 19
Servicing and other fees, net
of amortization 30 30
Other 49 35
- --------------------------------------------------------------------------------
Total noninterest income 117 84
- --------------------------------------------------------------------------------
Total revenue 198 171
Provision for credit losses (1) (7)
Noninterest expense 140 119
- --------------------------------------------------------------------------------
Pretax earnings 59 59
- --------------------------------------------------------------------------------
Noncontrolling interests in income
of consolidated entities (13) (2)
Income tax benefit (2) (6)
- --------------------------------------------------------------------------------
Earnings $74 $67
================================================================================
AVERAGE BALANCE SHEET
Loans
Commercial real estate $1,948 $2,251
Commercial - real estate related 1,422 1,474
- --------------------------------------------------------------------------------
Total loans 3,370 3,725
Commercial mortgages held for sale 305 252
Other loans held for sale 38 157
Other assets 1,025 883
- --------------------------------------------------------------------------------
Total assets $4,738 $5,017
================================================================================
Deposits $1,074 $702
Liabilities of certain variable
interest entities 33
Noncontrolling interests
in consolidated entities 13
Assigned funds and other liabilities 3,237 3,920
Assigned capital 381 395
- --------------------------------------------------------------------------------
Total funds $4,738 $5,017
================================================================================
PERFORMANCE RATIOS
Return on assigned capital 26% 23%
Noninterest income to total revenue 59 49
Efficiency 71 70
- --------------------------------------------------------------------------------
COMMERCIAL MORTGAGE SERVICING
PORTFOLIO(a)
January 1 $74 $68
Acquisitions/additions 17 15
Repayments/transfers (11) (9)
- --------------------------------------------------------------------------------
September 30 $80 $74
================================================================================
OTHER INFORMATION
Total nonperforming assets(b) $3 $3
Net charge-offs (recoveries) $1 $(6)
Average FTEs 745 762
Net carrying amount of commercial
mortgage servicing rights $200 $201
INSTITUTIONAL LENDING REPOSITIONING
Loans held for sale
Credit exposure $16 $68
Outstandings $16 $55
Exit portfolio
Credit exposure $25
Outstandings $13
Net gains on loans held for sale(c) $7 $6
================================================================================
(a) Dollars in billions.
(b) Includes nonperforming loans of $1 million and $3 million at September 30,
2003 and 2002, respectively.
(c) Included in Noninterest income-Net commercial mortgage banking-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 limits 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 nine months of 2003.
Effective July 1, 2003, PNC Real Estate Finance consolidated certain equity
investments in various limited partnerships that sponsor affordable housing
projects utilizing the Low Income Housing Tax Credit (LIHTC) in connection with
the Corporation's early adoption of FIN 46. In addition, the adoption of FIN 46
was applied to certain entities in which PNC Real Estate Finance is a national
syndicator of affordable housing equity and is the general partner. While the
adoption of FIN 46 for these entities had no impact on earnings for PNC Real
Estate Finance or on PNC's consolidated net income for the first nine months of
2003, it decreased taxable-equivalent net interest income by $2 million,
increased noninterest income by $9 million, and increased noninterest expense by
$18 million, with the remaining $11 million offset recorded as noncontrolling
interests in income of consolidated entities. See Early Adoption of FIN 46 in
the "Off-Balance Sheet Activities" section of this Financial Review and Note 2
Variable Interest Entities in the Notes to Consolidated Financial Statements for
further information.
PNC Real Estate Finance earned $74 million for the first nine months of 2003 and
$67 million for the first nine months of 2002. The increase was primarily due to
higher gains on commercial mortgage loan sales in 2003 that more than offset the
impact of lower taxable-equivalent net interest income and a lower benefit from
the provision for credit losses. The provision for the first nine months of 2003
is in a net credit position based on lower loans outstanding and continued
strong credit quality. The provision was in a higher net credit position in the
first nine months of 2002, which was primarily due to a $6 million net recovery
on an exited warehouse lending loan.
10
Total revenue increased $27 million for the first nine months of 2003 compared
with the first nine months of 2002 as a $33 million increase in noninterest
income more than offset a $6 million decline in taxable-equivalent net interest
income. The increase in noninterest income included an increase of $19 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 unusually favorable market
conditions for this activity. The decline in taxable-equivalent net interest
income was primarily due to a $355 million decline in average loans in the
comparison.
Noninterest expense for the first nine months of 2003 increased $21 million
compared with the prior year period. The impact of the adoption of FIN 46
represented $18 million of this increase as described above.
PNC Real Estate Finance recognized an income tax benefit for both the first nine
months of 2003 and 2002 due to the impact of tax credits received on LIHTC
investments. The income tax benefits were partially offset by passive losses
from these investments included in noninterest expense.
The commercial mortgage servicing portfolio increased $6 billion to $80 billion
at September 30, 2003 compared with the balance at September 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 $89 million
of advances were outstanding at September 30, 2003, compared with $77 million at
September 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
the cash flows from the related securitizations, including claims by the
security holders.
11
WHOLESALE BANKING - PNC BUSINESS CREDIT
Nine months ended September 30
Taxable-equivalent basis
Dollars in millions 2003 2002
- --------------------------------------------------------------------------------
INCOME STATEMENT
Net interest income $101 $101
Noninterest income 36 32
- --------------------------------------------------------------------------------
Total revenue 137 133
Provision for credit losses 51 72
Noninterest expense 44 41
- --------------------------------------------------------------------------------
Pretax earnings 42 20
Income taxes 16 8
- --------------------------------------------------------------------------------
Earnings $26 $12
================================================================================
AVERAGE BALANCE SHEET
Loans $3,515 $3,550
Loans held for sale 24 83
Other assets 239 237
- --------------------------------------------------------------------------------
Total assets $3,778 $3,870
================================================================================
Deposits $98 $78
Assigned funds and other liabilities 3,436 3,540
Assigned capital 244 252
- --------------------------------------------------------------------------------
Total funds $3,778 $3,870
================================================================================
PERFORMANCE RATIOS
Return on assigned capital 14% 6%
Noninterest income to total revenue 26 24
Efficiency 32 31
- --------------------------------------------------------------------------------
OTHER INFORMATION
Total nonperforming assets(a) $140 $179
Net charge-offs $45 $26
NBOC put option liability $78
NBOC put option valuation income(b) $8 $19
Marketing locations 24 23
Average FTEs 251 238
INSTITUTIONAL LENDING REPOSITIONING
Loans held for sale
Credit exposure $8 $46
Outstandings $7 $25
Net losses on loans held for sale(b) $(1) $(11)
================================================================================
(a) Includes nonperforming loans of $132 million and $151 million at September
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 3
Acquisitions for additional information.
PNC Business Credit earned $26 million for the first nine months of 2003
compared with $12 million for the first nine months of 2002. Higher earnings for
the first nine months of 2003 compared with the same period of 2002 were
primarily due to a $21 million decline in the provision for credit losses in
2003.
Total revenue was $137 million for the first nine months of 2003 and $133
million for the first nine months of 2002. Noninterest income increased $4
million compared with the first nine months of 2002. The increase in noninterest
income was primarily due to higher product-related revenue in the first nine
months of 2003, as the impact of an $11 million decline in income resulting from
the reduction in the value of the NBOC put option liability was largely offset
by a lower level of losses recognized on the institutional loans held for sale
in the current year period.
The provision for credit losses for the first nine months of 2003 was $51
million, a decrease of $21 million compared with the same period in 2002. Net
charge-offs were $45 million for the first nine months of 2003, an increase of
$19 million compared with the prior year period. Net charge-offs for the 2003
period included a $28 million charge-off related to a single loan to a wholesale
goods/retail customer for which a substantial reserve had been provided at June
30, 2003. This is the largest single nonperforming relationship in this business
and was supported more by its franchise value rather than a collateral value.
Approximately 98% of the total portfolio in this business is underwritten based
on the value of collateral. Notwithstanding the increase in the level of
charge-offs, the decline in the provision for 2003 represented changes in the
reserve methodology in 2002 and the comparative impact of a significant addition
to reserves at September 30, 2002. PNC Business Credit loans, including those
acquired in the NBOC acquisition, are primarily 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 $3 million for the first nine months of 2003
compared with the first nine months of 2002 primarily due to higher average FTEs
and benefit costs.
Nonperforming assets were $140 million at September 30, 2003 compared with $179
million at September 30, 2002. The decrease was primarily due to reductions to
credits through managed liquidation and charge-offs.
12
PNC ADVISORS
Nine months ended September 30
Taxable-equivalent basis
Dollars in millions 2003 2002
- --------------------------------------------------------------------------------
INCOME STATEMENT
Net interest income $65 $76
Noninterest income
Investment management and trust 232 258
Brokerage 87 102
Other 148 68
- --------------------------------------------------------------------------------
Total noninterest income 467 428
- --------------------------------------------------------------------------------
Total revenue 532 504
Provision for credit losses 2 3
Noninterest expense 373 368
- --------------------------------------------------------------------------------
Pretax earnings 157 133
Noncontrolling interests in income
of consolidated entities 69
Income taxes 32 49
- --------------------------------------------------------------------------------
Earnings $56 $84
================================================================================
AVERAGE BALANCE SHEET
Loans
Consumer $1,299 $1,216
Residential mortgage 268 537
Commercial 446 467
Other 285 335
- --------------------------------------------------------------------------------
Total loans 2,298 2,555
Other assets 806 421
- --------------------------------------------------------------------------------
Total assets $3,104 $2,976
================================================================================
Deposits $2,109 $2,004
Noncontrolling interests
in consolidated entities 182
Liabilities of certain variable
interest entities 22
Assigned funds and other liabilities 267 452
Assigned capital 524 520
- --------------------------------------------------------------------------------
Total funds $3,104 $2,976
================================================================================
PERFORMANCE RATIOS
Return on assigned capital 14% 22%
Noninterest income to total revenue 88 85
Efficiency 70 73
- --------------------------------------------------------------------------------
ASSETS UNDER MANAGEMENT(a)
Personal investment management and trust $42 $40
Institutional trust 9 10
- --------------------------------------------------------------------------------
Total $51 $50
ASSET TYPE
Equity $28 $26
Fixed income 16 17
Liquidity 7 7
- --------------------------------------------------------------------------------
Total $51 $50
================================================================================
OTHER INFORMATION
Total nonperforming assets (loans) $11 $4
Brokerage assets administered (in
billions)(b) $35 $31
Full service brokerage offices 99 108
Financial consultants/brokers 561 621
Margin loans $257 $257
Average FTEs 3,130 3,311
================================================================================
(a) At September 30 - in billions. Excludes brokerage assets administered.
(b) Includes assets administered by brokers operating within Regional Community
Banking.
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 its Hawthorn division. 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.
Effective July 1, 2003, the Corporation consolidated a number of private
investment funds organized as limited partnerships ("Private Funds") that are
managed by the Hawthorn division of PNC Advisors. While the consolidation of the
Private Funds had no impact on earnings for PNC Advisors or on PNC's
consolidated net income for the first nine months of 2003, it increased
taxable-equivalent net interest income by $3 million, increased noninterest
income by $73 million, increased noninterest expense by $7 million and increased
noncontrolling interests in income of consolidated entities by $69 million. The
adoption of FIN 46 increased average assets by $211 million and average
liabilities by $29 million for PNC Advisors for the first nine months of 2003.
See Early Adoption of FIN 46 in the "Off-Balance Sheet Activities" section of
this Financial Review and Note 2 Variable Interest Entities in the Notes to
Consolidated Financial Statements for further information.
Although the third quarter of 2003 reflected a continued upward trend in the
financial markets, this business has been affected adversely by client
acquisition and retention issues. PNC Advisors is addressing these issues by
taking steps to strengthen client relationships and position itself as an
advice-based provider. The introduction of separately managed accounts in
September 2003 is expected to provide clients with an even broader array of
investment choices. PNC Advisors has completed 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 $15 million of expenses on an annual basis
beginning in 2004.
PNC Advisors earned $56 million for the first nine months of 2003 compared with
$84 million in the first nine months of 2002. The earnings decline reflected the
impact of comparatively weaker equity market conditions on asset management and
brokerage revenues, client acquisition and retention issues, and the effect of
reduced loan levels and the lower interest rate environment on
taxable-equivalent net interest income.
Total revenue for the first nine months of 2003 increased $28 million compared
with the prior year period. This increase reflected the impact of the adoption
of FIN 46 as described above. The run-off of residential mortgages along with a
narrower net interest margin reflecting the lower interest rate environment in
2003 were the primary factors in the decline in taxable-equivalent net interest
income. Investment management and trust fees declined $26 million, resulting
from 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 September 30, 2003 increased $1 billion compared with the balance
at September 30, 2002 due to improved equity markets.
Brokerage assets administered by Hilliard Lyons were $35 billion at September
30, 2003 compared with $31 billion at September 30, 2002. Consolidated revenue
from brokerage was $87 million for the first nine months of 2003 compared with
$102 million for the first nine months of 2002. Hilliard Lyons has responded to
the decline in revenue through selectively closing underperforming brokerage
offices and reducing headcount.
13
BLACKROCK
Nine months ended September 30
Dollars in millions 2003 2002
- --------------------------------------------------------------------------------
INCOME STATEMENT
Investment advisory and
administration fees $384 $397
Investment income 78 7
Other income 50 43
- --------------------------------------------------------------------------------
Total revenue 512 447
Other expense 250 246
Interest expense 24
Fund administration and servicing costs 23 34
- --------------------------------------------------------------------------------
Total operating expense 297 280
- --------------------------------------------------------------------------------
Earnings before income taxes and
noncontrolling interests 215 167
Noncontrolling interests in income
of consolidated entities 31
Income taxes 70 68
- --------------------------------------------------------------------------------
Earnings $114 $99
================================================================================
PERIOD-END BALANCE SHEET
Investments $2,550 $180
Goodwill and other intangible assets 192 181
Other assets 742 429
- --------------------------------------------------------------------------------
Total assets $3,484 $790
================================================================================
Borrowings $2,141
Liabilities 379 $194
Noncontrolling interests in consolidated
entities 268
Stockholders' equity 696 596
- --------------------------------------------------------------------------------
Total liabilities and
stockholders' equity $3,484 $790
================================================================================
PERFORMANCE DATA
Return on equity 22% 24%
Net income margin 22 22
Diluted earnings per share $1.73 $1.52
================================================================================
ASSETS UNDER MANAGEMENT(a)
Separate accounts
Fixed income $178 $146
Liquidity 6 5
Liquidity - securities lending 10 6
Equity 9 8
Alternative investment products 7 6
- --------------------------------------------------------------------------------
Total separate accounts 210 171
- --------------------------------------------------------------------------------
Mutual funds(b)
Fixed income 23 19
Liquidity 58 52
Equity 3 4
- --------------------------------------------------------------------------------
Total mutual funds 84 75
- --------------------------------------------------------------------------------
Total assets under management $294 $246
- --------------------------------------------------------------------------------
OTHER INFORMATION
Average FTEs 955 878
================================================================================
(a) At September 30 - in billions.
(b) 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 70% owned by PNC and is consolidated into PNC's
financial statements. Accordingly, approximately 30% 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 $294 billion of assets under management at
September 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.
Effective July 1, 2003, BlackRock consolidated six collateralized debt
obligation ("CDO") funds, including a collateralized loan obligation fund which
closed on September 30, 2003, in which BlackRock acts as collateral manager in
connection with the Corporation's early adoption of FIN 46. While the
consolidation of the CDOs had no impact on earnings for BlackRock or on PNC's
consolidated net income for the first nine months of 2003, it increased
investment income by $62 million, increased other expense by $7 million,
increased interest expense by $24 million and increased noncontrolling interests
in income of consolidated entities by $31 million. In addition, the
consolidation of the CDOs increased BlackRock's total assets by $2.6 billion and
increased total liabilities by $2.3 billion at September 30, 2003. See Early
Adoption of FIN 46 in the "Off-Balance Sheet Activities" section of this
Financial Review and Note 2 Variable Interest Entities in the Notes to
Consolidated Financial Statements for further information.
BlackRock earned $114 million for the first nine months of 2003 compared with
$99 million for the first nine months of 2002. Apart from the impact of FIN 46,
higher earnings for the first nine months of 2003 reflected the impact of lower
total expenses and a slight increase in total revenue in the first nine months
of 2003.
Total revenue for the first nine months of 2003 of $512 million increased $65
million compared with the first nine months of 2002. Apart from the impact of
FIN 46 described above, higher revenue in 2003 reflected increases in separate
account base fees and other income that were offset by decreases in separate
account performance fees and mutual fund revenue. The increase in separate
account base fees resulted from strong growth in fixed income separate account
assets.
Assets under management totaled $294 billion at September 30, 2003, an increase
of $48 billion, or 19%, compared with assets under management at September 30,
2002. The increase in assets under management reflected net subscriptions of $34
billion and net market appreciation of $14 billion.
Total operating expenses for the first nine months of 2003 increased $17 million
compared with the prior year period. Apart from the impact of FIN 46 described
above, expenses declined largely due to a decrease in fund administration and
servicing costs.
Income taxes increased only slightly compared with the first nine months of 2002
despite a $17 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.
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.
14
PFPC
Nine months ended September 30
Dollars in millions 2003 2002
- --------------------------------------------------------------------------------
INCOME STATEMENT
Fund servicing revenue $568 $622
Operating expense 463 482
(Accretion)/amortization of
other intangibles, net (14) (14)
- --------------------------------------------------------------------------------
Operating income 119 154
Nonoperating income(a) 6 8
Debt financing 53 67
- --------------------------------------------------------------------------------
Pretax earnings 72 95
Income taxes 29 38
- --------------------------------------------------------------------------------
Earnings $43 $57
================================================================================
AVERAGE BALANCE SHEET
Goodwill and other intangible assets $1,038 $1,030
Other assets 846 861
- --------------------------------------------------------------------------------
Total assets $1,884 $1,891
- --------------------------------------------------------------------------------
Assigned funds and other liabilities $1,676 $1,683
Assigned capital 208 208
- --------------------------------------------------------------------------------
Total funds $1,884 $1,891
================================================================================
PERFORMANCE RATIOS
Return on assigned capital 28% 37%
Operating margin(b) 21 25
- --------------------------------------------------------------------------------
SERVICING STATISTICS (C)
Accounting/administration net assets(d)
Domestic $593 $464
Foreign(e) 41 25
- --------------------------------------------------------------------------------
Total $634 $489
- --------------------------------------------------------------------------------
Custody assets(d) $384 $311
- --------------------------------------------------------------------------------
Shareholder accounts (in millions)
Transfer agency 21 28
Subaccounting 29 24
- --------------------------------------------------------------------------------
Total 50 52
- --------------------------------------------------------------------------------
OTHER INFORMATION
Average FTEs 5,175 5,933
================================================================================
(a) Net of nonoperating expense.
(b) Operating income divided by total fund servicing revenue.
(c) At September 30.
(d) In billions.
(e) Represents net assets serviced offshore.
PFPC is among the largest providers of mutual fund transfer agency and
accounting and administration services in the United States, offering a wide
range of fund processing 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 $43 million for the first nine months of 2003 compared with $57
million for the first nine months of 2002. Earnings for the first nine months of
2003 declined compared with the prior year period as the $54 million decline in
fund servicing revenue more than offset a $19 million decline in operating
expenses and a $14 million decrease in debt financing costs.
Fund servicing revenue of $568 million for the first nine months of 2003
decreased $54 million compared with the first nine 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 and an additional $9
million related to the retirement services business, which was sold effective
June 30, 2003.
Operating expense decreased $19 million, or 4%, in the first nine months of 2003
compared with the prior year period. Operating expense for the first nine months
of 2002 reflected the benefit of a $19 million reduction in reserves that were
originally established in 2001 largely related to a previously reported plan to
consolidate selected facilities as discussed below. The decline in operating
expenses compared with the first nine months of 2002 was primarily due to
reductions in staff and contract programmers as well as the impact of the sale
of the retirement services business effective June 30, 2003 and reflected the
initiatives launched in the second half of 2002 designed to improve efficiency.
These included such projects as consolidating transfer agency platforms,
increasing automation and executing planned facilities consolidations. In 2003,
PFPC expects 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 13% for the first nine
months of 2003 compared with the first nine months of 2002.
Notwithstanding these initiatives, market conditions in early 2003, 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.
PFPC's performance is partially dependent on the underlying performance of its
mutual fund clients and, in particular, their ability to attract and retain
customers. As a result, to the extent that its clients' businesses are adversely
affected by on-going governmental investigations into the practices of the
mutual fund industry, PFPC's results could be impacted.
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. Over comparative
periods, 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, has
recently renewed several existing relationships and has been awarded several new
servicing contracts, partially offsetting the revenue impact of client
attrition.
Operating income for the first nine months of 2003 reflected the accretion of a
discounted client contract liability of $26 million. Accretion for the first
nine months of 2002 was $25 million.
Increases in both accounting/administration and custody pooled investment assets
at September 30, 2003 compared with the balances at September 30, 2002 resulted
primarily from new business, asset inflows from existing clients and the
continued upward trend in the equity markets during the second and third
quarters of 2003. Total assets serviced by PFPC amounted to $1.5 trillion at
September 30, 2003 and $1.3 trillion at September 30, 2002.
PFPC serviced approximately 21 million transfer agency shareholder accounts at
September 30, 2003 compared with 28 million at September 30, 2002. The decline
in transfer agency accounts in 2003 was primarily due to a loss of one large
client in the first quarter. Subaccounting shareholder accounts serviced by PFPC
totaled 29 million at September 30, 2003 compared with 24 million at September
30, 2002. The increase in subaccounting shareholder accounts serviced resulted
from net new business and growth in existing client accounts.
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 nine months of
2003, the Corporation recognized a $7 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 $7 million at September 30, 2003.
15
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 Balance Sheet Highlights in the Overview section of this Financial
Review and Statistical Information-Consolidated Average Balance Sheet and Net
Interest Analysis for additional information.
PNC's adoption, effective July 1, 2003, of Statement of Financial Accounting
Standards No. 150, "Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity," ("SFAS 150") negatively
impacted taxable-equivalent net interest income and net interest margin for both
the first nine months and third quarter of 2003. As required by SFAS 150, the
Corporation's mandatorily redeemable capital securities of subsidiary trusts
(trust preferred securities) totaling $848 million were reclassified in the
third quarter of 2003 from between the liabilities and shareholders' equity
sections of the Consolidated Balance Sheet to borrowed funds. The dividends paid
on these financial instruments, previously classified as noninterest expense,
were recharacterized as interest expense. Reclassification of prior period
amounts was not permitted under SFAS 150.
Taxable-equivalent net interest income was $1.543 billion and the net interest
margin was 3.71% for the first nine months of 2003 compared with $1.683 billion
and 4.00%, respectively, for the first nine months of 2002. The declines in
taxable-equivalent net interest income and net interest margin compared with the
first nine months of 2002 were primarily due to the impact of the lower interest
rate environment in 2003 and a $.6 billion or 1% decrease in average
interest-earning assets. Average interest-earning assets for the first nine
months of 2003 included $1.6 billion recognized in connection with the adoption
of FIN 46. Apart from the impact of FIN 46, the decline in average
interest-earning assets reflected a $1.5 billion reduction in average loans held
for sale, the prepayment of residential mortgages that reduced the average
balance of residential mortgages by $1.8 billion, and a $1.2 billion decline in
average commercial loans. Partially offsetting these declines in average
interest-earning assets was an increase of $3.0 billion in securities available
for sale, primarily United States government agency and mortgage-backed ("MBS"),
and a $1.2 billion increase in average home equity loans compared with the first
nine months of 2002. See Market Risk Management-Interest Rate Risk in the Risk
Management section of this Financial Review for additional information.
The adoption of SFAS 150 decreased taxable-equivalent net interest income and
net interest margin by $14 million and 3 basis points, respectively, for the
first nine months of 2003. The adoption of FIN 46 increased taxable-equivalent
net interest income by $29 million but, due to the comparatively narrower spread
on the interest-earning assets that were consolidated, reduced the net interest
margin by 4 basis points for the first nine months of 2003.
Taxable-equivalent net interest income totaled $514 million and the net interest
margin was 3.49% for the third quarter of 2003 compared with $532 million and
3.88%, respectively, for the third quarter of 2002. Declines in
taxable-equivalent net interest income and margin compared with the third
quarter of 2002 reflected the lower interest rate environment in 2003. Apart
from the $4.6 billion positive impact on average interest-earning assets due to
the adoption of FIN 46, all other average interest-earning assets declined $.5
billion compared with the third quarter of 2002 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 third quarter of 2003 compared with the prior year third
quarter partially offset the impact of these declines on all other average
interest-earning assets.
The adoption of SFAS 150 decreased third quarter 2003 taxable-equivalent net
interest income and net interest margin by $14 million and 10 basis points,
respectively. The adoption of FIN 46 increased taxable-equivalent net interest
income by $29 million but, due to the comparatively narrower spread on the
interest-earning assets that were consolidated, reduced the net interest margin
by 9 basis points for the third quarter of 2003.
PROVISION FOR CREDIT LOSSES
The provision for credit losses was $143 million for the first nine months of
2003 compared with $244 million for the first nine months of 2002. The provision
for credit losses for the third quarter of 2003 totaled $50 million compared
with $73 million for the prior year third quarter. The provision for both the
first nine months and third quarter of 2002 reflected additional reserves
provided for Corporate Banking related to Market Street matters.
See Allowances for Credit Losses And Unfunded Loan Commitments And Letters of
Credit in the Credit Risk Management portion of the Risk Management section of
this Financial Review for additional information regarding factors impacting the
provision for credit losses.
NONINTEREST INCOME
Noninterest income was $2.5 billion for the first nine months of 2003 compared
with $2.4 billion for the first nine months of 2002. Third quarter 2003
noninterest income totaled $906 million compared with $771 million in the third
quarter of 2002.
Asset management fees were $628 million for the first nine months of 2003, a
decline of $23 million compared with the first nine months of 2002. Third
quarter 2003 asset management fees increased $12 million, to $212 million,
compared with the third quarter of 2002. Consolidated assets
16
under management were $336 billion at September 30, 2003, an increase of $51
billion, or 18%, from September 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 $53 million, to $569 million, for the first nine
months of 2003 compared with the year-ago period. Fund servicing fees decreased
$5 million, to $188 million, for the third quarter of 2003 compared with the
third 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 that impacted shareholder activity
levels in both comparisons. While comparatively weaker equity market conditions
negatively impacted the year-to-date comparison, improvement in the equity
markets in the second and third quarters of 2003 mitigated the revenue decline
in the quarter-over-quarter comparison. In addition, fund servicing revenue for
the first nine months of 2002 included the benefit of approximately $13 million
of fees related to the renegotiation of a client contract and an additional $9
million related to PFPC's retirement services business, which was sold effective
June 30, 2003.
Service charges on deposits totaled $177 million for the first nine months of
2003, an increase of $11 million compared with the first nine months of 2002 due
to a $2.2 billion increase in average transaction deposits, including a 4%
increase in checking relationships over the prior year period. Service charges
on deposits increased $3 million, to $60 million, for the third quarter of 2003
compared with the third quarter of 2002. The increases in both periods reflected
higher volumes partially offset by lower monthly service charges due to higher
sales of free checking.
Brokerage fees totaled $133 million for the first nine months of 2003, a
decrease of $18 million compared with the comparable prior year period. The
decrease is due to lower sales commissions and lower trading volumes that
reflected the comparatively weaker equity markets in the first nine months of
2003. Brokerage fees increased $5 million, to $46 million, in the third quarter
of 2003 compared with the third quarter of 2002 reflecting an upward trend in
the equity markets in the 2003 period.
Consumer services revenue totaled $188 million for the first nine months of
2003, an increase of $10 million, or 6%, compared with the first nine months of
2002. Consumer service revenue totaled $65 million for the third quarter of
2003, an increase of $3 million, or 5%, compared with the third 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 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
effectively lowered 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 that became effective August 1, 2003, the lost revenue impact to PNC
is estimated to be approximately $6 million in 2003.
Corporate services revenue totaled $362 million for the first nine months of
2003, a decline of $13 million compared with the first nine months 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
$53 million for the first nine months of 2003 and $95 million for the first nine
months of 2002. Partially offsetting this decline were net gains on sales of
commercial mortgages of $38 million for the first nine months of 2003, an
increase of $20 million compared with the first nine months of 2002.
Corporate services revenue was $132 million for the third quarter of 2003
compared with $108 million for the third quarter of 2002. Net gains on sales of
commercial mortgages were $15 million for the third quarter of 2003 and $5
million for the third quarter of 2002. Net gains in excess of valuation
adjustments related to the liquidation of institutional loans held for sale
increased $6 million, to $23 million, in the third quarter of 2003 compared with
the third quarter of 2002.
Equity management (private equity activities) net losses on portfolio
investments were $25 million for the first nine months of 2003 compared with net
losses of $37 million for the first nine months of 2002. For the third quarter
of 2003, equity management losses totaled $4 million compared with net losses of
$22 million for the prior year quarter.
Net securities gains totaled $101 million for the first nine months of 2003
compared with $88 million for the first nine months of 2002. Net securities
gains for the first nine months 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 $19 million for the third
quarter of 2003 and $68 million for the third quarter of 2002.
Noninterest income from investments held by certain variable interest entities
totaled $96 million for the first nine months and third quarter of 2003 due to
PNC's adoption of FIN 46.
Other noninterest income totaled $248 million for the first nine months of 2003,
an increase of $11 million compared with the first nine months of 2002. Other
noninterest income was $92 million for the third quarter of 2003, an increase of
$28 million from the third quarter of 2002. The first nine months of 2002
reflected the impact of a $14 million gain on the sale of a real estate
investment. Net trading income included in other noninterest income increased
$19 million, to $96 million, for the first nine
17
months of 2003 compared with the first nine months of 2002 and increased $12
million, to $36 million, in the third quarter of 2003 compared with the prior
year quarter. See Note 7 Trading Activities in the Notes to Consolidated
Financial Statements for additional information.
PRODUCT REVENUE
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
$261 million for the first nine months of 2003, up $4 million compared with the
first nine months of 2002 as the benefit of higher sales activity was mostly
offset by the impact of lower interest rates on compensating deposit balances.
Consolidated revenue from capital markets products was $87 million for the first
nine months of 2003, a decrease of $1 million compared with the same period in
2002 primarily due to lower transaction volume attributable to the comparatively
weaker market conditions in year-to-date 2003. Consolidated revenue from
equipment leasing products was $62 million for the first nine months of 2003
compared with $58 million for the first nine months of 2002.
NONINTEREST EXPENSE
Total noninterest expense was $2.6 billion for the first nine months of 2003, an
increase of $190 million, or 8%, compared with the first nine months of 2002.
The efficiency ratio was 65% for the first nine months of 2003 and 59% for the
first nine months of 2002. Noninterest expense for the first nine 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. Also, noninterest expense for the first nine months 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 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 nine months 2003 pretax income was mostly offset by related net securities
gains included in noninterest income. Total noninterest expense for the first
nine months of 2003 also included $28 million of expenses resulting from PNC's
adoption of FIN 46.
Noninterest expense for the first nine 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. In addition,
noninterest expense for the first nine months of 2002 included the benefit of a
$19 million pretax reduction in reserves for PFPC that were originally
established in 2001 largely related to a previously reported plan to consolidate
selected facilities that was recognized in the third quarter of 2002.
Total noninterest expense was $835 million for the third quarter of 2003, an
increase of $45 million compared with the third quarter of 2002. The efficiency
ratio was 59% for the third quarter of 2003 compared with 61% for the third
quarter of 2002. The FIN 46 related expenses of $28 million are included in the
third quarter 2003 amounts and the $19 million PFPC restructuring reserve
reversal described above is reflected in the third quarter 2002 amounts.
The changes in total noninterest expense for both the first nine months and
third quarter of 2003 compared with the corresponding 2002 periods also
reflected the impact of the Corporation's 2003 efficiency initiative. A $66
million benefit from this initiative impacted the first nine months of 2003,
including a $29 million benefit in the third quarter. Noninterest expense for
both the first nine months and third quarter of 2003 was also impacted by costs
related to reinvestment in new business initiatives and higher pension, stock
option, incentive compensation 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 nine 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.
Management believes that the cost of executive risk insurance may increase
significantly in 2004 relative to the current level. The Corporation expensed
approximately $5 million related to this insurance in the first nine months of
2003.
Average employees totaled approximately 23,400 and 24,000 for the first nine
months of 2003 and 2002, respectively. The decrease was mainly in PFPC, PNC
Advisors and Regional Community Banking.
18
CONSOLIDATED BALANCE SHEET REVIEW
BALANCE SHEET DATA
September 30 December 31
In millions 2003 2002
- --------------------------------------------------------------------------------
Assets
Loans, net of unearned income $34,514 $35,450
Securities 14,893 13,763
Loans held for sale 1,531 1,607
Other 21,346 15,557
- --------------------------------------------------------------------------------
Total assets $72,284 $66,377
Liabilities
Funding sources $59,386 $54,098
Other 4,644 4,302
- --------------------------------------------------------------------------------
Total liabilities 64,030 58,400
Minority and noncontrolling interests
in consolidated entities 1,617 270
Capital securities 848
Total shareholders' equity 6,637 6,859
- --------------------------------------------------------------------------------
Total liabilities, minority and
noncontrolling interests, capital
securities and shareholders' equity $72,284 $66,377
================================================================================
The Corporation's Consolidated Balance Sheet is presented on page 48 of this
Form 10-Q.
Total assets were $72.3 billion at September 30, 2003 compared with $66.4
billion at December 31, 2002. PNC's adoption of FIN 46 resulted in increases in
total assets of $6.5 billion, increases in total liabilities of $5.1 billion and
increases in minority and noncontrolling interests in consolidated entities of
$1.4 billion at September 30, 2003. The adoption of FIN 46 increased "Other"
assets, "Funding sources" and "Other" liabilities as shown above by $6.5
billion, $4.9 billion and $.2 billion, respectively. Apart from FIN 46, 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.
An analysis of changes in other balance sheet categories follows.
LOANS
Loans were $34.5 billion at September 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
September 30 December 31
In millions 2003 2002
- --------------------------------------------------------------------------------
Commercial
Retail/wholesale $4,093 $4,161
Manufacturing 3,618 3,454
Service providers 1,865 1,906
Real estate related 1,454 1,481
Financial services 1,251 1,218
Communications 68 124
Health care 413 458
Other 1,861 2,185
- --------------------------------------------------------------------------------
Total commercial 14,623 14,987
- --------------------------------------------------------------------------------
Commercial real estate
Real estate project 1,429 1,750
Mortgage 464 517
- --------------------------------------------------------------------------------
Total commercial real estate 1,893 2,267
- --------------------------------------------------------------------------------
Consumer
Home equity 9,486 8,108
Automobile 522 484
Other 1,151 1,262
- --------------------------------------------------------------------------------
Total consumer 11,159 9,854
- --------------------------------------------------------------------------------
Residential mortgage 2,894 3,921
Lease financing
Equipment 3,684 3,560
Vehicle 934 1,521
- --------------------------------------------------------------------------------
Total lease financing 4,618 5,081
- --------------------------------------------------------------------------------
Other 363 415
Unearned income (1,036) (1,075)
- --------------------------------------------------------------------------------
Total, net of unearned income $34,514 $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 $12.7 billion at September 30, 2003. Of the total
exposure to relationships with greater than $50 million in loans and unfunded
commitments at September 30, 2003, 73% was investment grade equivalent.
WHOLESALE LENDING STATISTICS
September 30 December 31
Dollars in millions 2003 2002
- --------------------------------------------------------------------------------
Portfolio composition-total exposure
Investment grade equivalent 52% 52%
Non-investment grade (secured lending) 25 24
Non-investment grade 23 24
- --------------------------------------------------------------------------------
Total 100% 100%
- --------------------------------------------------------------------------------
Client relationships greater than $50 million-total
exposure $12,662 $13,392
Client relationships greater than $50 million-customers 139 140
- --------------------------------------------------------------------------------
19
The equipment lease financing portfolio totaled $3.7 billion at September 30,
2003 and included approximately $1.7 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 September 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 September 30, 2003, loans of $34.5 billion included $.9 billion of vehicle
leases, net of unearned income, and $10 million of commercial and commercial
real estate loans that have been designated for exit. PNC's vehicle leasing
business, which has been designated for exit, is comprised of vehicle leases
with an aggregate residual value of $.7 billion and $.2 billion of estimated
future customer lease payments. As of September 30, 2003, the active vehicle
leases scheduled to mature are as follows.
VEHICLE LEASE MATURITY SCHEDULE
Number of Active Associated
Scheduled Maturity Date(a) Vehicle Leases Residual Values(b)
- --------------------------------------------------------------------------------
Fourth quarter of 2003 5,700 $102
2004 20,100 331
2005 12,300 170
2006 5,900 66
- --------------------------------------------------------------------------------
Total 44,000 $669
================================================================================
(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 September 30, 2003, the related liability
was $118 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 September
30, 2003.
NET UNFUNDED COMMITMENTS
September 30 December 31
In millions 2003 2002
- --------------------------------------------------------------------------------
Commercial $16,832 $19,525
Commercial real estate 746 718
Consumer 5,551 5,372
Lease financing 118 103
Purchased customer receivables 931
Other 134 125
Institutional lending repositioning 352 1,015
- --------------------------------------------------------------------------------
Total $24,664 $26,858
================================================================================
Commitments to extend credit represent arrangements to lend funds or provide
liquidity subject to specified contractual conditions. Commercial commitments
are reported net of participations, assignments and syndications, primarily to
financial institutions, totaling $6.3 billion at September 30, 2003 and $6.2
billion at December 31, 2002.
Net outstanding letters of credit totaled $3.9 billion at September 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.
At September 30, 2003, purchased customer receivables totaled $2.5 billion
related to Market Street and due to PNC's adoption of FIN 46. Unfunded
commitments related to purchased customer receivables totaled $931 million at
September 30, 2003. See Early Adoption of FIN 46 in the "Off-Balance Sheet"
Activities section of this Financial Review and Note 2 Variable Interest
Entities in the Notes to Consolidated Financial Statements for further
information.
SECURITIES
Total securities were $14.9 billion at September 30, 2003 compared with $13.8
billion at December 31, 2002. Securities represented 21% of total assets at both
September 30, 2003 and December 31, 2002. The increase in total securities
compared with December 31, 2002 was primarily due to purchases during the first
nine months of 2003 of United States government agency and MBS partially offset
by the sale of securities classified as held to maturity at December 31, 2002.
At September 30, 2003, the securities available for sale balance included a net
unrealized gain of $96 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. If interest rates rise subsequent to September 30, 2003, such movement,
if sustained, will adversely impact the fair value of securities available for
sale at December 31, 2003 compared with the balance at September 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 9 months at September 30, 2003 and 2 years and 8 months at
December 31, 2002.
Management estimates the effective duration of securities available for sale is
2.7% for an immediate 50 basis points parallel increase in interest rates and
2.4% for an immediate 50 basis points parallel decrease in interest rates.
MBS comprise 49% of available for sale securities or $7.2 billion. These
securities are predominantly CMOs (collateralized mortgage obligations) and
securitized pools of hybrid adjustable rate mortgages. The Corporation has
limited holdings of fixed rate MBS. As of September 30, 2003, the fair values of
15- and 30-year fixed rate MBS were $800 million and $37 million, respectively.
20
Securities classified as held to maturity are carried at amortized cost.
Securities classified as held to maturity at September 30, 2003 were due to the
adoption of FIN 46 and are related to Market Street. Securities classified as
held to maturity at December 31, 2002 were assets of companies formed in 2001 in
transactions with AIG that were consolidated in PNC's financial statement. In
January 2003, these securities were sold and these companies were liquidated.
The expected weighted-average life of securities held to maturity was 2 years
and 10 months at September 30, 2003 and 20 years and 2 months at December 31,
2002.
DETAILS OF SECURITIES
Amortized Fair
In millions Cost Value
- --------------------------------------------------------------------------------
SEPTEMBER 30, 2003
SECURITIES AVAILABLE FOR SALE
Debt securities
U.S. Treasury and government agencies $1,913 $1,939
Mortgage-backed 7,255 7,241
Commercial mortgage-backed 2,595 2,678
Asset-backed 2,487 2,486
State and municipal 76 75
Other debt 57 60
Corporate stocks and other 412 412
- --------------------------------------------------------------------------------
Total securities available for sale $14,795 $14,891
- --------------------------------------------------------------------------------
SECURITIES HELD TO MATURITY
Debt securities
Asset-backed $2 $2
- --------------------------------------------------------------------------------
Total securities held to maturity $2 $2
================================================================================
December 31, 2002
SECURITIES AVAILABLE FOR SALE
Debt securities
U.S. Treasury and government agencies $813 $826
Mortgage-backed 6,110 6,216
Commercial mortgage-backed 2,806 2,887
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 September 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, partially offset by an increase in education loans held for sale.
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
September 30 December 31
In millions 2003 2002
- --------------------------------------------------------------------------------
Education loans $1,140 $1,035
Total institutional lending
repositioning 98 298
Other 293 274
- --------------------------------------------------------------------------------
Total loans held for sale $1,531 $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 5
Sales (141) (76)
Payments and other exposure
reductions (304) (110)
Valuation adjustments, net (31) (19)
- --------------------------------------------------------------------------------
September 30, 2003 $150 $98
================================================================================
During the third quarter and first nine months of 2003, the liquidation of
institutional loans held for sale resulted in net gains in excess of valuation
adjustments of $23 million and $53 million, respectively. The corresponding
amounts for 2002 were $17 million for the third quarter and $95 million for the
first nine months. Details by Wholesale Banking business for 2003 follow:
INSTITUTIONAL LENDING HELD FOR SALE ACTIVITY
Three months ended
September 30, 2003 Net gains on Valuation
In millions liquidation adjustments Total
- --------------------------------------------------------------------------------
Corporate Banking $19 $(2) $17
PNC Real Estate Finance 3 3 6
- --------------------------------------------------------------------------------
Total $22 $1 $23
================================================================================
Nine months ended
September 30, 2003 Net gains on Valuation
In millions liquidation adjustments Total
- --------------------------------------------------------------------------------
Corporate Banking $71 $(24) $47
PNC Real Estate Finance 11 (4) 7
PNC Business Credit 2 (3) (1)
- --------------------------------------------------------------------------------
Total $84 $(31) $53
================================================================================
FUNDING SOURCES
Total funding sources were $59.4 billion at September 30, 2003 and $54.1 billion
at December 31, 2002, an increase of $5.3 billion corresponding to an increase
of $5.9 billion in total assets and an increase in accrued expenses and other
liabilities of $.3 billion. Total deposits increased $.5 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 nine months of 2003. Total borrowed funds
increased $4.7 billion from December 31, 2002. This increase reflected the
recognition of commercial paper totaling $2.5 billion and liabilities of certain
variable interest entities of $2.4 billion due to PNC's adoption of FIN
21
46. The increase in borrowed funds also reflected the reclassification of $.8
billion of mandatorily redeemable capital securities of subsidiary trusts from
between the Liabilities and Shareholders' Equity sections of the Consolidated
Balance Sheet in accordance with PNC's adoption of SFAS No. 150 effective July
1, 2003. Restatement of prior period amounts was not permitted under SFAS No.
150. These increases were partially offset by a decrease in bank notes and
senior debt maturities during the first nine months of 2003.
DETAILS OF FUNDING SOURCES
September 30 December 31
In millions 2003 2002
- --------------------------------------------------------------------------------
Deposits
Demand and money market $34,712 $32,349
Savings 2,110 2,014
Retail certificates of deposit 8,337 9,839
Other time 264 317
Deposits in foreign offices 100 463
- --------------------------------------------------------------------------------
Total deposits 45,523 44,982
- --------------------------------------------------------------------------------
Borrowed funds
Federal funds purchased 881 38
Repurchase agreements 1,048 814
Bank notes and senior debt 2,839 4,400
Federal Home Loan Bank borrowings 1,127 1,256
Subordinated debt 1,980 2,423
Mandatorily redeemable capital
securities of subsidiary trusts 848
Commercial paper 2,483
Liabilities of certain variable
interest entities 2,415
Other borrowed funds 242 185
- --------------------------------------------------------------------------------
Total borrowed funds 13,863 9,116
- --------------------------------------------------------------------------------
Total $59,386 $54,098
================================================================================
SHAREHOLDERS' EQUITY
Total shareholders' equity was $6.6 billion at September 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
Corporation's repurchase of 9.8 million shares of common stock in the first nine
months of 2003 at a total cost of $452 million and a decline in accumulated
other comprehensive income 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 September 30, 2003, each banking subsidiary of
the Corporation was considered "well capitalized" based on regulatory capital
ratio requirements.
RISK-BASED CAPITAL
September 30 December 31
Dollars in millions 2003 2002
- --------------------------------------------------------------------------------
Capital components
Shareholders' equity
Common $6,628 $6,849
Preferred 9 10
Trust preferred capital securities 848 848
Minority interest 246 234
Goodwill and other intangibles (2,498) (2,446)
Net unrealized securities gains (63) (179)
Net unrealized gains on cash flow
hedge derivatives (77) (135)
Equity investments in
nonfinancial companies (33) (34)
Other, net (20) (26)
- --------------------------------------------------------------------------------
Tier 1 risk-based capital 5,040 5,121
Subordinated debt 1,142 1,350
Minority interest 36
Eligible allowance for credit losses 741 726
- --------------------------------------------------------------------------------
Total risk-based capital $6,923 $7,233
================================================================================
Assets
Risk-weighted assets, including
off-balance sheet instruments and
market risk equivalent assets $61,465 $58,030
Adjusted average total assets 68,705 62,967
================================================================================
Capital ratios
Tier 1 risk-based 8.2% 8.8%
Total risk-based 11.3 12.5
Leverage 7.3 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 September 30, 2003 were 277.3 million. PNC's
current stock repurchase program permits the purchase of up to 35 million shares
of common stock through February 29, 2004. PNC purchased 3.2 million common
shares under this program during the third quarter of 2003 at a total cost of
$152 million. During the first nine months of 2003, 9.8 million shares were
repurchased at a total cost of $452 million. 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. A total of 10.1 million common shares have been repurchased
under this program from inception through September 30, 2003.
In October 2003, the Corporation's Board of Directors approved a four percent
increase in the quarterly cash dividend on common stock, to 50 cents a share.
22
"OFF-BALANCE SHEET" ACTIVITIES
As previously reported, PNC has reputational, legal, operational and fiduciary
risks in virtually every area of its business, a portion of which are not
reflected in assets and liabilities recorded on the balance sheet. 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.
EARLY ADOPTION OF FIN 46
In October 2003, the Financial Accounting Standards Board announced that the
effective date of FIN 46 was deferred from July 1, 2003 to December 31, 2003 for
interests held by public companies in all variable interest entities created
prior to February 1, 2003. However, PNC, as permitted, elected to adopt the
accounting provisions of FIN 46 as of the original July 1, 2003 implementation
date by consolidating those variable interest entities currently subject to the
standard and of which PNC is considered the primary beneficiary.
A number of variable interest entities that previously represented "off-balance
sheet" activities of the Corporation were consolidated by PNC upon adoption of
FIN 46:
- - Market Street Funding Corporation, a multi-seller asset-backed commercial
paper conduit that is independently owned and managed, was consolidated as
PNC Bank, N.A. is the primary beneficiary since it receives a majority of
the expected residual returns and would absorb a majority of any expected
losses of the conduit. This entity is reflected in the results of Corporate
Banking.
- - BlackRock acts as collateral manager for six collateralized debt obligation
("CDO") funds, including a collateralized loan obligation fund which closed
on September 30, 2003. BlackRock is considered the primary beneficiary
given its role as collateral manager since it receives a majority of the
expected residual returns in the form of non-fixed, market-based fees from
the funds.
- - PNC Real Estate Finance makes equity investments in various limited
partnerships that sponsor affordable housing projects utilizing the Low
Income Housing Tax Credit. PNC Real Estate Finance is considered the
primary beneficiary of those entities in which PNC owns in excess of 50
percent of the limited partnership interests. Additionally, PNC Real Estate
Finance is a national syndicator of affordable housing equity and is the
general partner in these structures. In certain of these transactions, PNC
is considered the primary beneficiary as it receives a majority of the
expected residual returns through the receipt of fees.
- - The Hawthorn division of PNC Advisors manages a number of private
investment funds organized as limited partnerships ("Private Funds"). These
entities were consolidated as PNC was determined to be the primary
beneficiary since it receives a majority of the expected residual returns
in the form of fees received from these entities.
A Consolidating Statement of Income for the three months ended September 30,
2003 and a Consolidating Balance Sheet as of September 30, 2003 are included on
the following pages to indicate the impact of the adoption of FIN 46 on a line
item basis.
In connection with the deferral of the effective date of FIN 46, the FASB is
continuing to evaluate the scope of entities covered and other implementation
issues related to FIN 46. Therefore, any modifications or refinement of the
current FIN 46 guidance provided by the FASB could result in the consolidation
of additional entities or the deconsolidation of entities previously included in
PNC's consolidated financial statements.
See Note 2 Variable Interest Entities in the Notes to Consolidated Financial
Statements for further information regarding the Corporation's adoption of FIN
46.
23
IMPACT OF FIN 46
CONSOLIDATING STATEMENT OF INCOME (Unaudited)
Impact of FIN 46
--------------------------------------------------------------
Results before Market Hawthorn Affordable
For the three months ended September 30, 2003 adoption Street BlackRock Private Housing Eliminations Results as
In millions of FIN 46 Funding CDOs Funds Partnerships and Other reported
- -----------------------------------------------------------------------------------------------------------------------------------
INTEREST INCOME
Loans and fees on loans $477 $477
Securities 136 $4 140
Loans held for sale 8 8
Purchased customer receivables $11 11
Investments held by certain
variable interest entities $48 48
Other 33 $1 34
- -----------------------------------------------------------------------------------------------------------------------------------
Total interest income 654 11 48 4 1 718
- -----------------------------------------------------------------------------------------------------------------------------------
INTEREST EXPENSE
Deposits 106 106
Borrowed funds 51 51
Capital securities 14 14
Commercial paper 7 7
Liabilities of certain
variable interest entities 24 1 3 28
- -----------------------------------------------------------------------------------------------------------------------------------
Total interest expense 171 7 24 1 3 206
- -----------------------------------------------------------------------------------------------------------------------------------
Net interest income 483 4 24 3 (2) 512
Provision for credit losses 50 50
- -----------------------------------------------------------------------------------------------------------------------------------
Net interest income less
provision for credit losses 433 4 24 3 (2) 462
- -----------------------------------------------------------------------------------------------------------------------------------
NONINTEREST INCOME
Asset management 217 (5) 212
Fund servicing 188 188
Service charges on deposits 60 60
Brokerage 46 46
Consumer services 65 65
Corporate services 135 (3) 132
Equity management (4) (4)
Net securities gains 19 19
Investments held by certain variable
interest entities 14 73 9 96
Other 92 92
- -----------------------------------------------------------------------------------------------------------------------------------
Total noninterest income 818 (3) 9 73 9 906
- -----------------------------------------------------------------------------------------------------------------------------------
NONINTEREST EXPENSE
Staff expense 447 4 $1 452
Net occupancy 63 63
Equipment 67 67
Marketing 16 16
Other 214 1 2 3 18 (1) 237
- -----------------------------------------------------------------------------------------------------------------------------------
Total noninterest expense 807 1 2 7 18 835
- -----------------------------------------------------------------------------------------------------------------------------------
Income before minority and noncontrolling interests
and income taxes 444 31 69 (11) 533
Minority and noncontrolling interests in income
of consolidated entities 13 31 69 (11) (2) 100
Income taxes 152 152
- -----------------------------------------------------------------------------------------------------------------------------------
Net income $279 $2 $281
- -----------------------------------------------------------------------------------------------------------------------------------
24
IMPACT OF FIN 46
CONSOLIDATING BALANCE SHEET (Unaudited)
Impact of FIN 46
--------------------------------------------------------------
Results before Market Hawthorn Affordable
At September 30, 2003 adoption Street BlackRock Private Housing Eliminations Results as
In millions, except par value of FIN 46 Funding CDOs Funds Partnerships and Other reported
- -----------------------------------------------------------------------------------------------------------------------------------
ASSETS
Cash and due from banks $3,148 $148 $315 $3 $3,614
Other short-term investments 2,533 57 2,590
Loans held for sale 1,531 1,531
Securities 14,891 $2 14,893
Loans, net of unearned income of $1,037 34,600 (86) 34,514
Allowance for credit losses (649) 1 (648)
- -----------------------------------------------------------------------------------------------------------------------------------
Net loans 33,951 (85) 33,866
Goodwill 2,385 2,385
Other intangible assets 311 311
Purchased customer receivables 2,481 2,481
Investments held by certain variable
interest entities 2,318 2,318
Other 7,084 (1) 41 727 467 ($23) 8,295
- -----------------------------------------------------------------------------------------------------------------------------------
Total assets $65,834 $2,397 $2,564 $1,042 $470 ($23) $72,284
- -----------------------------------------------------------------------------------------------------------------------------------
LIABILITIES
Deposits
Noninterest-bearing $12,118 $12,118
Interest-bearing 33,491 ($86) 33,405
- -----------------------------------------------------------------------------------------------------------------------------------
Total deposits 45,609 (86) 45,523
Borrowed funds
Federal funds purchased 881 881
Repurchase agreements 1,048 1,048
Bank notes and senior debt 2,839 2,839
Federal Home Loan Bank borrowings 1,127 1,127
Subordinated debt 1,980 1,980
Mandatorily redeemable capital
securities of subsidiary trusts 848 848
Commercial paper 2,483 2,483
Liabilities of certain variable
interest entities $2,141 $114 $160 2,415
Other borrowed funds 188 54 242
- -----------------------------------------------------------------------------------------------------------------------------------
Total borrowed funds 8,911 2,483 2,195 114 160 13,863
Allowance for unfunded loan
commitments and letters of credit 89 89
Accrued expenses 2,214 14 2,228
Other 2,128 87 36 76 2,327
- -----------------------------------------------------------------------------------------------------------------------------------
Total liabilities 58,951 2,397 2,296 150 236 64,030
- -----------------------------------------------------------------------------------------------------------------------------------
Minority and noncontrolling interests in
consolidated entities 246 268 892 234 ($23) 1,617
SHAREHOLDERS' EQUITY
Common stock - $5 par value
Authorized 800 shares, issued 353 shares 1,764 1,764
Capital surplus 1,110 1,110
Retained earnings 7,507 7,507
Deferred benefit expense (24) (24)
Accumulated other comprehensive income 147 147
Common stock held in treasury
at cost: 76 shares (3,867) (3,867)
- -----------------------------------------------------------------------------------------------------------------------------------
Total shareholders' equity 6,637 6,637
- -----------------------------------------------------------------------------------------------------------------------------------
Total liabilities, minority and
noncontrolling interests and
shareholders' equity $65,834 $2,397 $2,564 $1,042 $470 ($23) $72,284
- -----------------------------------------------------------------------------------------------------------------------------------
CAPITAL AND OTHER RATIOS
Tier 1 Risk-based(a) 8.9% (.5)% (.1)% (.1)% 8.2%
Total Risk-based(a) 12.3 (.7) (.2) (.1) 11.3
Leverage 8.0 (.3)% (.2) (.1) (.1) 7.3
Shareholders' equity to total assets 10.08 (.34) (.36) (.15) (.06) .01% 9.18
Common shareholders' equity to total assets 10.07 (.34) (.36) (.15) (.06) .01 9.17
Return on average assets 1.68 (.06) (.05) (.02) .01 1.56
- -----------------------------------------------------------------------------------------------------------------------------------
(a) Regulatory capital relief has been granted through April 1, 2004 with
respect to consolidation of the Market Street conduit.
25
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
Cautionary Statement Regarding Forward-Looking Information 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.
See Note 2 Variable Interest Entities of this report for further information
regarding investments in variable interest entities that are accounted for under
FIN 46.
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 $530 million, or 82%, of the total
allowance for credit losses at September 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 9 Allowances For Credit Losses And Unfunded Loan Commitments And Letters of
Credit for additional information.
26
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.
27
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.
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
28
expense for the first nine months of 2003 totaled $37 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 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 will
first provide an overview of the governance structure, measurement, control
strategies, and monitoring aspects of the Corporation's corporate-level 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, operational, liquidity, and market.
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 its business
activities. Risk management is not about eliminating risks, but about accepting
risks that are expected to optimize shareholder value and that the Corporation
should effectively manage.
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
Risk management is supported through a governance structure at the Board and
management level, and through a risk organization structure at both the
corporate and business unit level. These structures are designed to provide
active and effective management of risks.
Although the Board as a whole is responsible generally for oversight of risk
management, committees of the Board provide oversight to specific areas of risk
with respect to the level of risk and risk management structure. The Board
committees with primary responsibility for risk management oversight are as
follows:
- - Audit Committee: major financial risk exposures, compliance with legal and
regulatory requirements, internal controls, and the Corporation's code of
ethics
- - Credit Committee: risk within the Corporation's lending and credit-related
activities
- - 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
- - Operations and Technology Committee: operations and operational risk
management, and activities related to information technology and
information security
- - Nominating and Governance Committee: recommendation of nominees for the
Corporation's Board and implementation of appropriate corporate governance
practices
Management level risk 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 those 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.
29
The following tables outline the three primary corporate-level risk management
areas:
- --------------------------------------------------------------------------------
AREA RISK MANAGEMENT
- --------------------------------------------------------------------------------
EXECUTIVE Chief Risk Officer
- --------------------------------------------------------------------------------
KEY ROLES OF - Facilitates the identification,
CORPORATE TEAM measurement, control and monitoring of
risk across the Corporation
- Sets risk tolerance limits
- Has authority to review and challenge
all risk-taking activities
- Provides support and oversight to the
businesses
- Identifies and implements risk
management best practices
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
AREA REGULATORY RELATIONS AND COMPLIANCE
- --------------------------------------------------------------------------------
EXECUTIVES Chief Regulatory Officer
Chief Compliance Officer
- --------------------------------------------------------------------------------
KEY ROLES OF - Facilitates the identification,
CORPORATE TEAM assessment and monitoring of
regulatory and compliance risk
throughout the Corporation
- Facilitates relationships with
regulatory agencies and serves as
liaison to the businesses
- Provides compliance support and
oversight at the corporate level and
to the businesses
- Administers the Corporation's ethics
and business conduct programs
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
AREA LEGAL
- --------------------------------------------------------------------------------
EXECUTIVES Vice Chairman, Legal and Governance
General Counsel
- --------------------------------------------------------------------------------
KEY ROLES OF - Facilitates the identification,
CORPORATE TEAM assessment, and monitoring of legal
risk throughout the Corporation
- 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 across the Corporation.
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 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-level risk management. Corporate risk management is authorized to take
action to either prevent or mitigate exceptions to policies and is responsible
for monitoring compliance with risk management policies. 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
ERMC 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.
30
GOVERNANCE STRUCTURE
The credit lending businesses maintain direct responsibility for credit risk
within the Corporation. The Corporate Credit Policy area 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 commercial loans and provides
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
portion of this Credit Risk Management discussion. Unexpected loss seeks to
capture 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
internal 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, an independent Credit Risk Review
function, reporting directly to the Credit Committee of the Board, and
indirectly to the Chief Risk Officer, performs regular analyses of the quality
of credit 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, Credit Risk Review 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.
31
NONPERFORMING ASSETS BY TYPE
September 30 December 31
Dollars in millions 2003 2002
- --------------------------------------------------------------------------------
Nonaccrual loans
Commercial $286 $226
Lease financing 15 57
Commercial real estate 4 7
Consumer 10 11
Residential mortgage 8 7
- --------------------------------------------------------------------------------
Total nonaccrual loans 323 308
Troubled debt restructured loan 1 1
- --------------------------------------------------------------------------------
Total nonperforming loans 324 309
Nonperforming loans held for sale(a) 35 97
Foreclosed assets
Lease 18
Residential mortgage 9 6
Other 10 6
- --------------------------------------------------------------------------------
Total foreclosed assets 37 12
- --------------------------------------------------------------------------------
Total nonperforming assets $396 $418
================================================================================
Nonperforming loans to total loans .94% .87%
Nonperforming assets to total loans,
loans held for sale and foreclosed assets 1.10 1.13
Nonperforming assets to total assets .55 .63
================================================================================
(a) Includes troubled debt restructured loans held for sale of $9 million and
$17 million as of September 30, 2003 and December 31, 2002, respectively.
Of the total nonperforming loans at September 30, 2003, 41% are related to PNC
Business Credit. PNC Business Credit loans, including those acquired in the NBOC
acquisition, are primarily 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 are 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 and
service sectors 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 $38 million and $40 million at September 30, 2003 and
December 31, 2002, respectively, and included in other assets on the
Consolidated Balance Sheet. Nonperforming equity management assets at September
30, 2003 and December 31, 2002, include $7 million and $12 million,
respectively, of troubled debt restructured assets.
The increase in foreclosed lease assets since December 31, 2002 primarily
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 $149 million at September 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 $5 million at September 30, 2003 and $46 million at
December 31, 2002.
NONPERFORMING ASSETS BY BUSINESS
September 30 December 31
In millions 2003 2002
- --------------------------------------------------------------------------------
Regional Community Banking $74 $82
Corporate Banking 168 187
PNC Real Estate Finance 3 2
PNC Business Credit 140 142
PNC Advisors 11 5
- --------------------------------------------------------------------------------
Total nonperforming assets $396 $418
================================================================================
At September 30, 2003, Corporate Banking and PNC Business Credit had
nonperforming loans held for sale of $28 million and $7 million, respectively,
which are included in the preceding table.
CHANGE IN NONPERFORMING ASSETS
In millions 2003 2002
- --------------------------------------------------------------------------------
January 1 $418 $391
Purchases 42
Transferred from accrual 356 711
Returned to performing (4) (27)
Principal reductions (221) (310)
Asset sales (34) (145)
Charge-offs and valuation adjustments (161) (211)
- --------------------------------------------------------------------------------
September 30 $396 $409
================================================================================
For the remainder of 2003, weakness in 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
Amount Percent of Total Outstandings
- --------------------------------------------------------------------------------
Sept. 30 Dec. 31 Sept. 30 Dec. 31
Dollars in millions 2003 2002 2003 2002
- --------------------------------------------------------------------------------
Commercial $25 $41 .17% .27%
Commercial real estate 5 10 .26 .44
Consumer 27 25 .24 .25
Residential mortgage 39 38 1.35 .97
Lease financing 1 1 .03 .02
- ------------------------------------------------
Total loans 97 115 .28 .32
Loans held for sale 8 32 .52 1.99
- ------------------------------------------------
Total loans and
loans held for sale $105 $147 .29 .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 $73 million and $14 million,
respectively, at September 30, 2003. Approximately 49% of these loans are in the
PNC Business Credit portfolio. Loans held for sale relate to the institutional
lending repositioning.
32
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
September 30, 2003 December 31, 2002
--------------------------------------------------------
Loans to Loans to
Dollars in millions Allowance Total Loans Allowance Total Loans
- --------------------------------------------------------------------------------
Commercial $530 42.4% $504 42.3%
Commercial
real estate 37 5.5 52 6.4
Consumer 27 32.3 28 27.8
Residential mortgage 8 8.4 10 11.0
Lease financing
and other 46 11.4 79 12.5
- --------------------------------------------------------------------------------
Total $648 100.0% $673 100.0%
================================================================================
For purposes of this presentation, the unallocated portion of the allowance for
credit losses of $112 million at September 30, 2003 and $112 million at 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
September 30, 2003 and 17% of the total allowance and .32% of total loans at
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 nine months of 2003 and the
evaluation of the allowances for credit losses and unfunded loan commitments and
letters of credit as of September 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.
33
ROLLFORWARD OF ALLOWANCE FOR CREDIT LOSSES
In millions 2003 2002
- --------------------------------------------------------------------------------
January 1 $673 $560
Charge-offs (191) (224)
Recoveries 29 36
- --------------------------------------------------------------------------------
Net charge-offs (162) (188)
Provision for credit losses 143 244
Acquired allowance (NBOC acquisition) 41
Transfer of allowance to other assets (1)
Net change in allowance for unfunded
loan commitments and letters of credit (5) (9)
- --------------------------------------------------------------------------------
September 30 $648 $648
================================================================================
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 5 9
- --------------------------------------------------------------------------------
September 30 $89 $79
================================================================================
The allowance as a percent of nonperforming loans and total loans was 200% and
1.88%, respectively, at September 30, 2003. The comparable 2002 percentages were
239% and 1.80%, respectively.
CHARGE-OFFS AND RECOVERIES
Percent of
Nine months ended September 30 Net Average
Dollars in millions Charge-offs Recoveries Charge-offs Loans
- -------------------------------------------------------------------------------
2003
Commercial $115 $17 $98 .88%
Commercial real estate 3 3 .19
Consumer 29 9 20 .26
Residential mortgage 2 1 1 .04
Lease financing 42 2 40 1.42
- ---------------------------------------------------------------------
Total $191 $29 $162 .62
===============================================================================
2002
Commercial $167 $23 $144 1.20%
Commercial real estate 2 2 .11
Consumer 30 11 19 .27
Residential mortgage 5 1 4 .11
Lease financing 20 1 19 .60
- ---------------------------------------------------------------------
Total $224 $36 $188 .67
===============================================================================
Net charge-offs declined $26 million for the first nine months of 2003 compared
with the first nine months of 2002. The decrease was primarily due to the impact
of $88 million of charge-offs 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 and a $28 million charge-off in the
third quarter of 2003 in connection with a single wholesale goods/retail
customer. Reserves had been provided for a substantial portion of each of these
2003 charge-offs at December 31, 2002 and June 30, 2003, respectively.
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 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
34
control gaps. Corporate risk management provides oversight to the accuracy and
consistency of the self-assessments.
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:
- - A large and stable deposit base derived from the Corporation's retail and
wholesale banking activities;
- - A portfolio of liquid investment securities;
- - Diversified sources of short-term and long-term wholesale funding; and
- - Significant unused borrowing capacity at both the Federal Home Loan Bank
and the Federal Reserve discount window.
GOVERNANCE STRUCTURE
Asset and Liability Management ("ALM"), reporting to the Vice Chairman and 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 PNC Bank and the Capital Management
Policy for the parent 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 parent 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 parent 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. Parent 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 management's
Asset and Liability Committee ("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 and the parent company level.
Compliance with the Corporation's liquidity policy limits and guidelines is
reviewed with 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 September 30,
2003, such assets totaled $17.5 billion, with $6.7 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 September 30, 2003, total unused borrowing
capacity from the Federal Home Loan Bank under current collateral requirements
was $14.4 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.
PARENT 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
September 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. In November
2003, the Corporation issued $600 million of 5.25% Subordinated Notes due in
November 2015. This issuance reduced the amount of unused capacity available
under effective debt and equity shelf registration statements to approximately
$2.7 billion. The parent company also had an unused non-reciprocal credit
facility of $200 million at September 30, 2003.
The principal source of parent company revenue and cash flow is the dividends it
receives from PNC Bank. PNC Bank's dividend level may be impacted by its capital
needs, laws and regulations, 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 PNC Bank
without prior regulatory approval was approximately $286 million at September
30, 2003.
In addition to dividends from PNC Bank, other sources of parent company
liquidity include cash and short-term
35
investments, as well as dividends and loan repayments from other subsidiaries.
As of September 30, 2003, the parent company had approximately $322 million in
funds available from its cash and short-term investments or other funds
available from unrestricted subsidiaries. The Corporation's subordinated debt
issuance in November 2003 increased the parent company's liquidity position by
$594 million. The Corporation regularly assesses its ability to meet both the
obligatory and discretionary funding needs of the parent company. Based on the
amount of funds currently available at the parent company and the projected
amount of dividends from PNC Bank, management expects the parent company to have
sufficient liquidity to meet current obligations to its debt holders, vendors,
and others, to fund the cash portion of the United National acquisition and to
pay dividends at current rates through the next twelve months.
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 from 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 positioning itself to optimize net interest income and net
interest margin. In pursuance of 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, the investment policy, and the financial
derivatives policy, that govern interest rate risk management. The policies
define the Corporation's overall interest rate risk management philosophy and
risk tolerance level. ALCO is the management committee that oversees all
market-risk taking activities, including interest rate risk management
activities conducted by ALM.
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"). EVE is a
measurement of the inherent economic value of the Corporation at a given point
in time. It is the present value of the expected cash flows from the assets
minus the present value of the expected cash flows from the liabilities, plus
the present value of the net cash flows from the off-balance sheet items.
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.
EVE is also based on a series of assumptions, primarily about the expected
maturity and repricing behavior of existing on- and off-balance sheet positions.
Actual results may differ from those determined under these assumptions. To the
extent possible, these assumptions are consistent with those used in the NII
simulation process. Using these assumptions, the Corporation calculates EVE
given parallel instantaneous changes in interest rates. As part of that
calculation, the Corporation also calculates the effective duration, or changes
in fair value given a change in interest rates, of key on- and off-balance sheet
positions.
At September 30, 2003, the assumed effective duration of key on- and off-balance
sheet positions was as follows, given a +/-50 basis point change in interest
rates: loans 1.1%, securities 2.6%, total assets 1.4%, deposits 1.7%, borrowed
funds 1.7%, total liabilities 1.6%, and receive-fixed interest rate swaps, 2.7%.
36
The Corporation's interest rate risk simulation model is designed to capture key
components of interest rate risk 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
risks and develop appropriate 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. Policy limits are established
both for NII and EVE sensitivities.
RISK MONITORING
The Corporation has established a process for reporting its interest rate risk
profile and any significant risk issues. NII and EVE sensitivity reports are
reviewed regularly by ALCO and the Board Finance Committee.
The following table sets forth the sensitivity results for the quarters ended
September 30, 2003 and 2002.
INTEREST SENSITIVITY ANALYSIS
September 30 September 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 (.6)% .3%
100 basis point decrease (.8)% (2.7)%
Effect on net interest income in
second year from gradual interest rate
change over the preceding 12 months of:
100 basis point increase 2.6%
100 basis point decrease (7.7)% (11.9)%
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 (1.1)% (1.0)%
200 basis point decrease .1% (.1)%
KEY PERIOD-END INTEREST RATES
One month LIBOR 1.12% 1.81%
Three-year swap 2.34% 2.56%
================================================================================
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.
When forecasting net interest income, the Corporation makes assumptions about
interest rates and the shape of the yield curve, the volume and characteristics
of new business, and the behavior of existing positions. These assumptions
determine the future level of simulated net interest income in the base interest
rate scenario and the other interest rate scenarios presented in the following
table. These simulations assume that as assets and liabilities mature and are
replaced or repriced, this occurs at market rates. As a result, given the
current low level of interest rates and shape of the yield curve, forecasted net
interest income and the resulting net interest margin in the base rate scenario
decline from current levels as higher-yielding assets are replaced or repriced
at lower yields.
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 SEPTEMBER 30, 2003)
PNC Market
Economist Forward Low/Steep Low/Flat
- --------------------------------------------------------------------------------
Change in
forecasted net
interest income:
First year
sensitivity .3% .3% 1.6% (1.6)%
Second year
sensitivity (2.3) (2.1)% 4.9% (9.2)%
================================================================================
The graph below presents the yield curves for the base rate scenario and each of
the alternative scenarios one year forward.
[GRAPH]
ALTERNATIVE INTEREST RATE SCENARIOS
ONE YEAR FORWARD
1M LIBOR 2Y Swap 3Y Swap 5Y Swap
-------- ------- ------- -------
Base Rates 1.11 2.33 3.02 3.99
PNC Economist 1.50 2.66 3.23 4.17
Market Forward 2.05 3.72 4.22 5.02
Low / Steep 0.87 2.32 3.11 4.23
Low / Flat 1.14 1.52 1.69 1.81
37
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 comprised of investments that vary 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.
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 fourth quarter of 2003 valuation changes related to limited
partnership investments that reflect the impact of third 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. Also, 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 September 30, 2003, private equity investments carried at estimated fair
value totaled approximately $522 million compared with $530 million at December
31, 2002. As of September 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 $194 million
at September 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 $178
million for the first nine months of 2003 compared with $78 million for the
first nine months of 2002. See Note 7 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. 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
38
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 a 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 $225 million as of
September 30, 2003. See Credit Default Swaps in the Credit-Related Instruments
section of 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 September 30, 2003, the total VaR
usage for the Corporation is $.7 million. Total VaR usage ranged from $.5
million to $1.1 million during the third quarter of 2003. Currently, interest
rate risk, equity risk and foreign exchange risk contribute fairly evenly to
the overall VaR level.
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 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 September 30, 2003, the
Corporation experienced no backtesting exceptions at the enterprise-wide level.
39
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 nine 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 September 30 Average
Dollars in millions 2002 Additions Maturities Terminations 2003 Maturity
- -----------------------------------------------------------------------------------------------------------------------------------
Interest rate risk management
Interest rate swaps
Receive fixed $5,823 $3,474 $(25) $(2,645) $6,627 2 yrs. 10 mos.
Pay fixed 67 231 (1) (229) 68 4 yrs. 4 mos.
Basis swaps 52 2 (52) 2
Interest rate caps 16 16 3 yrs. 11 mos.
Interest rate floors 7 (5) 2 6 yrs. 6 mos.
Futures contracts 313 185 (240) 258 1 yr.
- ----------------------------------------------------------------------------------------------------------------
Total interest rate risk
management 6,278 3,892 (31) (3,166) 6,973
- ----------------------------------------------------------------------------------------------------------------
Commercial mortgage banking risk
management
Pay fixed interest rate swaps 273 514 (697) 90 12 yrs. 10 mos.
Pay total rate of return swaps 100 225 (200) (50) 75 2 mos.
- ----------------------------------------------------------------------------------------------------------------
Total commercial mortgage
banking risk management 373 739 (200) (747) 165
- ----------------------------------------------------------------------------------------------------------------
Total $6,651 $4,631 $(231) $(3,913) $7,138
===================================================================================================================================
40
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 September 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.
FINANCIAL DERIVATIVES - 2003
Weighted-Average Interest Rates
Notional --------------------------------
September 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 $4,281 $79 1.93% 2.41%
Pay fixed designated to loans 68 (9) 5.83 3.04
Basis swaps designated to loans 2 2.58 2.58
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 258 NM NM
- ---------------------------------------------------------------------------------------------------
Total asset rate conversion 4,627 70
- ---------------------------------------------------------------------------------------------------
Liability rate conversion
Interest rate swaps(a)
Receive fixed designated to borrowed funds 2,346 316 2.92 5.92
- ---------------------------------------------------------------------------------------------------
Total liability rate conversion 2,346 316
- ---------------------------------------------------------------------------------------------------
Total interest rate risk management(d) 6,973 386
- ---------------------------------------------------------------------------------------------------
Commercial mortgage banking risk management
Pay fixed interest rate swaps designated to loans held for sale(a) 90 (7) 5.32 4.88
Pay total rate of return swaps designated to loans held for sale(a) 75 (1) NM .68
- ---------------------------------------------------------------------------------------------------
Total commercial mortgage banking risk management 165 (8)
- ---------------------------------------------------------------------------------------------------
Total financial derivatives designated for risk management $7,138 $378
===================================================================================================================================
(a) The floating rate portion of interest rate contracts is based on
money-market indices. As a percent of notional value, 67% were based on
1-month LIBOR and 33% 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
September 30, 2003, 3-month LIBOR was 1.16% 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 September 30, 2003, Prime was 4.00%.
(d) Fair value amounts include accrued interest of $50 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(a) 273 (13) 4.73 4.36
Pay total rate of return swaps designated to loans held for sale(a) 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
41
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 basis swaps. Derivatives held by certain variable
interest entities was a result of the adoption of FIN 46. Other noninterest
income for the first nine months of 2003 included $.9 million of net gains
related to the derivatives held for risk management purposes not designated as
accounting hedges.
OTHER DERIVATIVES
At September 30, 2003
----------------------------------------------------------------------------------
Positive Negative Average
Notional Fair Fair Net Asset Fair
In millions Value Value Value (Liability) Value(a)
- -----------------------------------------------------------------------------------------------------------------------------------
Customer-related
Interest rate
Swaps $29,011 $528 $(518) $10 $(5)
Caps/floors
Sold 957 (17) (17) (24)
Purchased 792 16 16 21
Futures 1,242 1
Foreign exchange 3,202 61 (55) 6 5
Equity 2,018 66 (65) 1 1
Other 244 10 (3) 7 9
- -----------------------------------------------------------------------------------------------------------------------------------
Total customer-related 37,466 681 (658) 23 8
===================================================================================================================================
Other risk management and proprietary
Interest rate
Basis swaps 1,139 3 (1) 2 3
Pay fixed swaps 148 1 (6) (5) (1)
Receive fixed swaps 1
Other 709 16 (4) 12 7
- -----------------------------------------------------------------------------------------------------------------------------------
Total other risk management and proprietary 1,996 20 (11) 9 10
- -----------------------------------------------------------------------------------------------------------------------------------
Derivatives held by certain variable interest
entities
Interest rate
Pay fixed swaps 474 (76) (76) (7)
Caps
Purchased 320 1 1
Foreign exchange 88 12 (11) 1
Equity 63 13 (16) (3)
- -----------------------------------------------------------------------------------------------------------------------------------
Total derivatives held by certain variable
interest entities 945 26 (103) (77) (7)
- -----------------------------------------------------------------------------------------------------------------------------------
Total other derivatives $40,407 $727 $(772) $(45) $11
===================================================================================================================================
(a) Represents average for nine months ended September 30, 2003.
FASB DERIVATIVES IMPLEMENTATION GROUP MATTER
Derivatives Implementation Group Statement 133 Implementation Issue No. B36,
"Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments
That Incorporate Credit Risk Exposures That Are Unrelated or Only Partially
Related to the Creditworthiness of the Obligor under Those Instruments" ("DIG
B36") is effective October 1, 2003. DIG B36 clarifies Statement 133 by requiring
separate accounting for certain terms embedded in modified coinsurance
agreements and credit-linked notes as derivatives under Statement 133. The
initial effects of applying the requirements of DIG B36 to existing contracts as
of October 1, 2003 will be reported as a cumulative effect-type adjustment of
net income. While management is currently evaluating certain implementation
issues related to the adoption of DIG B36, the impact of DIG B36 is not
expected to have a material impact on the Corporation's consolidated financial
position.
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 September 30, 2003, credit default swaps
with $225 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 nine months
ending September 30, 2003 were $3.8 million and $1.1 million in the third
quarter of 2003.
42
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 $68 million at September 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 September 30, 2003 compared with $109
million at December 31, 2002. These agreements were entered into prior to July
1, 2003 and are considered to be financial guarantees and therefore are not
included in the Financial And Other Derivatives section of this Financial
Review.
INTERNAL CONTROLS AND DISCLOSURE CONTROLS AND PROCEDURES
As of September 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 September 30, 2003.
There has been no change in the Corporation's internal control over financial
reporting that occurred during the third quarter of 2003 that has materially
affected, or is reasonably likely to materially affect, the Corporation's
internal control over financial reporting.
43
GLOSSARY OF TERMS
Accounting/administration net assets - Net domestic and foreign pooled
investment assets for which PNC provides accounting and administration services.
These assets are not included on PNC's consolidated 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 on PNC's consolidated balance
sheet.
Assigned capital - 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 it 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. 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 - All assets, including pooled investment assets, held on behalf
of clients under safekeeping arrangements. Such assets are not reported on PNC's
consolidated balance sheet. Assets held in custody at other institutions on
behalf of PNC are included in the appropriate asset categories as if held
physically by 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 - 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 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 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.
Return on assigned capital - Annualized net income divided by assigned capital.
Return on average assets - Annualized net income or annualized income from
continuing operations divided by average assets.
Return on average equity - Annualized net income or annualized income from
continuing operations divided by average shareholders' equity.
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 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 - Total domestic and foreign pooled investment assets for
which PNC provides fund related services. These assets are not included on PNC's
consolidated balance sheet.
Total risk-based capital ratio - Total risk-based capital divided by
risk-weighted assets.
44
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION
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 previously disclosed in PNC's SEC reports and those
discussed elsewhere in this report, forward-looking statements are subject to,
among others, the following risks and uncertainties, which could cause actual
results or future events 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 regulatory and other
governmental 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 affecting interest rates, money supply
or otherwise reflecting changes in monetary policy;
(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 agreements with governmental agencies, and
regulators' future use of supervisory and enforcement tools;
(15) terrorist activities and international hostilities which may adversely
affect the general economy, financial and capital markets, specific industries,
and the Corporation; and
(16) issues related to the completion of the pending acquisition of United
National and the expected consequences of the integration of its
business into that of PNC, including the following: completion of the
transaction is dependent on, among other things, receipt of stockholder and
regulatory approvals, which may not be received or which may be received later
than anticipated; the transaction may be materially more expensive to complete
than anticipated, including as a result of unexpected factors or events; the
integration of United National's business and operations into PNC, which will
45
include the conversion of UnitedTrust Bank's different systems and procedures,
may take longer than anticipated or be more costly than anticipated or have
unanticipated adverse results relating to United National's or PNC's existing
businesses; the anticipated cost savings of the acquisition may take longer than
expected to be realized, may not be achieved or may not be achieved in their
entirety; and the anticipated benefits to PNC are dependent in part on United
National's business performance in the future, and there can be no assurance as
to actual future results, which could be impacted by various factors, including
the risks and uncertainties generally related to PNC's and United National's
performance (with respect to United National, see United National's SEC reports,
also accessible on the SEC's website) or due to factors related to the
acquisition of United National and the process of integrating it into PNC.
The Corporation's SEC reports, accessible on the SEC's website at www.sec.gov
and on PNC's website at www.pnc.com, contain additional information about the
foregoing risks and uncertainties and identify additional factors that could
affect the results anticipated in forward-looking statements or from historical
performance.
46
CONSOLIDATED STATEMENT OF INCOME
THE PNC FINANCIAL SERVICES GROUP, INC.
Three months ended September 30 Nine months ended September 30
------------------------------- ------------------------------
In millions, except per share data
Unaudited 2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------------------------------------
INTEREST INCOME
Loans and fees on loans $477 $567 $1,479 $1,754
Securities 140 140 438 466
Loans held for sale 8 24 35 117
Purchased customer receivables 11 11
Investments held by certain variable interest entities 48 48
Other 34 38 91 94
- ---------------------------------------------------------------------------------------------------------------------------------
Total interest income 718 769 2,102 2,431
- ---------------------------------------------------------------------------------------------------------------------------------
INTEREST EXPENSE
Deposits 106 162 355 510
Borrowed funds 51 79 162 248
Capital securities 14 14
Commercial paper 7 7
Liabilities of certain variable interest entities 28 28
- ---------------------------------------------------------------------------------------------------------------------------------
Total interest expense 206 241 566 758
- ---------------------------------------------------------------------------------------------------------------------------------
Net interest income 512 528 1,536 1,673
Provision for credit losses 50 73 143 244
- ---------------------------------------------------------------------------------------------------------------------------------
Net interest income less provision for credit losses 462 455 1,393 1,429
- ---------------------------------------------------------------------------------------------------------------------------------
NONINTEREST INCOME
Asset management 212 200 628 651
Fund servicing 188 193 569 622
Service charges on deposits 60 57 177 166
Brokerage 46 41 133 151
Consumer services 65 62 188 178
Corporate services 132 108 362 375
Equity management (4) (22) (25) (37)
Net securities gains 19 68 101 88
Investments held by certain variable interest entities 96 96
Other 92 64 248 237
- ---------------------------------------------------------------------------------------------------------------------------------
Total noninterest income 906 771 2,477 2,431
- ---------------------------------------------------------------------------------------------------------------------------------
NONINTEREST EXPENSE
Staff expense 452 422 1,336 1,293
Net occupancy 63 64 217 181
Equipment 67 68 205 203
Marketing 16 14 49 40
Distributions on capital securities 15 28 44
Other 237 207 791 675
- ---------------------------------------------------------------------------------------------------------------------------------
Total noninterest expense 835 790 2,626 2,436
- ---------------------------------------------------------------------------------------------------------------------------------
Income before minority and noncontrolling interests and
income taxes 533 436 1,244 1,424
Minority and noncontrolling interests in income of
consolidated entities 100 4 124 26
Income taxes 152 147 393 476
- ---------------------------------------------------------------------------------------------------------------------------------
Net income $281 $285 $727 $922
=================================================================================================================================
EARNINGS PER COMMON SHARE
Basic $1.01 $1.00 $2.59 $3.25
Diluted $1.00 $1.00 $2.57 $3.23
AVERAGE COMMON SHARES OUTSTANDING
Basic 278 284 281 283
Diluted 280 285 282 285
=================================================================================================================================
See accompanying Notes to Consolidated Financial Statements.
47
CONSOLIDATED BALANCE SHEET
THE PNC FINANCIAL SERVICES GROUP, INC.
In millions, except par value September 30 December 31
Unaudited 2003 2002
- ---------------------------------------------------------------------------------------------------------------------------------
ASSETS
Cash and due from banks $3,614 $3,201
Federal funds sold 1,847
Other short-term investments 2,590 1,811
Loans held for sale 1,531 1,607
Securities 14,893 13,763
Loans, net of unearned income of $1,037 and $1,075 34,514 35,450
Allowance for credit losses (648) (673)
- ---------------------------------------------------------------------------------------------------------------------------------
Net loans 33,866 34,777
Goodwill 2,385 2,313
Other intangible assets 311 333
Purchased customer receivables 2,481
Investments held by certain variable interest entities 2,318
Other 8,295 6,725
- ---------------------------------------------------------------------------------------------------------------------------------
Total assets $72,284 $66,377
==================================================================================================================================
LIABILITIES
Deposits
Noninterest-bearing $12,118 $10,563
Interest-bearing 33,405 34,419
- ---------------------------------------------------------------------------------------------------------------------------------
Total deposits 45,523 44,982
Borrowed funds
Federal funds purchased 881 38
Repurchase agreements 1,048 814
Bank notes and senior debt 2,839 4,400
Federal Home Loan Bank borrowings 1,127 1,256
Subordinated debt 1,980 2,423
Mandatorily redeemable capital securities of subsidiary trusts 848
Commercial paper 2,483
Liabilities of certain variable interest entities 2,415
Other borrowed funds 242 185
- ---------------------------------------------------------------------------------------------------------------------------------
Total borrowed funds 13,863 9,116
Allowance for unfunded loan commitments and letters of credit 89 84
Accrued expenses 2,228 2,046
Other 2,327 2,172
- ---------------------------------------------------------------------------------------------------------------------------------
Total liabilities 64,030 58,400
- ---------------------------------------------------------------------------------------------------------------------------------
Minority and noncontrolling interests in consolidated entities 1,617 270
Mandatorily redeemable capital securities of subsidiary trusts 848
SHAREHOLDERS' EQUITY
Common stock - $5 par value
Authorized 800 shares, issued 353 shares 1,764 1,764
Capital surplus 1,110 1,101
Retained earnings 7,507 7,187
Deferred benefit expense (24) (9)
Accumulated other comprehensive income 147 321
Common stock held in treasury at cost: 76 and 68 shares (3,867) (3,505)
- ---------------------------------------------------------------------------------------------------------------------------------
Total shareholders' equity 6,637 6,859
- ---------------------------------------------------------------------------------------------------------------------------------
Total liabilities, minority and noncontrolling interests, capital
securities and shareholders' equity $72,284 $66,377
==================================================================================================================================
See accompanying Notes to Consolidated Financial Statements.
48
CONSOLIDATED STATEMENT OF CASH FLOWS
THE PNC FINANCIAL SERVICES GROUP, INC.
Nine months ended September 30 - in millions
Unaudited 2003 2002
- ---------------------------------------------------------------------------------------------------------------------------------
OPERATING ACTIVITIES
Net income $727 $922
Adjustments to reconcile net income
to net cash provided by operating activities
Provision for credit losses 144 244
Depreciation, amortization and accretion 215 179
Deferred income taxes 126 279
Securities transactions (101) (88)
Valuation adjustments (28) 33
Change in
Loans held for sale 184 2,497
Other short-term investments (722) (3,829)
Other (175) 3,316
- ---------------------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 370 3,553
- ---------------------------------------------------------------------------------------------------------------------------------
INVESTING ACTIVITIES
Net change in
Loans 1,621 3,067
Federal funds sold 1,847 (3,031)
Repayment of securities 5,013 1,960
Sales
Securities 9,492 13,689
Loans 2
Foreclosed assets 10 8
Purchases
Securities (15,809) (13,144)
Loans (1,022) (22)
Net cash received (paid) for divestitures/acquisitions (1,676)
Net cash due to FIN 46 consolidation 466
Other (373) (223)
- ---------------------------------------------------------------------------------------------------------------------------------
Net cash provided by investing activities 1,247 628
- ---------------------------------------------------------------------------------------------------------------------------------
FINANCING ACTIVITIES
Net change in
Noninterest-bearing deposits 1,555 6
Interest-bearing deposits (928) (2,350)
Federal funds purchased 843 (132)
Repurchase agreements 234 34
Sales/issuances
Other borrowed funds 17,272 16,525
Common stock 96 100
Repayments/maturities
Bank notes and senior debt (1,555) (1,483)
Federal Home Loan Bank borrowings (129) (777)
Subordinated debt (430)
Other borrowed funds (17,269) (16,566)
Acquisition of treasury stock (486) (53)
Cash dividends paid (407) (409)
- ---------------------------------------------------------------------------------------------------------------------------------
Net cash used by financing activities (1,204) (5,105)
- ---------------------------------------------------------------------------------------------------------------------------------
INCREASE (DECREASE) IN CASH AND DUE FROM BANKS 413 (924)
Cash and due from banks at beginning of period 3,201 4,327
- ---------------------------------------------------------------------------------------------------------------------------------
Cash and due from banks at end of period $3,614 $3,403
=================================================================================================================================
CASH PAID FOR
Interest $574 $800
Income taxes 126 115
NON-CASH ITEMS
Transfer from loans to loans held for sale, net 80 266
Transfer from loans to other assets 12 11
=================================================================================================================================
See accompanying Notes to Consolidated Financial Statements.
49
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 interim consolidated financial statements ("consolidated financial
statements") include the accounts of PNC and its subsidiaries, most of which are
wholly owned, and certain partnership interests and variable interest entities.
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, as amended ("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 investments. 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 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.
50
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 (or
are) 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. See
Note 2 Variable Interest Entities for more information regarding PNC's adoption
of FIN 46 as of July 1, 2003.
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
51
employee compensation included in net income for the three months and nine
months ended September 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 Nine months ended
------------------------------ ---------------------------
In millions, except for Sept. 30 Sept. 30 Sept. 30 Sept. 30
per share data 2003 2002 2003 2002
- ------------------------------------------------------------------------------------------
Net income as reported $281 $285 $727 $922
Add: Stock-based
employee compensation
expense (credit) included
in reported net income,
net of related tax effects 6 (3) 16 1
Deduct: Total
stock-based employee
compensation expense
determined under the
fair value method for
all awards, net of
related tax effects (16) (11) (40) (37)
- ------------------------------------------------------------------------------------------
Pro forma net income $271 $271 $703 $886
- ------------------------------------------------------------------------------------------
Earnings per share
Basic-as reported $1.01 $1.00 $2.59 $3.25
Basic-pro forma $.97 $.96 $2.51 $3.13
Diluted-as reported $1.00 $1.00 $2.57 $3.23
Diluted-pro forma $.97 $.95 $2.49 $3.11
==========================================================================================
During the third quarter of 2002, the net credit to expense was due to
forfeitures and adjustments of accruals related to performance-based awards
under PNC's incentive plans.
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 nine
months ended September 30 2003 2002
- --------------------------------------------------------------------------------
Risk-free interest rate 2.9% 4.5%
Dividend yield 3.5% 3.5%
Volatility 30.8% 26.5%
Expected life 5 yrs. 5 yrs.
================================================================================
NOTE 2 VARIABLE INTEREST ENTITIES
In October 2003, the Financial Accounting Standards Board announced that the
effective date of FIN 46 was deferred from July 1, 2003 to December 31, 2003 for
interests held by public companies in VIEs created prior to February 1, 2003.
However, PNC, as permitted, elected to adopt the accounting provisions of FIN 46
as of the original July 1, 2003 implementation date by consolidating those VIEs
that management believes are currently subject to the standard and of which PNC
is considered the primary beneficiary. Note 1, Accounting Policies, provides
further background regarding FIN 46.
The adoption of FIN 46 resulted in increases of $6.5 billion and $5.1 billion to
PNC's total assets and total liabilities, respectively, at September 30, 2003.
Several line items in the Consolidated Statement of Income changed significantly
with the inclusion of the results of the VIEs that were consolidated, but the
impact on consolidated net income was minimal.
The following VIEs were consolidated by PNC in the third quarter of 2003:
- - Market Street Funding Corporation ("Market Street"), a multi-seller
asset-backed commercial paper conduit that is independently owned and
managed. PNC Bank, N.A. provides credit enhancement, liquidity facilities
and certain administrative services to Market Street. 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. PNC Bank provides
certain administrative 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 a credit loan facility with a five-year term expiring on
December 31, 2004. At September 30, 2003, approximately $86 million was
outstanding on this facility. This amount was eliminated in PNC's
Consolidated Balance Sheet as of September 30, 2003 due to the
consolidation of Market Street under FIN 46. An additional $257 million was
52
provided by a major insurer. Also at September 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
$7.9 million for the nine months ended September 30, 2003. Commitment fees
related to PNC's portion of the liquidity facilities amounted to $2.3
million for the nine months ended September 30, 2003. PNC holds no
ownership interest in Market Street. Program administrator and commitment
fees of $2.3 million and $.7 million, respectively, for the three months
ended September 30, 2003 were eliminated in PNC's Consolidated Statement of
Income for the three and nine months ended September 30, 2003 due to the
consolidation of Market Street under FIN 46. All of Market Street's assets
at September 30, 2003 collateralize its commercial paper obligations.
Neither creditors nor equity investors in Market Street have any recourse
to the general credit of PNC.
The consolidation of Market Street was reflected in the Corporate Banking
business segment and increased PNC's total assets and liabilities by $2.4
billion at September 30, 2003. The most significant increases to the
Consolidated Balance Sheet were reflected in "Purchased customer
receivables" of $2.5 billion and "Commercial paper" of $2.5 billion.
- - Six collateralized debt obligation ("CDO") funds for which BlackRock, a
majority-owned subsidiary of PNC, acts as collateral manager. 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. The funds' assets totaling $2.6 billion at September 30, 2003
collateralize the funds' obligations. Neither creditors nor equity
investors in the funds have any recourse to the general credit of BlackRock
or PNC.
The consolidation of the BlackRock CDOs increased PNC's total assets by
$2.6 billion and total liabilities by $2.3 billion at September 30, 2003.
The most significant increases to the Consolidated Balance Sheet were
reflected in "Cash and due from banks" of $.1 billion, "Investments held by
certain variable interest entities" of $2.3 billion, "Liabilities of
certain variable interest entities" of $2.1 billion and "Minority and
noncontrolling interests in consolidated entities" of $.3 billion.
- - Equity investments made by PNC Real Estate Finance in various limited
partnerships that sponsor affordable housing projects utilizing the Low
Income Housing Tax Credit 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. Also consolidated were entities in which PNC
Real Estate Finance, as a national syndicator of affordable housing equity,
serves as the general partner (together with the aforementioned limited
partnership investments "LIHTC investments"). 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. Neither creditors nor equity investors in
the LIHTC investments have any recourse to the general credit of PNC.
The consolidation of the LIHTC investments was reflected in the PNC Real
Estate Finance business segment and increased PNC's total assets by $.5
billion and total liabilities by $.2 billion at September 30, 2003. The
most significant increases to the Consolidated Balance Sheet were reflected
in "Other assets" of $.5 billion, "Liabilities of certain variable interest
entities" of $.2 billion and "Minority and noncontrolling interests in
consolidated entities" of $.2 billion.
- - Six private investment funds, organized as limited partnerships, managed by
the Hawthorn division of PNC Advisors ("Private Funds"). All of the Private
Funds' $1.0 billion of assets at September 30, 2003, collateralize their
obligations. Neither creditors nor investors in the Private Funds have
recourse to the general credit of PNC.
The consolidation of the Private Funds was reflected in the PNC Advisors
business segment and increased PNC's total assets by $1.0 billion and total
liabilities by $.1 billion at September 30, 2003. The most significant
increases to the Consolidated Balance Sheet were reflected in "Cash and due
from banks" of $.3 billion, "Other assets" of $.7 billion, "Liabilities of
certain variable interest entities" of $.1 billion, and "Minority and
noncontrolling interests in consolidated entities" of $.9 billion.
53
In addition to the variable interests in the consolidated VIEs discussed above,
PNC holds significant variable interests in various other VIEs. These VIEs,
which are not consolidated because PNC is not considered the primary
beneficiary, are as follows:
- - 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. This entity had assets of $347 million at September 30, 2003.
BlackRock's equity ownership in the entity was approximately $5.5 million
at September 30, 2003 and represents its maximum potential loss.
- - As previously discussed, PNC Real Estate Finance has equity investments in
various limited partnerships that sponsor affordable housing projects
utilizing the Low Income Housing Tax Credit pursuant to Section 42 of the
Internal Revenue Code. Certain of these entities were consolidated as PNC
is considered the primary beneficiary. Additionally, PNC is considered to
have a significant variable interest in certain of these entities in which
PNC is not the primary beneficiary. These entities have total assets of
$40.5 million. PNC uses the equity method to account for its investment in
these entities. PNC has $6.2 million recorded as its investment at
September 30, 2003 and has $.2 million in commitments to these entities; as
a result, its maximum potential loss is $6.4 million.
As previously reported, management 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.
In connection with the deferral of the effective date of FIN 46, the FASB is
continuing to evaluate the scope of entities covered and other implementation
issues related to FIN 46. Therefore, any modifications or refinement of the
current FIN 46 guidance provided by the FASB could result in the consolidation
of additional entities or the deconsolidation of entities previously included in
PNC's consolidated financial statements.
NOTE 3 ACQUISITIONS
UNITED NATIONAL BANCORP ACQUISITION
On August 21, 2003, PNC and its wholly owned subsidiary PNC Bancorp, Inc.
entered into an Agreement and Plan of Merger to acquire United National Bancorp,
a bank holding company with over $3 billion in assets. A subsidiary of United
National Bancorp, UnitedTrust Bank, provides a full range of commercial and
retail bank services through 45 branches in New Jersey and seven branches in
Pennsylvania. Under the terms of the merger agreement, United National Bancorp's
shareholders are entitled to elect to receive the merger consideration in shares
of PNC common stock or cash, subject to pro ration. The aggregate merger
consideration is approximately 6.5 million shares of PNC common stock, subject
to adjustment, and approximately $320 million in cash.
The transaction is expected to close in the first quarter of 2004. The merger is
subject to customary closing conditions, including regulatory approvals and the
approval of shareholders of United National Bancorp. A special meeting of United
National Bancorp shareholders has been called for December 2, 2003 to consider
this transaction. PNC has filed all applicable applications for approval of the
merger and the bank combination with the Federal Reserve Bank of Cleveland, the
Office of the Comptroller of the Currency and the New Jersey Department of
Banking and Insurance.
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. 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. 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 was to aggressively liquidate the Serviced Portfolio during the
servicing term.
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 absorbed 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").
54
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. NBOC exercised the Put
Option effective July 15, 2003. At September 30, 2003, the Put Option liability
was zero compared with $57 million at December 31, 2002. An $8 million reduction
from the acquisition date amount was recognized in earnings in 2003 as other
noninterest income. In addition, $7 million was paid to NBOC as Excess Loss
Payments during 2003. The remaining liability of $42 million was eliminated upon
exercise of the Put Option on July 15, 2003. The loans were recorded at the
purchase price of $121 million net of the remaining Put Option liability of $42
million as determined by an independent third party in connection with the final
valuation. The net recorded amount of $79 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. A
total of $36 million of these loans was classified as nonperforming at September
30, 2003. PNC will continue to liquidate these loans in an orderly manner and
these loans will be considered in the determination of the adequacy of the
allowance for credit losses.
NOTE 4 RECENT ACCOUNTING PRONOUNCEMENTS
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's adoption of
SFAS No. 149 prospectively as of July 1, 2003 did not have a material impact on
PNC's consolidated financial statements.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity" ("SFAS 150").
See Note 5 Capital Securities of Subsidiary Trusts.
Derivatives Implementation Group Statement 133 Implementation Issue No. B36,
"Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments
That Incorporate Credit Risk Exposures That Are Unrelated or Only Partially
Related to the Creditworthiness of the Obligor under Those Instruments" ("DIG
B36") is effective October 1, 2003. DIG B36 clarifies Statement 133 by requiring
separate accounting for certain terms embedded in modified coinsurance
agreements and credit-linked notes as derivatives under Statement 133. The
initial effects of applying the requirements of DIG B36 to existing contracts as
of October 1, 2003 will be reported as a cumulative effect-type adjustment of
net income. While management is currently evaluating certain implementation
issues related to the adoption of DIG B36, the impact of DIG B36 is not expected
to have a material impact on the Corporation's consolidated financial position.
NOTE 5 CAPITAL SECURITIES OF SUBSIDIARY TRUSTS
SFAS 150 requires that certain financial instruments, which under prior GAAP
could be designated as equity, be classified as liabilities on the balance
sheet. SFAS 150 was effective for certain financial instruments entered into or
modified after May 31, 2003, and otherwise was effective July 1, 2003 for PNC.
The Corporation previously classified its mandatorily redeemable capital
securities of subsidiary trusts ("Capital Securities") between the liabilities
and shareholders' equity sections of the Consolidated Balance Sheet. These
securities were reclassified as borrowed funds under the provisions of SFAS 150
effective July 1, 2003. Additionally, the related dividends were reclassified
from noninterest expense and included in interest expense in the Consolidated
Statement of Income. Reclassification of prior period amounts was not permitted
under SFAS 150. The adoption of SFAS 150 did not have a material effect on PNC's
consolidated financial statements. However, the effect of reclassifying
dividends to interest expense decreased the Corporation's net interest margin
for the third quarter of 2003 by approximately 10 basis points.
The Corporation's Capital Securities include nonvoting preferred beneficial
interests in the assets of PNC Institutional Capital Trust A, Trust B and Trust
C. Trust A, formed in December 1996, holds $350 million of 7.95% junior
subordinated debentures, due December 15, 2026, and redeemable after December
15, 2006, at a premium that declines from 103.975% to par on or after December
15, 2016. Trust B, formed in May 1997, holds $300 million of 8.315% junior
subordinated debentures due May 15, 2027, and redeemable after May 15, 2007, at
a premium that declines from 104.1575% to par on or after May 15, 2017. Trust C,
formed in June 1998, holds $200 million of junior subordinated debentures due
June 1, 2028, bearing interest at a floating rate per annum equal to 3-month
LIBOR plus 57 basis points. The rate in effect at September 30, 2003 was 1.71%.
Trust C Capital Securities are redeemable on or after June 1, 2008 at par.
Cash distributions on the Capital Securities are made to the extent interest on
the debentures is received by the Trusts. In the event of certain changes or
amendments to regulatory requirements or federal tax rules, the Capital
Securities are redeemable in whole. Cash distributions of $14 million were
recognized as interest expense during the third quarter of 2003.
Trust A is a wholly owned finance subsidiary of PNC Bank, N.A., PNC's principal
bank subsidiary, and Trusts B and C are wholly owned finance subsidiaries of the
Corporation.
55
The respective parents of the Trusts have, through the agreements governing the
Capital Securities, taken together, fully, irrevocably and unconditionally
guaranteed all of the obligations of the Trusts under the Capital Securities.
Also, as indicated in Note 1, PNC consolidated certain VIEs as of July 1, 2003
as a result of the adoption of FIN 46. In November 2003, the FASB issued FASB
Staff Position (FSP) 150-3, "Effective Date, Disclosures, and Transition for
Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and
Certain Mandatorily Redeemable Noncontrolling Interests under FASB Statement No.
150, Accounting for Certain Financial Instruments with Characteristics of Both
Liabilities and Equity." FSP 150-3 deferred indefinitely the classification and
measurement provisions of SFAS 150 for certain mandatorily redeemable
noncontrolling interests, including interests that are redeemed only upon the
liquidation of a limited-life subsidiary. The lives of the VIEs constituting the
CDO funds, LIHTC investments and Private Funds are contractually limited. The
mandatorily redeemable noncontrolling interests in these entities are included
in the Consolidated Balance Sheet under the caption, "Minority and
noncontrolling interests in consolidated entities." Generally, at the
termination date of these VIEs, the liquidation value of the noncontrolling
interests would equal the residual value of the net assets of the respective
entity at that date. The distribution of that liquidation value to the
noncontrolling interest holders would generally be in proportion to their
respective interests. Liquidation and settlement of these noncontrolling
interests at September 30, 2003 would have resulted in payments of approximately
$1.6 billion based on the terms of the respective entity's governing documents
and the measurement principles included in SFAS 150.
The FASB is continuing to evaluate the scope, requirements and implications of
FIN 46 and its relationship to the specific requirements of SFAS 150. Changes,
if any, resulting from the FASB's deliberations regarding SFAS 150 could impact
the presentation of certain line items in the Corporation's consolidated
financial statements.
NOTE 6 CASH FLOWS
During the first nine 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 nine 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 $31 million. During the third quarter of 2003, BlackRock made a
contingency payment of $5 million related to the 2002 acquisition of Cyllenius.
During the first nine 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 3.
NOTE 7 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 nine months of 2003 totaled $178 million
compared with $78 million for the first nine months of 2002 and was included in
several line items within noninterest income in the Consolidated Statement of
Income, as follows:
DETAILS OF TRADING ACTIVITIES
Nine months ended September 30 - in millions 2003 2002
- --------------------------------------------------------------------------------
Corporate services $1
Investments held by certain VIEs
Securities underwriting and trading $81
Derivatives trading 1
Other noninterest income
Securities underwriting and trading 62 39
Derivatives trading 15 19
Foreign exchange 19 19
- --------------------------------------------------------------------------------
Net trading income $178 $78
================================================================================
56
NOTE 8 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 litigation
referred to below. 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 pending securities litigation
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, alleged 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 sought, among other things, unquantified
damages, declaratory and injunctive relief, and attorneys' fees and costs. In
November 2003, the court dismissed the complaint without prejudice upon the
joint stipulation of the parties.
The Corporation received a letter in June 2003 on behalf of an alleged
shareholder of the Corporation demanding that
57
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 September 2003, the
Corporation moved to stay the action until resolution of the claims against the
Corporation in the pending securities litigation described above.
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.
In connection with industry-wide investigations of practices regarding market
timing, late day trading and employee trading in mutual funds, several of PNC's
subsidiaries have received requests for information from state and federal
regulatory authorities. These subsidiaries are fully cooperating in all of
these matters.
NOTE 9 NONPERFORMING ASSETS
Nonperforming assets were as follows:
September 30 December 31
In millions 2003 2002
- --------------------------------------------------------------------------------
Nonperforming loans (a) $324 $309
Nonperforming loans held for sale (b) 35 97
Foreclosed assets 37 12
- --------------------------------------------------------------------------------
Total nonperforming assets (c) $396 $418
================================================================================
(a) Includes a troubled debt restructured loan of $1 million as of September
30, 2003 and December 31, 2002.
(b) Includes troubled debt restructured loans held for sale of $9 million and
$17 million as of September 30, 2003 and December 31, 2002, respectively.
(c) Excludes equity management assets carried at estimated fair value of $38
million and $40 million as of September 30, 2003 and December 31, 2002,
respectively. Such assets include troubled debt restructured assets of $7
million and $12 million, respectively.
NOTE 10 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 (115) (167)
Commercial real estate (3) (2)
Consumer (29) (30)
Residential mortgage (2) (5)
Lease financing (42) (20)
- --------------------------------------------------------------------------------
Total charge-offs (191) (224)
- --------------------------------------------------------------------------------
Recoveries
Commercial 17 23
Commercial real estate
Consumer 9 11
Residential mortgage 1 1
Lease financing 2 1
- --------------------------------------------------------------------------------
Total recoveries 29 36
- --------------------------------------------------------------------------------
Net charge-offs
Commercial (98) (144)
Commercial real estate (3) (2)
Consumer (20) (19)
Residential mortgage (1) (4)
Lease financing (40) (19)
- --------------------------------------------------------------------------------
Total net charge-offs (162) (188)
- --------------------------------------------------------------------------------
Provision for credit losses 143 244
Acquired allowance (NBOC acquisition) 41
Transfer of allowance to other assets (1)
Net change in allowance for unfunded loan
commitments and letters of credit (5) (9)
- --------------------------------------------------------------------------------
Allowance at September 30 $648 $648
================================================================================
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 5 9
- --------------------------------------------------------------------------------
Allowance at September 30 $89 $79
================================================================================
58
NOTE 11 SECURITIES
Unrealized
Amortized ------------------------------ Fair
In millions Cost Gains Losses Value
- ------------------------------------------------------------------------------------------------------------------------------------
SEPTEMBER 30, 2003
SECURITIES AVAILABLE FOR SALE
Debt securities
U.S. Treasury and government agencies $1,913 $26 $1,939
Mortgage-backed 7,255 52 $(66) 7,241
Commercial mortgage-backed 2,595 83 2,678
Asset-backed 2,487 14 (15) 2,486
State and municipal 76 2 (3) 75
Other debt 57 3 60
- ------------------------------------------------------------------------------------------------------------------------------------
Total debt securities 14,383 180 (84) 14,479
Corporate stocks and other 412 5 (5) 412
- ------------------------------------------------------------------------------------------------------------------------------------
Total securities available for sale $14,795 $185 $(89) $14,891
====================================================================================================================================
SECURITIES HELD TO MATURITY
Debt securities
Asset-backed $2 $2
- ------------------------------------------------------------------------------------------------------------------------------------
Total debt securities 2 2
- ------------------------------------------------------------------------------------------------------------------------------------
Total securities held to maturity $2 $2
====================================================================================================================================
DECEMBER 31, 2002
SECURITIES AVAILABLE FOR SALE
Debt securities
U.S. Treasury and government agencies $813 $13 $826
Mortgage-backed 6,110 108 $(2) 6,216
Commercial mortgage-backed 2,806 81 2,887
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 September 30, 2003 were $14.9 billion compared with $13.8
billion at December 31, 2002. Securities represented 21% of total assets at
September 30, 2003 and December 31, 2002. The increase in total securities
compared with December 31, 2002 was primarily due to purchases during the first
nine months of 2003 of United States government agency and mortgage-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 9 months at September 30, 2003 and 2 years and 8 months at December 31,
2002.
Securities classified as held to maturity are carried at amortized cost.
Securities classified as held to maturity at September 30, 2003 were due to the
Corporation's adoption of FIN 46 and are related to Market Street. Securities
classified as held to maturity on December 31, 2002 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 2 years
and 10 months at September 30, 2003 and 20 years and 2 months at December 31,
2002.
At September 30, 2003, the securities available for sale balance included a net
unrealized gain of $96 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. A rise in interest rates subsequent
to September 30, 2003 will adversely impact the fair value of securities
available for sale at December 31, 2003 compared with the balance at September
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.
59
Net securities gains were $101 million for the first nine months of 2003,
including $25 million of gains related to the liquidation of the entities formed
in 2001 in transactions with AIG, compared with $88 million for the first nine
months of 2002.
Information relating to securities sold is set forth in the following table:
SECURITIES SOLD
Nine months
ended
September 30 Gross Gross Net Income
In millions Proceeds Gains Losses Gains Taxes
- --------------------------------------------------------------------------------
2003 $9,492 $112 $11 $101 $35
2002 13,689 100 12 88 31
================================================================================
NOTE 12 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 nine months ended
September 30, 2003 follows:
GOODWILL
December 31 Goodwill September 30
In millions 2002 Additions Sales 2003
- --------------------------------------------------------------------------------
Regional Community Banking $438 $438
Corporate Banking 39 39
PNC Real Estate Finance 302 $3 305
PNC Business Credit 298 298
PNC Advisors 152 1 153
BlackRock 175 3 178
PFPC 909 43 $(6) 946
Other 28 28
- --------------------------------------------------------------------------------
Total $2,313 $78 $(6) $2,385
================================================================================
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 in customer-related
intangibles of $14 million and a reduction in goodwill of $6 million.
During the third quarter of 2003, goodwill of $28 million was recorded due to a
change in the Corporation's ownership percentage of BlackRock resulting from
BlackRock share repurchases.
The gross carrying amount, accumulated amortization and net carrying amount of
other intangible assets by major category consisted of the following:
OTHER INTANGIBLE ASSETS
September 30 December 31
In millions 2003 2002
- --------------------------------------------------------------------------------
Customer-related intangibles
Gross carrying amount $185 $199
Accumulated amortization (74) (67)
- --------------------------------------------------------------------------------
Net carrying amount $111 $132
- --------------------------------------------------------------------------------
Mortgage and other loan
servicing rights
Gross carrying amount $332 $313
Accumulated amortization (132) (112)
- --------------------------------------------------------------------------------
Net carrying amount $200 $201
- --------------------------------------------------------------------------------
Total $311 $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 September 30, 2003,
the Corporation had three indefinite-lived other intangible assets included in
"Customer-related intangibles" in the table above: two investment management
contracts held by BlackRock and an intangible asset recorded pursuant to SFAS
No. 87, "Employers' Accounting for Pensions." The aggregate carrying value of
these indefinite-lived intangible assets was $10.4 million at September 30, 2003
and $3.5 million at December 31, 2002.
For customer-related intangibles, the estimated remaining useful lives range
from 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 nine months ended September 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 78 8 19
Sales (6) (14)
Amortization (15) (20)
- ------------------------------------------------------------------------------
Balance at September 30, 2003 $2,385 $111 $200
==============================================================================
Amortization expense on intangible assets for the third quarter and the first
nine months of 2003 was approximately $12 million and $35 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 $11 million, $41 million,
$38 million, $35 million, $34 million and $31 million, respectively.
60
NOTE 13 EARNINGS PER SHARE
The following table sets forth basic and diluted earnings per share
calculations.
Three months ended September 30 Nine months ended September 30
---------------------------------------------------------------
In millions, except share and per share data 2003 2002 2003 2002
- ------------------------------------------------------------------------------------------------------------------------------------
CALCULATION OF BASIC EARNINGS PER COMMON SHARE
Net income $281 $285 $727 $922
Less: Preferred dividends declared 1 1
- ------------------------------------------------------------------------------------------------------------------------------------
Net income applicable to basic earnings per common share $281 $285 $726 $921
Basic weighted-average common shares outstanding (in thousands) 278,374 283,689 280,595 283,195
- ------------------------------------------------------------------------------------------------------------------------------------
Basic earnings per common share $1.01 $1.00 $2.59 $3.25
====================================================================================================================================
CALCULATION OF DILUTED EARNINGS PER COMMON SHARE
Net income $281 $285 $727 $922
Less: BlackRock adjustment for common stock equivalents 1 1
- ------------------------------------------------------------------------------------------------------------------------------------
Net income applicable to diluted earnings per common share $281 $285 $726 $921
Basic weighted-average common shares outstanding (in thousands) 278,374 283,689 280,595 283,195
Conversion of preferred stock Series A and B 92 95 92 99
Conversion of preferred stock Series C and D 724 786 737 803
Conversion of debentures 14 15 14 16
Exercise of stock options 420 207 338 654
Incentive share awards 467 422 444 426
- ------------------------------------------------------------------------------------------------------------------------------------
Diluted weighted-average common shares outstanding (in thousands) 280,091 285,214 282,220 285,193
- ------------------------------------------------------------------------------------------------------------------------------------
Diluted earnings per common share $1.00 $1.00 $2.57 $3.23
====================================================================================================================================
61
NOTE 14 SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME
The following table sets forth the activity in shareholders' equity for the
first nine months of 2003. The value of the Corporation's preferred stock
outstanding as of September 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 727 727
Other comprehensive income
(loss), net of tax (a)
Net unrealized securities losses (116) (116)
Net unrealized losses on cash
flow hedge derivatives (58) (58)
- -----------------------------------------------------------------------------------------------------------------------------------
Comprehensive income 553
- -----------------------------------------------------------------------------------------------------------------------------------
Cash dividends declared
Common ($1.44 per share) (406) (406)
Preferred (1) (1)
Treasury stock activity (8) (2) (362) (364)
Tax benefit of stock option plans 5 5
Stock options granted 9 9
Subsidiary stock transactions (3) (3)
Deferred benefit expense (15) (15)
- -----------------------------------------------------------------------------------------------------------------------------------
Balance at September 30, 2003 277 $1,764 $1,110 $7,507 $(24) $147 $(3,867) $6,637
===================================================================================================================================
(a) A summary of the components of the change in accumulated other
comprehensive income (loss) follows:
Nine months ended September 30, 2003 Tax Benefit
In millions Pretax Amount (Expense) After-tax Amount
- -----------------------------------------------------------------------------------------------------------------------------------
Unrealized securities losses $(106) $37 $(69)
Less: Reclassification adjustment for gains realized in net income 72 (25) 47
- -----------------------------------------------------------------------------------------------------------------------------------
Net unrealized securities losses (178) 62 (116)
- -----------------------------------------------------------------------------------------------------------------------------------
Unrealized losses on cash flow hedge derivatives (37) 13 (24)
Less: Reclassification adjustment for gains realized in net income 52 (18) 34
- -----------------------------------------------------------------------------------------------------------------------------------
Net unrealized losses on cash flow hedge derivatives (89) 31 (58)
- -----------------------------------------------------------------------------------------------------------------------------------
Other comprehensive income (loss) $(267) $93 $(174)
===================================================================================================================================
The accumulated balances related to each component of other comprehensive income
are as follows:
September 30, 2003 December 31, 2002
In millions Pretax After-tax Pretax After-tax
- -----------------------------------------------------------------------------------------------------------------------------------
Net unrealized securities gains $96 $63 $274 $179
Net unrealized gains on cash flow hedge
derivatives 119 77 208 135
Other (b) 11 7 11 7
- -----------------------------------------------------------------------------------------------------------------------------------
Accumulated other comprehensive income $226 $147 $493 $321
===================================================================================================================================
(b) Consists of interest-only strip valuation adjustments, foreign currency
translation adjustments and minimum pension liability adjustments.
62
NOTE 15 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 third 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 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 BlackRock; 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 its Hawthorn
division. 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 $294 billion of assets under management at
September 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 among the largest providers of mutual fund transfer agency and
accounting and administration services in the United States, offering a wide
range of fund processing services to the investment management industry and
providing processing solutions to the international marketplace through its
Ireland and Luxembourg operations.
63
RESULTS OF BUSINESSES
Regional PNC PNC
Three months ended September 30 Community Corporate Real Estate Business PNC
In millions Banking Banking Finance Credit Advisors BlackRock PFPC
- ----------------------------------------------------------------------------------------------------------------------
2003 INCOME STATEMENT
Net interest income (expense) $308 $76 $24 $35 $23 $43 $(16)
Noninterest income 194 88 55 12 208 147 188
- ----------------------------------------------------------------------------------------------------------------------
Total revenue 502 164 79 47 231 190 172
Provision for credit losses 11 23 (8) 23 1
Depreciation and amortization 10 2 1 1 3 6 5
Other noninterest expense 272 83 57 14 127 89 139
- ----------------------------------------------------------------------------------------------------------------------
Earnings before minority and
other interests and income taxes 209 56 29 9 100 95 28
Minority and other interests in
income of consolidated entities (11) 69 31
Income taxes 71 19 6 3 11 24 12
- ----------------------------------------------------------------------------------------------------------------------
Earnings $138 $37 $34 $6 $20 $40 $16
======================================================================================================================
Inter-segment revenue $4 $1 $6 $4 $2
======================================================================================================================
AVERAGE ASSETS (a) $38,407 $13,558 $4,683 $3,926 $3,578 $3,484 $1,896
======================================================================================================================
2002 INCOME STATEMENT
Net interest income (expense) $336 $87 $26 $35 $24 $1 $(19)
Noninterest income 240 89 28 8 126 137 190
- ----------------------------------------------------------------------------------------------------------------------
Total revenue 576 176 54 43 150 138 171
Provision for credit losses 14 44 (2) 15 2
Depreciation and amortization 9 3 4 1 2 5 4
Other noninterest expense 259 86 41 13 114 77 136
- ----------------------------------------------------------------------------------------------------------------------
Earnings before minority and
other interests and income taxes 294 43 11 14 32 56 31
Minority and other interests in
income of consolidated entities (2)
Income taxes 102 13 (6) 6 12 23 12
- ----------------------------------------------------------------------------------------------------------------------
Earnings $192 $30 $19 $8 $20 $33 $19
======================================================================================================================
Inter-segment revenue $8 $1 $8 $4 $2
======================================================================================================================
AVERAGE ASSETS (a) $39,188 $13,337 $4,892 $3,814 $2,872 $790 $1,893
======================================================================================================================
Nine months ended September 30
In millions
2003 INCOME STATEMENT
Net interest income (expense) $956 $221 $80 $101 $65 $54 $(46)
Noninterest income 598 289 117 36 467 434 567
- ----------------------------------------------------------------------------------------------------------------------
Total revenue 1,554 510 197 137 532 488 521
Provision for credit losses 32 63 (1) 51 2
Depreciation and amortization 28 7 5 2 8 16 15
Other noninterest expense 814 271 135 42 365 257 434
- ----------------------------------------------------------------------------------------------------------------------
Earnings before minority and
other interests and income taxes 680 169 58 42 157 215 72
Minority and other interests in
income of consolidated entities (13) 69 31
Income taxes 231 57 (3) 16 32 70 29
- ----------------------------------------------------------------------------------------------------------------------
Earnings $449 $112 $74 $26 $56 $114 $43
======================================================================================================================
Inter-segment revenue $16 $4 $19 $13 $6
======================================================================================================================
AVERAGE ASSETS (a) $38,608 $12,194 $4,738 $3,778 $3,104 $3,484 $1,884
======================================================================================================================
2002 INCOME STATEMENT
Net interest income (expense) $1,074 $267 $86 $101 $76 $7 $(55)
Noninterest income 593 317 84 32 428 440 617
- ----------------------------------------------------------------------------------------------------------------------
Total revenue 1,667 584 170 133 504 447 562
Provision for credit losses 37 139 (7) 72 3
Depreciation and amortization 27 7 6 1 7 15 8
Other noninterest expense 770 265 113 40 361 265 459
- ----------------------------------------------------------------------------------------------------------------------
Earnings before minority and
other interests and income taxes 833 173 58 20 133 167 95
Minority and other interests in
income of consolidated entities (2)
Income taxes 288 56 (7) 8 49 68 38
- ----------------------------------------------------------------------------------------------------------------------
Earnings $545 $117 $67 $12 $84 $99 $57
======================================================================================================================
Inter-segment revenue $15 $5 $31 $12 $6
======================================================================================================================
AVERAGE ASSETS (a) $39,010 $14,275 $5,017 $3,870 $2,976 $790 $1,891
======================================================================================================================
Three months ended September 30 Intercompany
In millions Other Eliminations Consolidated
- --------------------------------------------------------------------------
2003 INCOME STATEMENT
Net interest income (expense) $19 $512
Noninterest income 38 $(24) 906
- --------------------------------------------------------------------------
Total revenue 57 (24) 1,418
Provision for credit losses 50
Depreciation and amortization 16 44
Other noninterest expense 28 (18) 791
- --------------------------------------------------------------------------
Earnings before minority and
other interests and income taxes 13 (6) 533
Minority and other interests in
income of consolidated entities 13 (2) 100
Income taxes 8 (2) 152
- --------------------------------------------------------------------------
Earnings $(8) $(2) $281
==========================================================================
Inter-segment revenue $7 $(24)
==========================================================================
AVERAGE ASSETS (a) $3,776 $(2,024) $71,284
==========================================================================
2002 INCOME STATEMENT
Net interest income (expense) $38 $528
Noninterest income (20) $(27) 771
- --------------------------------------------------------------------------
Total revenue 18 (27) 1,299
Provision for credit losses 73
Depreciation and amortization 17 45
Other noninterest expense 40 (21) 745
- --------------------------------------------------------------------------
Earnings before minority and
other interests and income taxes (39) (6) 436
Minority and other interests in
income of consolidated entities 6 4
Income taxes (13) (2) 147
- --------------------------------------------------------------------------
Earnings $(32) $(4) $285
==========================================================================
Inter-segment revenue $4 $(27)
==========================================================================
AVERAGE ASSETS (a) $1,021 $(1,949) $65,858
==========================================================================
Nine months ended September 30
In millions
2003 INCOME STATEMENT
Net interest income (expense) $105 $1,536
Noninterest income 40 $(71) 2,477
- --------------------------------------------------------------------------
Total revenue 145 (71) 4,013
Provision for credit losses (4) 143
Depreciation and amortization 55 136
Other noninterest expense 231 (59) 2,490
- --------------------------------------------------------------------------
Earnings before minority and
other interests and income taxes (137) (12) 1,244
Minority and other interests in
income of consolidated entities 39 (2) 124
Income taxes (34) (5) 393
- --------------------------------------------------------------------------
Earnings $(142) $(5) $727
==========================================================================
Inter-segment revenue $13 $(71)
==========================================================================
AVERAGE ASSETS (a) $1,777 $(1,946) $67,621
==========================================================================
2002 INCOME STATEMENT
Net interest income (expense) $117 $1,673
Noninterest income (1) $(79) 2,431
- --------------------------------------------------------------------------
Total revenue 116 (79) 4,104
Provision for credit losses 244
Depreciation and amortization 54 125
Other noninterest expense 106 (68) 2,311
- --------------------------------------------------------------------------
Earnings before minority and
other interests and income taxes (44) (11) 1,424
Minority and other interests in
income of consolidated entities 28 26
Income taxes (20) (4) 476
- --------------------------------------------------------------------------
Earnings $(52) $(7) $922
==========================================================================
Inter-segment revenue $10 $(79)
==========================================================================
AVERAGE ASSETS (a) $1,017 $(2,005) $66,841
==========================================================================
(a) Period-end balances for BlackRock.
64
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 represents the net of
investment income and interest expense as presented 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 16 COMMITMENTS AND GUARANTEES
EQUITY FUNDING COMMITMENTS
The Corporation has commitments to make additional equity investments in certain
equity management entities of $194 million and affordable housing limited
partnerships of $21 million at September 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 September 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 $5.2 billion at
September 30, 2003. Assets valued, as of September 30, 2003, at approximately
$1.8 billion secured certain specifically identified standby letters of credit
and letter of credit risk participations having aggregate potential future
payments of approximately $1.8 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.
STANDBY BOND PURCHASE AGREEMENTS AND OTHER LIQUIDITY FACILITIES
PNC enters into Standby Bond Purchase Agreements to support municipal bond
obligations and enters into certain other liquidity facilities to support
individual pools of receivables acquired by unrelated commercial paper conduits.
At September 30, 2003, PNC's total commitments under these facilities were $343
million and $282 million, respectively.
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; and 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.
65
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 $5.1 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. The Corporation and
its subsidiaries 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 nine months 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 PFPC 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 September
30, 2003, the aggregate maximum potential exposure as a result of these
indemnity obligations was $9.1 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.
66
STATISTICAL INFORMATION
THE PNC FINANCIAL SERVICES GROUP, INC.
CONSOLIDATED AVERAGE BALANCE SHEET AND NET INTEREST ANALYSIS
Nine months ended September 30
- ------------------------------------------------------------------------------------------------------------------------------------
2003 2002
- -----------------------------------------------------------------------------------------------------------------------------------
Taxable-equivalent basis Average Interest Average Average Interest Average
Dollars in millions Balances Income/Expense Yields/Rates Balances Income/Expense Yields/Rates
- -----------------------------------------------------------------------------------------------------------------------------------
ASSETS
Interest-earning assets
Loans held for sale $1,671 $35 2.77% $3,204 $117 4.83%
Securities
Securities available for sale
U.S. Treasury and government agencies/corporations 3,828 115 3.99 3,144 123 5.22
Other debt 9,955 309 4.14 7,670 317 5.52
State and municipal 61 4 8.78 61 4 9.16
Corporate stocks and other 486 9 2.66 480 11 3.03
- ---------------------------------------------------------------------------------- ------------------------
Total securities available for sale 14,330 437 4.07 11,355 455 5.35
Securities held to maturity 24 2 7.88 356 13 4.78
- ---------------------------------------------------------------------------------- ------------------------
Total securities 14,354 439 4.07 11,711 468 5.33
Loans, net of unearned income
Commercial 14,908 640 5.66 16,089 719 5.90
Commercial real estate 2,155 76 4.66 2,474 99 5.26
Consumer 10,387 454 5.84 9,481 474 6.68
Residential mortgage 3,220 141 5.86 5,005 254 6.78
Lease financing 3,769 164 5.82 4,231 203 6.41
Other 361 10 3.57 405 13 4.19
- ---------------------------------------------------------------------------------- ------------------------
Total loans, net of unearned income 34,800 1,485 5.66 37,685 1,762 6.21
Federal funds sold 652 6 1.24 1,282 17 1.75
Purchased customer receivables 841 11 1.75
Investments held by certain
variable interest entities 718 48 8.91
Other 2,204 85 5.14 1,942 77 5.29
- ---------------------------------------------------------------------------------- ------------------------
Total interest-earning assets/interest income 55,240 2,109 5.07 55,824 2,441 5.81
Noninterest-earning assets
Allowance for credit losses (676) (619)
Cash and due from banks 2,819 2,733
Other assets 10,238 8,903
- ------------------------------------------------------------------- ----------
Total assets $67,621 $66,841
=================================================================== ==========
LIABILITIES, MINORITY AND NONCONTROLLING INTERESTS,
CAPITAL SECURITIES AND SHAREHOLDERS' EQUITY
Interest-bearing liabilities
Interest-bearing deposits
Demand and money market $22,231 122 .73 $21,446 185 1.16
Savings 2,108 5 .33 2,037 8 .49
Retail certificates of deposit 8,992 211 3.13 10,490 289 3.69
Other time 266 15 7.30 654 22 4.50
Deposits in foreign offices 221 2 1.04 417 6 1.72
- ---------------------------------------------------------------------------------- ------------------------
Total interest-bearing deposits 33,818 355 1.40 35,044 510 1.94
Borrowed funds
Federal funds purchased 683 6 1.13 721 9 1.61
Repurchase agreements 1,071 9 1.09 962 10 1.45
Bank notes and senior debt 3,570 58 2.14 5,421 111 2.69
Federal Home Loan Bank borrowings 1,159 (13) (1.49) 1,617 4 .33
Subordinated debt 2,041 62 4.03 2,210 76 4.60
Mandatorily redeemable capital securities of
subsidiary trusts 286 14 6.60
Commercial paper 843 7 1.11
Liabilities of certain variable
interest entities 624 24 5.08
Other borrowed funds 215 44 27.04 343 38 14.73
- ---------------------------------------------------------------------------------- ------------------------
Total borrowed funds 10,492 211 2.66 11,274 248 2.92
- ---------------------------------------------------------------------------------- ------------------------
Total interest-bearing liabilities/interest
expense 44,310 566 1.70 46,318 758 2.18
Noninterest-bearing liabilities, minority interest,
capital securities and shareholders' equity
Demand and other noninterest-bearing deposits 10,492 9,079
Allowance for unfunded commitments and letters of
credit 79 80
Accrued expenses and other liabilities 4,948 4,157
Minority and noncontrolling interests in
consolidated entities 539 196
Mandatorily redeemable capital securities of
subsidiary trusts 562 848
Shareholders' equity 6,691 6,163
- ------------------------------------------------------------------- ----------
Total liabilities, minority and noncontrolling
interests, capital securities and shareholders'
equity $67,621 $66,841
- -----------------------------------------------------------------------------------------------------------------------------------
Interest rate spread 3.37 3.63
Impact of noninterest-bearing sources .34 .37
- -----------------------------------------------------------------------------------------------------------------------------------
Net interest income/margin $1,543 3.71% $1,683 4.00%
===================================================================================================================================
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).
67
- -----------------------------------------------------------------------------------------------------------------------------------
Third Quarter 2003 Second Quarter 2003 Third 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
- -----------------------------------------------------------------------------------------------------------------------------------
$1,480 $8 2.11% $1,754 $15 3.45% $2,125 $24 4.43%
4,562 42 3.62 3,825 37 3.95 2,962 37 5.07
10,187 94 3.70 10,325 112 4.34 7,205 95 5.27
67 2 8.47 57 1 8.90 60 1 9.05
466 2 2.50 465 4 2.86 541 4 2.53
- ---------------------------- ----------------------------- ---------------------------
15,282 140 3.66 14,672 154 4.21 10,768 137 5.10
5 6.66 1 340 4 5.02
- ---------------------------- ----------------------------- ---------------------------
15,287 140 3.66 14,672 155 4.21 11,108 141 5.10
14,712 208 5.53 14,965 215 5.69 15,698 236 5.89
2,034 24 4.67 2,169 25 4.62 2,501 33 5.16
10,832 153 5.61 10,346 152 5.87 9,649 160 6.56
2,807 39 5.57 3,244 47 5.83 4,296 71 6.63
3,633 52 5.69 3,767 54 5.73 4,124 65 6.31
360 3 3.29 360 4 3.64 419 5 4.16
- ---------------------------- ----------------------------- ---------------------------
34,378 479 5.50 34,851 497 5.67 36,687 570 6.13
46 .98 116 1.22 2,212 10 1.75
2,495 11 1.77
2,130 48 9.00
2,601 34 5.11 1,863 27 5.82 2,110 28 5.27
- ---------------------------- ----------------------------- ---------------------------
58,417 720 4.88 53,256 694 5.19 54,242 773 5.64
(674) (671) (665)
3,079 2,679 2,619
10,462 10,301 9,662
- ------------- -------------- -----------
$71,284 $65,565 $65,858
============= ============== ===========
$22,475 35 .63 $22,141 41 .74 $21,376 62 1.15
2,133 1 .24 2,131 2 .37 2,050 2 .50
8,460 64 2.98 8,892 69 3.11 10,347 92 3.52
264 5 7.19 269 5 7.27 269 5 7.23
238 1 .92 220 1.11 215 1 1.52
- ---------------------------- ----------------------------- ---------------------------
33,570 106 1.25 33,653 117 1.40 34,257 162 1.88
1,306 3 1.03 692 3 1.28 42 2.97
1,204 3 .96 1,116 4 1.17 990 4 1.51
2,904 16 2.15 3,555 19 2.14 5,154 35 2.63
1,129 (5) (1.88) 1,138 (5) (1.49) 1,272 (.15)
1,949 19 3.82 2,025 20 4.01 2,210 25 4.61
848 14 6.67
2,501 7 1.11
1,851 24 5.08
323 19 22.96 175 13 29.55 158 15 37.25
- ---------------------------- ----------------------------- ---------------------------
14,015 100 2.81 8,701 54 2.46 9,826 79 3.16
- ---------------------------- ----------------------------- ---------------------------
47,585 206 1.71 42,354 171 1.61 44,083 241 2.16
11,040 10,278 9,405
77 77 73
4,934 4,980 4,754
1,104 252 218
848 848
6,544 6,776 6,477
- ------------- -------------- -----------
$71,284 $65,565 $65,858
- -----------------------------------------------------------------------------------------------------------------------------------
3.17 3.58 3.48
.32 .33 .40
- -----------------------------------------------------------------------------------------------------------------------------------
$514 3.49% $523 3.91% $532 3.88%
===================================================================================================================================
Loan fees for the nine months ended September 30, 2003 and September 30, 2002
were $82 million and $80 million, respectively. Loan fees for the three months
ended September 30, 2003, June 30, 2003 and September 30, 2002 were $29 million,
$26 million and $22 million, respectively.
68
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 litigation
referred to below. 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 pending securities litigation
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, alleged 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 sought, among other things, unquantified
damages, declaratory and injunctive relief, and attorneys' fees and costs. In
November 2003, the court
69
dismissed the complaint without prejudice upon the joint stipulation of the
parties.
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 September 2003, the
Corporation moved to stay the action until resolution of the claims against the
Corporation in the pending securities litigation described above.
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.
In connection with industry-wide investigations of practices regarding market
timing, late day trading and employee trading in mutual funds, several of PNC's
subsidiaries have received requests for information from state and federal
regulatory authorities. These subsidiaries are fully cooperating in all of
these matters.
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
99.1 Termination of Agreement between The PNC Financial
Services Group, Inc. and the Federal Reserve Bank
of Cleveland
99.2 Termination of Agreement between PNC Bank, National
Association and the Office of the Comptroller of
the Currency
99.3 Agreement and Plan of Merger, dated as of August 21,
2003, by and among the Corporation, United National
Bancorp and PNC Bancorp, Inc.*
- --------------------------------------------------------------------------------
*Incorporated by reference to Exhibit 99.1 of the Corporation's Current Report
on Form 8-K dated September 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 June
30, 2003, the Corporation filed two Current Reports on Form 8-K ("Form 8-K") on
July 21, 2003. In addition, the Corporation filed the following Reports on Form
8-K during and subsequent to the third quarter of 2003 through the date of this
Quarterly Report on Form 10-Q on the dates indicated:
August 21, 2003
- ---------------
Item 9, Regulation FD Disclosure, regarding the Corporation's planned
acquisition of United National Bancorp. Copies of a news release issued jointly
by the Corporation and United National Bancorp and certain other information
regarding the acquisition were filed as Exhibits to this Form 8-K.
September 2, 2003
- -----------------
Item 5, Other Events, regarding the Agreement and Plan of Merger ("Merger
Agreement") entered into by the Corporation, United National Bancorp and a
wholly-owned subsidiary of the Corporation on August 21, 2003. The Merger
Agreement was filed as an Exhibit to this Form 8-K.
70
September 8, 2003
- -----------------
Item 12, Disclosure of Results of Operations and Financial Condition, regarding
a presentation to investors by certain executives of the Corporation in
connection with the Lehman Brothers 2003 Financial Services Conference in New
York, New York. A copy of the electronic slides and related material used with
this presentation was furnished as an Exhibit to this Form 8-K.
September 15, 2003
- ------------------
Item 5, Other Events, regarding the Corporation's news release announcing that
the Federal Reserve Bank of Cleveland had lifted its formal written agreement
with the Corporation. A copy of this news release was filed as an Exhibit to
this Form 8-K.
September 29, 2003
- ------------------
Item 5, Other Events, regarding the Corporation's news release announcing that
the Office of the Comptroller of the Currency had lifted its formal written
agreement with PNC Bank, National Association, the Corporation's principal bank
subsidiary. A copy of this news release was filed as an Exhibit to this Form
8-K.
October 1, 2003
- ---------------
Item 5, Other Events, regarding the Corporation's summary of reconciliations of
non-GAAP financial measures included in the Corporation's 2002 Annual Report to
Shareholders that was incorporated by reference into the Corporation's Annual
Report on Form 10-K for the year ended December 31, 2002, as amended. The
summary of reconciliations of non-GAAP financial measures was filed as an
Exhibit to this Form 8-K.
October 16, 2003
- ----------------
Item 5, Other Events, and Item 12, Disclosure of Results of Operations and
Financial Condition, regarding the Corporation's release of third quarter 2003
earnings. A copy of the Corporation's earnings press release was included as an
Exhibit to this Form 8-K.
October 16, 2003
- ----------------
Item 5, Other Events, regarding supplementary financial information provided on
the Corporation's website in connection with its October 16, 2003 release of
third quarter 2003 earnings and related investor conference call. A copy of this
supplementary financial information was filed as an Exhibit to this Form 8-K.
November 3, 2003
- ----------------
Item 5, Other Events, regarding information in connection with the public
offering by PNC Funding Corp, a wholly owned subsidiary of the Corporation, of
$600 million aggregate principal amount of 5.25% Subordinated Notes due 2015.
The Underwriting Agreement, Form of Subordinated Notes and Form of Guarantees
related to the Subordinated Notes were filed as Exhibits to this Form 8-K.
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on November 14, 2003, on its
behalf by the undersigned thereunto duly authorized.
THE PNC FINANCIAL SERVICES GROUP, INC.
/s/ William S. Demchak
- ----------------------
William S. Demchak
Vice Chairman and Chief Financial Officer
(Principal Financial Officer)
71
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:
Donna C. Peterman, Senior Vice President, Director of 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
Third 50.170 46.410 47.580 .48
- --------------------------------------------------------------------------------
Total $1.44
================================================================================
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 stock 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
72