UNITED STATES
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 JUNE 30, 2003
Commission File Number 0-26481
FINANCIAL INSTITUTIONS, INC.
(Exact Name of Registrant as specified in its charter)
NEW YORK 16-0816610
(State or other jurisdiction of (I.R.S. Employer Identification Number)
incorporation or organization)
220 Liberty Street Warsaw, NY 14569
(Address of Principal Executive Offices) (Zip Code)
Registrant's Telephone Number Including Area Code:
(585) 786-1100
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 twelve months (or for such shorter period that the Registrant was
required to file reports) and (2) has been subject to such 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 |_|
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
CLASS OUTSTANDING AT JULY 31, 2003
----- ----------------------------
Common Stock, $0.01 par value 11,162,135 shares
1
FINANCIAL INSTITUTIONS, INC.
FORM 10-Q
INDEX
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Consolidated Statements of Financial Condition as of
June 30, 2003 and December 31, 2002 3
Consolidated Statements of Income for the three months and
six months ended June 30, 2003 and 2002 4
Consolidated Statements of Cash Flows for the six months ended
June 30, 2003 and 2002 5
Consolidated Statement of Changes in Shareholders' Equity and
Comprehensive Income for the six months ended
June 30, 2003 6
Notes to Unaudited Consolidated Financial Statements 7
Item 2. Management Discussion and Analysis of Financial Condition and
Results of Operations 12
Item 3. Quantitative and Qualitative Disclosures about Market Risk 25
Item 4. Controls and Procedures 25
PART II - OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders 26
Item 6. Exhibits and Reports on Form 8-K 26
SIGNATURES
EXHIBITS
2
Item 1. Financial Statements (Unaudited)
FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Unaudited)
June 30, December 31,
(Dollars in thousands, except per share amounts) 2003 2002
----------- ------------
Assets
Cash, due from banks and interest-bearing deposits $ 64,491 $ 48,429
Federal funds sold 77,333 --
Securities available for sale, at fair value 549,392 596,862
Securities held to maturity (fair value of $46,670 and $48,089
at June 30, 2003 and December 31, 2002, respectively) 45,191 47,125
Loans, net 1,344,135 1,300,232
Premises and equipment, net 32,674 27,254
Goodwill 40,621 40,593
Other assets 40,486 44,539
----------- -----------
Total assets $ 2,194,323 $ 2,105,034
=========== ===========
Liabilities And Shareholders' Equity
Liabilities:
Deposits:
Demand $ 251,994 $ 240,755
Savings, money market and interest-bearing checking 799,572 779,772
Certificates of deposit 774,667 687,996
----------- -----------
Total deposits 1,826,233 1,708,523
Short-term borrowings 68,985 87,189
Long-term borrowings 73,216 92,090
Guaranteed preferred beneficial interests in corporation's
junior subordinated debentures 16,200 16,200
Accrued expenses and other liabilities 23,429 22,738
----------- -----------
Total liabilities 2,008,063 1,926,740
Shareholders' equity:
3% cumulative preferred stock, $100 par value,
authorized 10,000 shares, issued and outstanding -
1,666 shares at June 30, 2003 and December 31, 2002 167 167
8.48% cumulative preferred stock, $100 par value,
authorized 200,000 shares, issued and outstanding - 175,683
shares at June 30, 2003 and 175,755 shares at December 31, 2002 17,568 17,575
Common stock, $ 0.01 par value, authorized 50,000,000 shares,
issued 11,303,533 shares at June 30, 2003 and December 31, 2002 113 113
Additional paid-in capital 20,871 19,728
Retained earnings 134,957 131,320
Accumulated other comprehensive income 13,604 10,368
Treasury stock, at cost - 147,516 shares at June 30, 2003
and 199,719 shares at December 31, 2002 (1,020) (977)
----------- -----------
Total shareholders' equity 186,260 178,294
----------- -----------
Total liabilities and shareholders' equity $ 2,194,323 $ 2,105,034
=========== ===========
See Accompanying Notes to Unaudited Consolidated Financial Statements.
3
FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
Three Months Ended Six Months Ended
June 30, June 30,
-------------------- ---------------------
(Dollars in thousands, except per share amounts) 2003 2002 2003 2002
------- ------- ------- --------
Interest income:
Loans $22,176 $22,490 $43,928 $ 44,535
Securities 6,465 7,250 13,137 13,646
Other 123 187 226 306
------- ------- ------- --------
Total interest income 28,764 29,927 57,291 58,487
------- ------- ------- --------
Interest expense:
Deposits 7,883 9,039 15,799 17,697
Borrowings 1,269 1,483 2,620 2,889
Guaranteed preferred beneficial interests in
Company's junior subordinated debentures 419 419 838 838
------- ------- ------- --------
Total interest expense 9,571 10,941 19,257 21,424
------- ------- ------- --------
Net interest income 19,193 18,986 38,034 37,063
Provision for loan losses 5,311 1,181 8,609 2,188
------- ------- ------- --------
Net interest income after
provision for loan losses 13,882 17,805 29,425 34,875
------- ------- ------- --------
Noninterest income:
Service charges on deposits 2,771 2,607 5,426 4,934
Financial services group fees and commissions 1,328 1,325 2,702 2,630
Mortgage banking revenues 951 274 1,736 1,217
Gain (loss) on securities transactions 151 96 442 (100)
Other 959 855 1,956 1,413
------- ------- ------- --------
Total noninterest income 6,160 5,157 12,262 10,094
------- ------- ------- --------
Noninterest expense:
Salaries and employee benefits 8,036 7,507 16,917 14,428
Occupancy and equipment 2,084 1,711 4,072 3,541
Supplies and postage 598 587 1,260 1,135
Amortization of intangible assets 309 216 617 430
Computer and data processing expense 426 403 877 780
Professional fees 480 352 1,060 698
Other 3,014 2,317 5,720 4,181
------- ------- ------- --------
Total noninterest expense 14,947 13,093 30,523 25,193
------- ------- ------- --------
Income before income taxes 5,095 9,869 11,164 19,776
Income taxes 1,445 3,225 3,218 6,475
------- ------- ------- --------
Net income $ 3,650 $ 6,644 $ 7,946 $ 13,301
======= ======= ======= ========
Earnings per common share (note 4):
Basic $ 0.29 $ 0.57 $ 0.65 $ 1.14
Diluted $ 0.29 $ 0.56 $ 0.64 $ 1.12
See Accompanying Notes to Unaudited Consolidated Financial Statements.
4
FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Six Months Ended
June 30,
-------------------------
(Dollars in thousands) 2003 2002
--------- ---------
Cash flows from operating activities:
Net income $ 7,946 $ 13,301
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 3,971 2,572
Provision for loan losses 8,609 2,188
Deferred income tax benefit (2,083) (592)
Proceeds from sale of loans held for sale 98,389 62,499
Originations of loans held for sale (101,393) (62,241)
(Gain) loss on sale of available for sale securities (442) 100
Gain on sale of loans held for sale (1,392) (786)
Loss on sale of other assets 12 134
Minority interest in net income of subsidiaries 17 47
Decrease in other assets 3,424 1,884
Increase (decrease) in accrued expenses and other liabilities 665 (1,441)
--------- ---------
Net cash provided by operating activities 17,723 17,665
Cash flows from investing activities:
Purchase of securities:
Available for sale (162,728) (357,583)
Held to maturity (10,021) (10,953)
Proceeds from maturity and call of securities:
Available for sale 160,807 200,993
Held to maturity 11,917 18,372
Proceeds from sale of available for sale securities 53,443 39,633
Loan originations less principal payments (48,116) (66,269)
Proceeds from sales of premises and equipment 36 5
Purchase of premises and equipment, net (7,090) (2,594)
Cash acquired in purchase of Bank of Avoca, net of cash paid -- 4,778
Equity investment in Mercantile Adjustment Bureau, LLC -- (2,500)
--------- ---------
Net cash used in investing activities (1,752) (176,118)
Cash flows from financing activities:
Net increase in deposits 117,711 157,360
Net decrease in short-term borrowings (18,204) (20,329)
Proceeds from long-term borrowings 5,000 17,056
Repayment of long-term borrowings (23,874) (191)
Purchase of preferred and common shares (425) (384)
Issuance of preferred and common shares 1,518 444
Dividends paid (4,302) (3,614)
--------- ---------
Net cash provided by financing activities 77,424 150,342
--------- ---------
Net increase (decrease) in cash and cash equivalents 93,395 (8,111)
Cash and cash equivalents at the beginning of the period 48,429 53,171
--------- ---------
Cash and cash equivalents at the end of the period $ 141,824 $ 45,060
========= =========
Supplemental disclosure of cash flow information: Cash paid during period for:
Interest $ 18,529 $ 23,122
Income taxes 4,385 7,037
Noncash investing and financing activities:
Fair value of noncash assets acquired in acquisitions $ -- $ 14,043
Fair value of liabilities assumed in acquisitions -- 17,322
Issuance of common stock in Bank of Avoca acquisition -- 1,499
Issuance of common stock for Burke Group, Inc. earnout -- 500
See Accompanying Notes to Unaudited Consolidated Financial Statements.
5
FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN
SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME
(Unaudited)
3% 8.48% Additional
(Dollars in thousands, Preferred Preferred Common Paid-in
except per share amounts) Stock Stock Stock Capital
----- ----- ----- -------
Balance - December 31, 2002 $ 167 $ 17,575 $ 113 $ 19,728
Purchase 72 shares of preferred stock -- (7) -- (1)
Purchase 22,000 shares of common stock -- -- -- --
Issue 2,440 shares of common stock-
directors plan -- -- -- 34
Issue 9,376 shares of common stock -
exercised stock options -- -- -- 75
Issue 62,387 shares of common stock -
Burke Group, Inc. contingent earnout -- -- -- 1,035
Comprehensive income:
Net income -- -- -- --
Unrealized gain on securities available
for sale (net of tax of $2,323) -- -- -- --
Reclassification adjustment for gains
included in net income (net of tax of $(176)) -- -- -- --
Net unrealized gain on securities available
for sale (net of tax of $2,146) -- -- -- --
Total comprehensive income -- -- -- --
Cash dividends declared:
3% Preferred - $1.50 per share -- -- -- --
8.48% Preferred - $4.24 per share -- -- -- --
Common - $0.32 per share -- -- -- --
--------- --------- --------- ---------
Balance - June 30, 2003 $ 167 $ 17,568 $ 113 $ 20,871
========= ========= ========= =========
Accumulated
Other
Comprehensive Total
(Dollars in thousands, Retained Income Treasury Shareholders'
except per share amounts) Earnings (Loss) Stock Equity
-------- ------ ----- ------
Balance - December 31, 2002 $ 131,320 $ 10,368 $ (977) $ 178,294
Purchase 72 shares of preferred stock -- -- -- (8)
Purchase 22,000 shares of common stock -- -- (417) (417)
Issue 2,440 shares of common stock-
directors plan -- -- 16 50
Issue 9,376 shares of common stock -
exercised stock options -- -- 53 128
Issue 62,387 shares of common stock -
Burke Group, Inc. contingent earnout -- -- 305 1,340
Comprehensive income:
Net income 7,946 -- -- 7,946
Unrealized gain on securities available
for sale (net of tax of $2,323) -- 3,502 -- 3,502
Reclassification adjustment for gains
included in net income (net of tax of $(176)) -- (266) -- (266)
---------
Net unrealized gain on securities available
for sale (net of tax of $2,146) -- -- -- 3,236
---------
Total comprehensive income -- -- -- 11,182
---------
Cash dividends declared:
3% Preferred - $1.50 per share (3) -- -- (3)
8.48% Preferred - $4.24 per share (745) -- -- (745)
Common - $0.32 per share (3,561) -- -- (3,561)
--------- --------- --------- ---------
Balance - June 30, 2003 $ 134,957 $ 13,604 $ (1,020) $ 186,260
========= ========= ========= =========
See Accompanying Notes to Unaudited Consolidated Financial Statements.
6
FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(1) Basis of Presentation
Financial Institutions, Inc. ("FII"), a financial holding company organized
under the laws of New York State, and subsidiaries (the "Company") provide
deposit, lending and other financial services to individuals and businesses in
Central and Western New York State. FII and subsidiaries are each subject to
regulation by certain federal and state agencies.
The consolidated financial statements include the accounts of FII and its four
banking subsidiaries, Wyoming County Bank (99.65% owned) ("WCB"), The National
Bank of Geneva (100% owned) ("NBG"), First Tier Bank & Trust (100% owned)
("FTB") and Bath National Bank (100% owned) ("BNB"), collectively referred to as
the "Banks". During 2002, the Company completed a geographic realignment of the
subsidiary banks, which involved the merger of the subsidiary formerly known as
The Pavilion State Bank ("PSB") into NBG and transfer of other branch offices
between subsidiary banks. The merger and transfers were accounted for at
historical cost as a combination of entities under common control. Also included
are the accounts of the Burke Group, Inc. (100% owned) ("BGI") and The FI Group,
Inc. (100% owned) ("FIGI"), collectively referred to as the "Financial Services
Group". BGI is an employee benefits and compensation consulting firm acquired in
October 2001. FIGI is a brokerage subsidiary that commenced operations in March
2000.
In February 2001, the Company formed FISI Statutory Trust I ("FISI") (100%
owned), to accommodate the private placement of $16.2 million in capital
securities, the proceeds of which were utilized to partially fund the
acquisition of BNB. The capital securities are identified on the consolidated
statements of financial condition as guaranteed preferred beneficial interests
in corporation's junior subordinated debentures.
The consolidated financial information included herein combines the results of
operations, the assets, liabilities and shareholders' equity of the Company and
its subsidiaries. All significant inter-company transactions and balances have
been eliminated in consolidation.
The consolidated financial statements have been prepared in accordance with
accounting principles generally accepted in the United States of America and
prevailing practices in the banking industry. In preparing the financial
statements, management is required to make estimates and assumptions that affect
the reported amounts of assets and liabilities and disclosure of contingent
assets and liabilities, and the reported revenues and expenses for the period.
All adjustments (consisting of normal recurring accruals) considered necessary
for a fair presentation of financial statements have been included. Actual
results could differ from those estimates. Amounts in the prior year's
consolidated financial statements are reclassified when necessary to conform to
the current year's presentation.
New Accounting Pronouncements
Financial Accounting Standards Board (FASB) Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others," was issued in November 2002. FASB
Interpretation No. 45 elaborates on the disclosures to be made by a guarantor in
its interim and annual financial statements about its obligations under certain
guarantees that it has issued. It also clarifies that a guarantor is required to
recognize, at the inception of a guarantee, a liability for the fair value of
the obligation undertaken in issuing the guarantee. The initial recognition and
initial measurement provisions of FASB Interpretation No. 45 are applicable on a
prospective basis to guarantees issued or modified after December 31, 2002. The
disclosure requirements are effective for financial statements of interim or
annual periods ending after December 15, 2002. The Company adopted the
recognition and measurement provisions of FASB Interpretation No. 45 effective
January 1, 2003. Such adoption did not have a material impact on the Company's
consolidated financial statements.
7
FASB Interpretation No. 46, "Consolidation of Variable Interest Entities," was
issued in January 2003. FASB Interpretation No. 46 clarifies the application of
Accounting Research Bulletin No. 51, "Consolidated Financial Statements," to
certain entities in which equity investors do not have the characteristics of a
controlling financial interest or do not have sufficient equity at risk for the
entity to finance its activities without additional subordinated financial
support from other parties. FASB Interpretation No. 46 requires an enterprise to
consolidate a variable interest entity if that enterprise has a variable
interest (or combination of variable interests) that will absorb a majority of
the entity's expected losses if they occur, receive a majority of the entity's
expected returns if they occur, or both. It also requires that both the primary
beneficiary and all other enterprises with a significant variable interest in a
variable interest entity make certain disclosures. FASB Interpretation No. 46
applies immediately to variable interest entities created after January 31,
2003, and to variable interest entities in which an enterprise obtains an
interest after that date. It applies in the first fiscal year or interim period
beginning after June 15, 2003, to variable interest entities in which an
enterprise holds a variable interest that it acquired before February 1, 2003.
The adoption of the provisions of FASB Interpretation No. 46 is not expected to
have a material impact on the Company's consolidated financial statements.
Statement of Financial Accounting Standard (SFAS) No. 149, "Amendment of
Statement 133 on Derivative Instruments and Hedging Activities," was issued by
FASB in April 2003. SFAS No. 149 amends and clarifies financial accounting and
reporting for derivative instruments, including certain derivative instruments
embedded in other contracts, and for hedging activities under SFAS No. 133. SFAS
No. 149 is generally effective for contracts entered into or modified after June
30, 2003 and is effective for hedging relationships designated after June 30,
2003. Provisions of SFAS No. 149 that relate to SFAS No. 133 implementation
issues that have been effective for fiscal quarters that began prior to June 15,
2003 should continue to be applied in accordance with their respective dates.
All provisions of SFAS No. 149 should be applied prospectively, except for
paragraphs 7(a) and 23(a), which relate to forward purchases or sales of
"when-issued" securities or other securities that do not yet exist, which should
be applied to both existing contracts and new contracts entered into after June
30, 2003. The adoption of the provisions of SFAS No. 149 is not expected to have
a material impact on the Company's consolidated financial statements.
SFAS No. 150, "Accounting for Certain Financial Instruments With Characteristics
of Both Liabilities and Equity," was issued by FASB in May 2003. SFAS No. 150
changes the classification in the statement of financial position of certain
common financial instruments from either equity or mezzanine presentation to
liabilities and requires an issuer of those financial statements to recognize
changes in fair value or redemption amount, as applicable, in earnings. SFAS No.
150 is effective for financial instruments entered into or modified after May
31, 2003, and with one exception, is effective at the beginning of the first
interim period beginning after June 15, 2003. The adoption of the provisions of
SFAS No. 150 is not expected to have a material impact on the Company's
consolidated financial statements.
8
(2) Stock Compensation Plans
The Company uses a fixed award stock option plan to compensate certain key
members of management of the Company and its subsidiaries. The Company accounts
for issuance of stock options under the intrinsic value-based method of
accounting prescribed by Accounting Principles Board (APB) Opinion No. 25,
"Accounting for Stock Issued to Employees." Under APB No. 25, compensation
expense is recorded on the date the options are granted only if the current
market price of the underlying stock exceeded the exercise price. SFAS No. 123,
"Accounting for Stock-Based Compensation," established accounting and disclosure
requirements using a fair value-based method of accounting for stock-based
employee compensation plans. As allowed under SFAS No. 123, the Company has
elected to continue to apply the intrinsic value-based method of accounting
described above and has adopted only the disclosure requirements of SFAS No.
123, as amended by SFAS No. 148, "Accounting for Stock - Based Compensation -
Transition and Disclosure."
Had the Company determined compensation cost based on the fair value method
under SFAS No. 123, the Company's net income and earnings per share would have
been as follows:
Three Months Ended Six Months Ended
June 30, June 30,
-------------------------- --------------------------
(Dollars in thousands, except per share amounts) 2003 2002 2003 2002
---------- ---------- ---------- ----------
Reported net income $ 3,650 $ 6,644 $ 7,946 $ 13,301
Less: Total stock-based compensation expense
determined under fair value based method for
all awards, net of related tax effects 108 120 112 188
---------- ---------- ---------- ----------
Pro forma net income $ 3,542 $ 6,524 $ 7,834 $ 13,113
========== ========== ========== ==========
Basic earnings per share:
Reported $ 0.29 $ 0.57 $ 0.65 $ 1.14
Pro forma 0.28 0.56 0.64 1.12
Diluted earnings per share:
Reported $ 0.29 $ 0.56 $ 0.64 $ 1.12
Pro forma 0.28 0.55 0.63 1.10
The weighted-average fair value of options granted during the quarters ended
June 30, 2003 and 2002 amounted to $9.10 and $15.05, respectively. The fair
value of each option grant was estimated on the date of grant using the
Black-Scholes option-pricing model and the following weighted-average
assumptions:
June 30,
-------------------
2003 2002
----- -----
Dividend yield 3.12% 1.45%
Expected life (in years) 10.00 10.00
Expected volatility 51.89% 30.81%
Risk-free interest rate 3.92% 5.11%
9
(3) Mergers and Acquisitions
On December 13, 2002, BNB acquired the two Chemung County branch offices of BSB
Bank & Trust Company of Binghamton, New York. The two offices purchased are
located in Elmira and Elmira Heights, and had deposit liabilities totaling $44.2
million at the time of acquisition. The acquisition was accounted for as a
business combination using the purchase method of accounting, and accordingly,
the excess of the purchase price over the fair value of identifiable tangible
and intangible assets acquired, less liabilities assumed, of approximately $1.5
million has been recorded as goodwill. In accordance with SFAS No. 142, the
Company is not required to amortize goodwill recognized in this acquisition. The
Company also recorded a $2.0 million intangible asset attributable to core
deposits, which is being amortized using the straight-line method over seven
years.
On May 1, 2002, FII acquired all of the common stock of the Bank of Avoca
("BOA") in exchange for 47,036 shares of FII common stock. BOA was a community
bank with its main office located in Avoca, New York, as well as a branch office
in Cohocton, New York. Subsequent to the acquisition, BOA was merged with BNB.
The acquisition was accounted for as a business combination using the purchase
method of accounting, and accordingly, the excess of the purchase price ($1.5
million) over the fair value of identifiable tangible and intangible assets
acquired ($18.4 million), less liabilities assumed ($17.3 million), of
approximately $0.4 million has been recorded as goodwill. In accordance with
SFAS No. 142, the Company is not required to amortize goodwill recognized in
this acquisition. The Company recorded a $146,000 core deposit intangible asset,
which is being amortized using the straight-line method over seven years. The
2002 results of operations for BOA are included in the income statements from
the date of acquisition (May 1, 2002).
(4) Earnings Per Common Share
Basic earnings per share, after giving effect to preferred stock dividends, has
been computed using weighted average common shares outstanding. Diluted earnings
per share reflect the effects, if any, of incremental common shares issuable
upon exercise of dilutive stock options.
Earnings per common share have been computed based on the following:
Three Months Ended Six Months Ended
June 30, June 30,
-------------------- --------------------
(Dollars and shares in thousands) 2003 2002 2003 2002
------- ------- ------- -------
Net income $ 3,650 $ 6,644 $ 7,946 $13,301
Less: Preferred stock dividends 374 374 748 748
------- ------- ------- -------
Net income available to common shareholders $ 3,276 $ 6,270 $ 7,198 $12,553
======= ======= ======= =======
Average number of common shares outstanding
used to calculate basic earnings per common share 11,159 11,067 11,133 11,041
Add: Effect of dilutive options 97 156 101 179
------- ------- ------- -------
Average number of common shares
used to calculate diluted earnings per common share 11,256 11,223 11,234 11,220
======= ======= ======= =======
10
(5) Segment Information
Reportable segments are comprised of WCB, NBG, BNB, FTB and the Financial
Services Group. As stated in Note 1, during 2002 the Company completed a
geographic realignment of the subsidiary banks, which involved the merger of the
subsidiary formerly known as PSB into NBG and subsequent transfer of branches
between NBG and WCB. Accordingly, the Company restated segment results to
reflect the merger and transfers for the 2002 periods presented. All of the
revenue, expenses, assets and liabilities of PSB have been reallocated to the
WCB and NBG segments. The reportable segment information is as follows:
June 30, December 31,
(Dollars in thousands) 2003 2002
----------- ------------
Assets
WCB $ 707,802 $ 674,755
NBG 759,281 721,090
BNB 499,330 495,055
FTB 218,029 203,382
Financial Services Group 4,783 5,052
----------- -----------
Total segment assets 2,189,225 2,099,334
Parent and eliminations, net 5,098 5,700
----------- -----------
Total assets $ 2,194,323 $ 2,105,034
=========== ===========
Three Months Ended Six Months Ended
June 30, June 30,
------------------------- ----------------------------
(Dollars in thousands) 2003 2002 2003 2002
--------- --------- ----------- -----------
Net interest income
WCB $ 7,069 $ 7,165 $ 14,096 $ 14,184
NBG 6,512 6,705 12,985 13,172
BNB 3,904 3,433 7,698 6,529
FTB 2,138 2,144 4,123 4,096
Financial Services Group -- -- -- --
--------- --------- ----------- -----------
Total segment net interest income 19,623 19,447 38,902 37,981
Parent and eliminations, net (430) (461) (868) (918)
--------- --------- ----------- -----------
Total net interest income $ 19,193 $ 18,986 $ 38,034 $ 37,063
========= ========= =========== ===========
Net income
WCB $ 2,364 $ 2,613 $ 4,922 $ 5,256
NBG 332 2,514 524 5,167
BNB 302 1,225 1,632 2,246
FTB 714 735 1,377 1,405
Financial Services Group (91) 21 (196) 59
--------- --------- ----------- -----------
Total segment net income 3,621 7,108 8,259 14,133
Parent and eliminations, net 29 (465) (313) (833)
--------- --------- ----------- -----------
Total net income $ 3,650 $ 6,643 $ 7,946 $ 13,300
========= ========= =========== ===========
11
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
INTRODUCTION
The principal objective of this discussion is to provide an overview of the
financial condition and results of operations of Financial Institutions, Inc.
and its subsidiaries for the periods covered in this quarterly report. This
discussion and tabular presentations should be read in conjunction with the
accompanying consolidated financial statements and accompanying notes.
CRITICAL ACCOUNTING POLICIES
The Company's consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States and are consistent
with predominant practices in the financial services industry. Application of
critical accounting policies, those policies that Management believes are the
most important to the Company's financial position and results, requires
Management to make estimates, assumptions, and judgments that affect the amounts
reported in the consolidated financial statements and accompanying notes and are
based on information available as of the date of the financial statements.
Future changes in information may affect these estimates, assumptions, and
judgments, which, in turn, may affect amounts reported in the financial
statements.
The Company has numerous accounting policies, of which the most significant are
presented in Note 1 of the Notes to Unaudited Consolidated Financial Statements
included in the Company's Annual Report on Form 10-K as of December 31, 2002,
dated March 14, 2003, as filed with the Securities and Exchange Commission.
These policies, along with the disclosures presented in the other financial
statement notes and in this discussion, provide information on how significant
assets and liabilities are reported in the financial statements and how those
reported amounts are determined. Based on the sensitivity of financial statement
amounts to the methods, assumptions, and estimates underlying those amounts,
Management has determined that the accounting policies with respect to the
allowance for loan losses and goodwill require subjective or complex judgments
important to the Company's financial position and results of operations, and, as
such, are considered to be critical accounting policies as discussed below.
Allowance for Loan Losses: Arriving at an appropriate level of allowance for
loan losses involves a high degree of judgment. The Company's allowance for loan
losses provides for probable losses based upon evaluations of known and inherent
risks in the loan portfolio. Management uses historical information to assess
the adequacy of the allowance for loan losses and considers the prevailing
business environment, as it is affected by changing economic conditions and
various external factors, which may impact the portfolio in ways currently
unforeseen. The allowance is increased by provisions for loan losses and by
recoveries of loans previously charged-off and reduced by loans charged-off.
Goodwill: SFAS No. 141 requires that the purchase method of accounting be used
for all business combinations and further clarifies the criteria for the initial
recognition and measurement of intangible assets separate from goodwill. SFAS
No. 142 prescribes the accounting for goodwill and intangible assets subsequent
to initial recognition. The provisions of SFAS No. 142 discontinue the
amortization of goodwill and intangible assets with indefinite lives. Instead,
these assets are subject to at least an annual impairment review, and more
frequently if certain impairment indicators are in evidence. SFAS No. 142 also
requires that reporting units be identified for the purpose of assessing
impairment of goodwill.
12
FORWARD LOOKING STATEMENTS
This report contains certain forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended (the "Securities Act"),
and Section 21E of the Securities Exchange Act of 1934, as amended (the
"Exchange Act"), that involve substantial risks and uncertainties. When used in
this report, or in the documents incorporated by reference herein, the words
"anticipate", "believe", "estimate", "expect", "intend", "may", and similar
expressions identify such forward-looking statements. Actual results,
performance or achievements could differ materially from those contemplated,
expressed or implied by the forward-looking statements contained herein. These
forward-looking statements are based on the current expectations of the Company
or the Company's management and are subject to a number of risks and
uncertainties, including but not limited to, economic, competitive, regulatory,
and other factors affecting the Company's operations, markets, products and
services, as well as expansion strategies and other factors discussed elsewhere
in this report filed by the Company with the Securities and Exchange Commission.
Many of these factors are beyond the Company's control.
SELECTED FINANCIAL DATA
The following table presents certain information and ratios that management of
the Company considers important in evaluating performance:
At or For the Six Months Ended June 30,
---------------------------------------
2003 2002 $ Change % Change
---- ---- -------- --------
Per common share data:
Net income - basic $0.65 $1.14 $(0.49) (43)%
Net income - diluted $0.64 $1.12 $(0.48) (43)%
Cash dividends declared $0.32 $0.27 $0.05 19%
Book value $15.17 $13.23 $1.94 15%
Common shares outstanding:
Weighted average shares - basic 11,133,222 11,040,619
Weighted average shares - diluted 11,234,187 11,220,279
Period end 11,156,017 11,090,881
Performance ratios, annualized:
Return on average assets 0.74% 1.41%
Return on average common equity 8.75% 18.32%
Common dividend payout ratio 49.23% 23.68%
Net interest margin (tax-equivalent) 4.00% 4.46%
Efficiency ratio * 56.15% 49.89%
Asset quality ratios:
Nonperforming loans to total loans 3.65% 0.87%
Nonperforming assets to total loans and other real estate 3.70% 0.99%
Net loan charge-offs to average loans 0.56% 0.22%
Allowance for loan losses to total loans 1.93% 1.62%
Allowance for loan losses to nonperforming loans 53% 187%
Capital ratios:
Average common equity to average total assets 7.71% 7.18%
Leverage ratio 6.83% 7.05%
Tier 1 risk based capital ratio 9.77% 10.16%
Risk-based capital ratio 11.03% 11.42%
* Efficiency ratio represents noninterest expense less other real estate expense
and amortization of intangibles divided by net interest income (tax equivalent)
plus other noninterest income less gain (loss) on sale of available for sale
securities.
13
ANALYSIS OF FINANCIAL CONDITION
Lending Activities
Loan Portfolio Composition
The following table provides selected information regarding the composition of
the Company's loan portfolio at the dates indicated.
June 30, December 31,
(Dollars in thousands) 2003 2002
---------------------- -----------------------
Commercial $ 264,885 19.3% $ 262,630 19.9%
Commercial real estate 356,352 26.0 332,134 25.1
Agricultural 244,771 17.9 233,769 17.7
Residential real estate 261,674 19.1 251,898 19.1
Consumer and home equity 242,971 17.7 241,461 18.2
----------- ----- ----------- ----
Total loans gross 1,370,653 100.0 1,321,892 100.0
Allowance for loan losses (26,518) (21,660)
----------- -----------
Total loans, net $ 1,344,135 $ 1,300,232
=========== ===========
Total gross loans increased $49 million to $1.371 billion at June 30, 2003 from
$1.322 billion at December 31, 2002. Commercial real estate loans increased $24
million to $356 million or 26.0% of the portfolio at June 30, 2003 from $332
million or 25.1% at December 31, 2002. Agricultural loans increased $11 million,
to $245 million at June 30, 2003 from $234 million at December 31, 2002.
Included in agricultural loans were $121 million in loans to dairy farmers, or
8.8% of the portfolio at June 30, 2003 compared to $119 million or 9.0% of the
portfolio at December 31, 2002. The residential real estate portfolio includes
loans held for sale totaling $9,975,000 and $6,971,000 at June 30, 2003 and
December 31, 2002, respectively.
Nonaccruing Loans and Nonperforming Assets
Nonperforming assets at June 30, 2003 were $50.7 million compared to $38.4
million at December 31, 2002. The increase in nonperforming loans includes an
increase of $5.7 million in commercial loans, $2.2 million in commercial
mortgage loans and $4.6 million in agricultural loans. The increase in
nonaccrual agricultural loans relates to an extended period of low milk prices
in the dairy industry that has adversely affected the borrowers' cash flow. More
recently there has been favorable upward movement in milk prices. The increase
in commercial and commercial mortgage nonaccrual loans relates to general
continued weak economic conditions and the overextended positions of the
borrowers. Over the past few quarters the Company has committed additional
resources toward management of the Company's nonperforming assets and
strengthening the credit administration function.
14
The following table provides information regarding nonaccruing loans and other
nonperforming assets at the dates indicated.
June 30, December 31,
(Dollars in thousands) 2003 2002
-------- ------------
Nonaccruing loans (1)
Commercial $19,420 $12,760
Commercial real estate 10,753 8,407
Agricultural 13,261 8,739
Residential real estate 1,583 1,065
Consumer and home equity 748 915
------- -------
Total nonaccruing loans 45,765 31,886
Restructured loans 3,076 4,129
Accruing loans 90 days or more delinquent 1,195 1,091
------- -------
Total nonperforming loans 50,036 37,106
Other real estate owned 640 1,251
------- -------
Total nonperforming assets $50,676 $38,357
======= =======
Total nonperforming loans to total loans 3.65% 2.81%
Total nonperforming assets to total loans and other real estate 3.70% 2.90%
(1) Loans are placed on nonaccrual status when they become 90 days or more
past due or if they have been identified by the Company as presenting
uncertainty with respect to the collectibility of interest or principal.
The recorded investment in loans that are considered to be impaired totaled
$27,759,000 and $24,626,000 at June 30, 2003 and December 31, 2002,
respectively. The allowance for loan losses related to impaired loans amounted
to $5,972,000 and $4,462,000 at June 30, 2003 and December 31, 2002,
respectively. Interest income recognized on impaired loans, while such loans
were impaired, during the six-months ended June 30, 2003 and 2002 was
approximately $69,000 and $139,000, respectively.
Analysis of the Allowance for Loan Losses
The allowance for loan losses represents the amount of probable credit losses in
the loan portfolio. Periodic, systematic reviews of each banks' portfolios are
performed to identify losses. These reviews result in the identification and
quantification of loss factors, which are used in determining the amount of the
allowance for loan losses. In addition, the Company periodically evaluates
prevailing economic and business conditions, industry concentrations, changes in
the size and characteristics of the portfolio and other pertinent factors. The
allowance for loan losses is allocated to cover the estimated losses in each
loan category based on the results of this detailed review. The process used by
the Company to determine the appropriate overall allowance for loan losses is
based on this analysis.
15
The following table sets forth the activity in the allowance for loan losses for
the periods indicated.
Three Months Ended Six Months Ended
June 30, June 30,
--------------------- ---------------------
(Dollars in thousands) 2003 2002 2003 2002
------- ------- ------- -------
Balance at beginning of period $23,434 $19,483 $21,660 $19,074
Addition as a result of acquisition -- 174 -- 174
Charge-offs:
Commercial 1,248 528 2,499 755
Commercial real estate 883 47 907 191
Agricultural 13 -- 27 29
Residential real estate 49 6 72 35
Consumer and home equity 418 371 755 675
------- ------- ------- -------
Total charge-offs 2,611 952 4,260 1,685
Recoveries:
Commercial 315 10 357 19
Commercial real estate 6 68 11 71
Agricultural 1 5 3 36
Residential real estate 1 54 8 54
Consumer and home equity 61 98 130 190
------- ------- ------- -------
Total recoveries 384 235 509 370
------- ------- ------- -------
Net charge-offs 2,227 717 3,751 1,315
Provision for loan losses 5,311 1,181 8,609 2,188
------- ------- ------- -------
Balance at end of period $26,518 $20,121 $26,518 $20,121
======= ======= ======= =======
Ratio of net loan charge-offs to average loans (annualized) 0.66% 0.24% 0.56% 0.22%
Ratio of allowance for loan losses to total loans 1.93% 1.62% 1.93% 1.62%
Ratio of allowance for loan losses to nonperforming loans 53% 187% 53% 187%
Net loan charge-offs were $3.8 million for the first six months of 2003 or 0.56%
(annualized) of average loans compared to $1.3 million or 0.22% of average loans
in the same period last year. The increase in loan charge-offs is attributed to
$1.2 million of commercial loan charge-offs at NBG and $844,000 of commercial
mortgage charge-offs at BNB during the first six months of 2003. Provision for
loan losses amounted to $8.6 million for the first six months of 2003 and
reflects the increased amount of net loan charge-offs, higher levels of specific
allocations associated with impaired loans, and higher allowances on pools of
homogeneous loans. The higher allowance on pooled homogeneous loans is
indicative of an increasing historical charge-off ratio as well as increased
levels of classified loans. The ratio of the allowance for loan losses to
nonperforming loans was 53% at June 30, 2003, compared to 58% at December 31,
2002. The ratio of the allowance for loan losses to total loans increased to
1.93% at June 30, 2003, compared to 1.64% at December 31, 2002.
16
Investing Activities
U.S. Treasury and Agency Securities
At June 30, 2003, the U.S. Treasury and Agency securities portfolio totaled
$104.5 million, all of which was classified as available for sale. The portfolio
was comprised entirely of U. S. federal agency securities, which were
predominately callable securities. These callable securities provide higher
yields than similar securities without call features. At December 31, 2002, the
U.S. Treasury and Agency securities portfolio totaled $120.6 million, all of
which was classified as available for sale. The portfolio consisted of $1.0
million in U. S. Treasury securities and $119.6 million in U. S. federal agency
securities.
State and Municipal Obligations
At June 30, 2003, the portfolio of state and municipal obligations totaled
$233.3 million, of which $188.1 million was classified as available for sale. At
that date, $45.2 million was classified as held to maturity, with a fair value
of $46.7 million. At December 31, 2002, the portfolio of state and municipal
obligations totaled $222.0 million, of which $174.9 million was classified as
available for sale. At that date, $47.1 million was classified as held to
maturity, with a fair value of $48.1 million. Over the past few years, the
growth in this portfolio can be attributed to the Company's efforts to expand
municipal banking relationships, which includes both deposit activities and
investing in obligations issued by those municipalities.
Mortgage-Backed Securities
Mortgage-backed securities, all of which were classified as available for sale,
totaled $235.7 million and $283.5 million at June 30, 2003 and December 31,
2002, respectively. The portfolio was comprised of $139.7 million of
mortgage-backed pass-through securities, $85.0 million of collateralized
mortgage obligations (CMOs) and $11.0 million of other asset-backed securities
at June 30, 2003. The mortgage backed pass-through securities were predominantly
agency issued debt (FNMA, FHLMC, or GNMA). Over 75% of the agency
mortgage-backed pass-through securities were in fixed rate securities that were
predominately formed with mortgages having an original balloon payment of five
or seven years. The adjustable rate agency mortgage-backed securities portfolio
is principally indexed to the one-year Treasury bill. The CMO portfolio consists
of government agency issues and privately issued AAA rated securities. The other
asset-backed securities are primarily Student Loan Marketing Association (SLMA)
floaters, which are securities backed by student loans. At December 31, 2002 the
portfolio consisted of $193.4 million of mortgage-backed pass-through securities
and $90.1 million of CMOs. The mortgage-backed portfolio at December 31, 2002
was primarily agency issued (FNMA, FHLMC, GNMA) obligations, but also included
privately issued AAA rated securities and SLMA floaters to further diversify the
portfolio. During the first six months of 2003, the low interest rate
environment has led to significant refinance activity and high prepayments of
mortgage-backed securities. These increased prepayments have led to a decline in
the Company's mortgage-backed security portfolio.
Corporate Bonds
The corporate bond portfolio, all of which was classified as available for sale,
totaled $12.2 million and $13.9 million at June 30, 2003 and December 31, 2002,
respectively. The portfolio was purchased to further diversify the investment
portfolio and increase investment yield. The Company's investment policy limits
investments in corporate bonds to no more than 10% of total investments and to
bonds rated as Baa or better by Moody's Investors Service, Inc. or BBB or better
by Standard & Poor's Ratings Services at the time of purchase.
Equity Securities
At June 30, 2003 and December 31, 2002, available for sale equity securities
totaled $8.9 million and $3.9 million, respectively. This portfolio is primarily
comprised of FHLMC preferred stock, but also includes some corporate equity
securities owned by the holding company.
17
Funding Activities
Deposits
The banks offer a broad array of core deposit products including checking
accounts, interest-bearing transaction accounts, savings and money market
accounts and certificates of deposit under $100,000. These core deposits totaled
$1.584 billion or 86.7% of total deposits of $1.826 billion at June 30, 2003
compared to core deposits of $1.507 billion or 88.2% of total deposits of $1.709
billion at December 31, 2002. The core deposit base consists almost exclusively
of in-market accounts. The Company had total public deposits of $381.5 million
at June 30, 2003 compared to $361.2 million at December 31, 2002. The increase
is a reflection of the Company's efforts to expense its municipal banking
relationships. Core deposits are supplemented with certificates of deposit over
$100,000, which amounted to $242.5 million and $201.8 million as of June 30,
2003 and December 31, 2002, respectively. As of June 30, 2003 and December 31,
2002, brokered certificates of deposit included in certificates of deposit over
$100,000 totaled $93.6 million and $71.6 million, respectively.
Non-Deposit Sources of Funds
The Company's most significant source of non-deposit funds is FHLB borrowings.
FHLB advances outstanding amounted to $109.8 million and $112.8 million as of
June 30, 2003 and December 31, 2002, respectively. These FHLB borrowings include
both short and long-term advances maturing on various dates through 2009. The
Company had approximately $20.4 million of immediate credit available under
lines of credit with the FHLB at June 30, 2003, collateralized by FHLB stock and
real estate mortgage loans. The Company also has lines of credit with the
Federal Agricultural Mortgage Corp. (Farmer Mac) permitting borrowings to a
maximum of $50.0 million. However, no advances were outstanding against the
Farmer Mac lines as of June 30, 2003. The Company also utilizes securities sold
under agreements to repurchase as a source of funds. The short-term repurchase
agreements amounted to $26.9 million and $60.7 million as of June 30, 2003 and
December 31, 2002, respectively.
During 2001 FISI Statutory Trust I (the "Trust") was established and issued 30
year guaranteed preferred beneficial interests in junior subordinated debentures
of the Company ("capital securities") in the aggregate amount of $16.2 million
at a fixed rate of 10.2%. The Company used the net proceeds from the sale of the
capital securities to partially fund the acquisition of BNB. As of June 30,
2003, all of the capital securities qualified as Tier I capital under regulatory
definitions. Since the capital securities are classified as debt for financial
statement purposes, the tax-deductible expense associated with the capital
securities is recorded as interest expense in the consolidated statements of
income.
Equity Activities
Total shareholders' equity totaled $186.3 million at June 30, 2003, an increase
of $8.0 million from $178.3 million at December 31, 2002. Retained earnings
increased to $135.0 million at June 30, 2003, accounting for $3.6 million of the
increase in shareholders' equity from year-end. Stockholders' equity was also
positively impacted by a $3.2 million increase in accumulated other
comprehensive income attributed to unrealized gain on available for sale
securities.
RESULTS OF OPERATIONS
Average Balance Sheets
The tables on the following pages set forth certain information relating to the
Company's consolidated statements of financial condition and reflect the average
yields earned on interest-earning assets, as well as the average rates paid on
interest-bearing liabilities for the periods presented. Dividing interest income
or interest expense by the average balances of interest-earning assets or
interest-bearing liabilities, respectively, derived the yields and rates. Tax
equivalent adjustments have been made. All average balances are average daily
balances. Nonaccruing loan balances are included in the yield calculations in
these tables.
18
For The Three Months Ended June 30,
-----------------------------------
2003 2002
---- ----
Average Interest Annualized Average Interest Annualized
Outstanding Earned/ Yield/ Outstanding Earned/ Yield/
(Dollars in thousands) Balance Paid Rate Balance Paid Rate
------- ---- ---- ------- ---- ----
Interest-earning assets:
Federal funds sold and interest-bearing deposits $ 40,587 $ 123 1.22% $ 42,653 $ 187 1.76%
Investment securities (1):
Taxable 413,618 4,349 4.20% 374,085 5,109 5.46%
Non-taxable 233,765 3,256 5.57% 208,202 3,292 6.32%
---------- ------- ------ ---------- ------- ------
Total investment securities 647,383 7,605 4.70% 582,287 8,401 5.77%
Loans (2):
Commercial and agricultural 859,120 13,076 6.10% 752,234 13,184 7.03%
Residential real estate 259,781 4,802 7.39% 229,443 4,697 8.19%
Consumer and home equity 240,410 4,298 7.17% 229,805 4,609 8.04%
---------- ------- ------ ---------- ------- ------
Total loans 1,359,311 22,176 6.54% 1,211,482 22,490 7.44%
---------- ------- ------ ---------- ------- ------
Total interest-earning assets 2,047,281 29,904 5.85% 1,836,422 31,078 6.78%
---------- ------- ------ ---------- ------- ------
Allowance for loans losses (23,818) (19,879)
Other non-interest earning assets 155,548 147,338
---------- ----------
Total assets $2,179,011 $1,963,881
========== ==========
Interest-bearing liabilities:
Interest-bearing checking 384,359 953 0.99% 364,355 1,381 1.52%
Savings and money market 419,837 1,126 1.08% 366,501 1,515 1.66%
Certificates of deposit 766,729 5,804 3.04% 647,363 6,143 3.81%
Borrowed funds 147,011 1,269 3.46% 179,773 1,482 3.31%
Guaranteed preferred beneficial interests in
Corporation's junior subordinated debentures 16,200 419 10.37% 16,200 419 10.37%
---------- ------- ------ ---------- ------- ------
Total interest-bearing liabilities 1,734,136 9,571 2.21% 1,574,192 10,940 2.79%
---------- ------- ------ ---------- ------- ------
Non-interest bearing demand deposits 236,221 212,738
Other non-interest-bearing liabilities 22,940 18,179
---------- ----------
Total liabilities 1,993,297 1,805,109
Shareholders' equity (3) 185,714 158,772
---------- ----------
Total liabilities and shareholders' equity $2,179,011 $1,963,881
========== ==========
Net interest income - tax equivalent 20,333 20,138
Less: tax equivalent adjustment 1,140 1,152
------- -------
Net interest income $19,193 $18,986
======= =======
Net interest rate spread 3.64% 3.99%
====== ======
Net earning assets $ 313,145 $ 262,230
========== ==========
Net interest margin (4) 3.98% 4.39%
====== ======
Ratio of average interest-earning assets to
average interest-bearing liabilities 118.06% 116.66%
====== ======
(1) Amounts shown are amortized cost for held to maturity securities and fair
value for available for sale securities. In order for pre-tax income and
resultant yields on tax-exempt securities to be comparable to those on
taxable securities and loans, a tax-equivalent adjustment to interest
earned from tax-exempt securities has been computed using a federal rate
of 35%.
(2) Net of deferred loan fees and costs, and loan discounts and premiums.
(3) Includes gains (losses) on securities available for sale.
(4) The net interest margin is equal to net interest income divided by average
interest-earning assets and is presented on an annualized basis.
19
For The Six Months Ended June 30,
---------------------------------
2003 2002
---- ----
Average Interest Annualized Average Interest Annualized
Outstanding Earned/ Yield/ Outstanding Earned/ Yield/
(Dollars in thousands) Balance Paid Rate Balance Paid Rate
------- ---- ---- ------- ---- ----
Interest-earning assets:
Federal funds sold and interest-bearing deposits $ 36,877 $ 226 1.24% $ 35,173 $ 306 1.75%
Investment securities (1):
Taxable 414,003 8,909 4.31% 338,556 9,367 5.54%
Non-taxable 229,795 6,505 5.66% 206,993 6,583 6.36%
---------- ------- ------ ---------- ------- ------
Total investment securities 643,798 15,414 4.79% 545,549 15,950 5.85%
Loans (2):
Commercial and agricultural 848,570 25,807 6.13% 730,114 25,641 7.08%
Residential real estate 256,113 9,415 7.35% 231,716 9,597 8.28%
Consumer and home equity 240,049 8,706 7.31% 229,845 9,297 8.16%
---------- ------- ------ ---------- ------- ------
Total loans 1,344,732 43,928 6.57% 1,191,675 44,535 7.52%
---------- ------- ------ ---------- ------- ------
Total interest-earning assets 2,025,407 59,568 5.91% 1,772,397 60,791 6.89%
---------- ------- ------ ---------- ------- ------
Allowance for loans losses (22,896) (19,584)
Other non-interest earning assets 154,549 145,292
---------- ----------
Total assets $2,157,060 $1,898,105
========== ==========
Interest-bearing liabilities
Interest-bearing checking 386,579 2,011 1.05% 337,232 2,498 1.49%
Savings and money market 415,088 2,391 1.16% 349,495 2,842 1.64%
Certificates of deposit 745,664 11,397 3.08% 635,598 12,357 3.92%
Borrowed funds 154,837 2,620 3.41% 173,058 2,889 3.37%
Guaranteed preferred beneficial interests in
Corporation's junior subordinated debentures 16,200 838 10.43% 16,200 838 10.43%
---------- ------- ------ ---------- ------- ------
Total interest-bearing liabilities 1,718,368 19,257 2.26% 1,511,583 21,424 2.86%
---------- ------- ------ ---------- ------- ------
Non-interest bearing demand deposits 232,379 210,647
Other non-interest-bearing liabilities 22,714 19,931
---------- ----------
Total liabilities 1,973,461 1,742,161
Shareholders' equity (3) 183,599 155,944
---------- ----------
Total liabilities and shareholders' equity $2,157,060 $1,898,105
========== ==========
Net interest income - tax equivalent 40,311 39,367
Less: tax equivalent adjustment 2,277 2,304
------- -------
Net interest income $38,034 $37,063
======= =======
Net interest rate spread 3.65% 4.03%
====== ======
Net earning assets $ 307,039 $ 260,814
========== ==========
Net interest margin (4) 4.00% 4.46%
====== ======
Ratio of average interest-earning assets to
average interest-bearing liabilities 117.87% 117.25%
====== ======
(1) Amounts shown are amortized cost for held to maturity securities and fair
value for available for sale securities. In order for pre-tax income and
resultant yields on tax-exempt securities to be comparable to those on
taxable securities and loans, a tax-equivalent adjustment to interest
earned from tax-exempt securities has been computed using a federal rate
of 35%.
(2) Net of deferred loan fees and costs, and loan discounts and premiums.
(3) Includes gains (losses) on securities available for sale.
(4) The net interest margin is equal to net interest income divided by average
interest-earning assets and is presented on an annualized basis.
20
Net Interest Income
Net interest income, the principal source of the Company's earnings, increased
1% in the second quarter of 2003 to $19.2 million compared to $19.0 million in
the second quarter of 2002. Net interest margin was 3.98% for the second quarter
of 2003 a drop of 41 basis points from the 4.39% level for the same period last
year. Growth in average earning assets of $210.9 million, or 11%, offset the
fall in net interest margin and produced the increased revenue. The growth in
average earning assets reflects average increases of $65.1 million, or 11%, in
the Company's investment portfolio and $147.8 million, or 12%, in loans.
For the six months ended June 30, 2003, net interest income increased 3% to
$38.0 million compared to $37.1 million for the same period in 2002. In 2003
six-month average earning assets grew 14%, or $253.0 million, from the same
period last year, while net interest margin decreased to 4.00% from 4.46% for
these same periods.
Net interest margin has declined over the past year, as market interest rates
have fallen to historically low levels. The trend of net interest margin
compression has developed from yields on incremental asset growth being low
relative to funding costs in this period of low interest rates. The increase in
nonaccrual loans has also contributed to the decline in net interest margin in
the most recent quarters.
Provision for Loan Losses
The provision for loan losses for the second quarter of 2003 totaled $5.3
million, which represents an increase of $4.1 million over the $1.2 million
provision for loan losses for the second quarter of 2002. For the first six
months of 2003, the provision for loan losses totaled $8.6 million compared to
$2.2 for the same period last year.
The increased provision for loan losses in 2003 is a reflection of higher loan
charge-offs, increased specific reserve allocations on impaired loans, decline
in asset quality and the extended soft economy and its affects on the Company's
analysis of the allowance for loan losses. See discussion of the "Analysis of
the Allowance for Loan Losses. Noninterest Income Noninterest income increased
19% in the second quarter of 2003 to $6.2 million from $5.2 million for the
second quarter of 2002. For the first six months of 2003, noninterest income
totaled $12.3 million, an increase of 21% over the same period last year.
Growth in deposits and related activity resulted in service charges on deposits
increasing $492,000 to $5.4 million for the six months ending June 30, 2003
compared to $4.9 million for the same period a year ago. Mortgage banking
activities, which include gains and losses from the sale of residential mortgage
loans, mortgage servicing income and the amortization of mortgage servicing
rights, accounted for $519,000 of the year-to-date increase. The increase in
mortgage banking revenues corresponds with the increase in residential mortgage
refinance activity resulting from the historically low interest rate
environment. The Company sells most newly originated and refinanced mortgage
loans in the secondary market.
Noninterest Expense
Noninterest expense for the second quarter of 2003 totaled $14.9 million
compared with $13.1 million for the second quarter of 2002. For the six months
ended June 30, 2003, noninterest expense was $30.5 million, an increase of $5.3
million over $25.2 million for the prior year.
Salaries and benefits have increased $2.5 million for year-to-date 2003,
primarily as a result of additional staffing associated with the Company's new
branch offices and the expansion of the credit administration department. The
first quarter of 2003 also included $674,000 of former management separation
costs. Occupancy and equipment costs have increased $531,000 during the six
months ended June 30, 2003 due to the additional branches and expansion of the
Company's technology platform.
Additional items affecting noninterest expense during the six months ended June
30, 2003 include an impairment charge of $489,000 for a partnership investment,
professional services amounting to
21
$232,000 related to organizational governance and credit administration issues
at NBG, and a $538,000 write-down of a parcel of other real estate owned.
These additional expenses, coupled with a slowing of revenue growth, are the
principal factors increasing the Company's year-to-date efficiency ratio for
2003 to 56.15%, compared to 49.89% for the same period a year ago. During 2002,
offices were opened in six new locations. During the first half of 2003, one
additional branch was added and there are plans to open two more during the
second half of 2003. As the Company invests in the future, the costs associated
with expansion and the related support structure have contributed to a higher
efficiency ratio. Management expects improvement in operating measures as the
new offices develop and credit-related costs decline as problem loans are worked
out.
Income Tax Expense
The provision for income taxes, which provides for Federal and New York State
income taxes, amounted to $1.4 million and $3.2 million for the second quarter
of 2003 and 2002, respectively. For the six months ended June 30, 2003 and 2002,
the provision for income taxes totaled $3.2 million and $6.5 million,
respectively. While the decrease corresponds generally to the decreased levels
of taxable income, the effective tax rate for year-to-date 2003 decreased to
28.8%, compared to 32.7% for year-to-date 2002, primarily as a result of an
increase in holdings of tax-exempt securities.
Liquidity and Capital Resources
Liquidity
The objective of maintaining adequate liquidity is to assure the ability of the
Company and its subsidiaries to meet their financial obligations. These
obligations include the withdrawal of deposits on demand or at their contractual
maturity, the repayment of borrowings as they mature, the ability to fund new
and existing loan commitments and the ability to take advantage of new business
opportunities. The Company and its subsidiaries achieve liquidity by maintaining
a strong base of core customer funds, maturing short-term assets, the ability to
sell securities, lines of credit, and access to capital markets.
Liquidity at the subsidiary bank level is managed through the monitoring of
anticipated changes in loans, core deposits, and wholesale funds. The strength
of the subsidiary bank's liquidity position is a result of its base of core
customer deposits. These core deposits are supplemented by wholesale funding
sources, including credit lines with the other banking institutions, the FHLB,
Farmer Mac, and the Federal Reserve Bank.
The primary source of liquidity for the parent company is dividends from
subsidiaries, lines of credit, and access to capital markets. Dividends from
subsidiaries are limited by various regulatory requirements related to capital
adequacy and earnings trends. The Company's subsidiaries rely on cash flows from
operations, core deposits, borrowings, short-term liquid assets, and, in the
case of non-banking subsidiaries, funds from the parent company.
In the normal course of business, the Company has outstanding commitments to
extend credit not reflected in the Company's consolidated financial statements.
The commitments generally have fixed expiration dates or other termination
clauses and may require payment of a fee. At June 30, 2003 letters of credit
totaling $14.0 million and unused loan commitments of $340.7 million were
contractually available. Comparable amounts for these commitments at December
31, 2002 were $13.4 million and $316.6 million, respectively. The total
commitment amounts do not necessarily represent future cash requirements as
certain of the commitments are expected to expire without funding.
The Company's cash and cash equivalents were $141.8 million at June 30, 2003, an
increase of $93.4 million from the balance of $48.4 million at December 31,
2002. The primary factors leading to the increase in cash during the first six
months of 2003 were the increase in deposits and decrease in securities, offset
by an increase in net loans and decrease in borrowings.
22
Capital Resources
The Federal Reserve Board has adopted a system using risk-based capital
guidelines to evaluate the capital adequacy of bank holding companies. The
guidelines require a minimum total risk-based capital ratio of 8.0%. Leverage
ratio is also utilized in assessing capital adequacy with a minimum requirement
that can range from 3.0% to 5.0%.
The Company's Tier 1 leverage ratio was 6.83% and 6.96% at June 30, 2003 and
December 31, 2002, respectively, well-above minimum regulatory capital
requirements. Total Tier 1 capital of $144.9 million at June 30, 2002 increased
$5.3 million from $139.6 million at December 31, 2002. The increase in Tier 1
capital relates primarily to the increase of $3.6 million in retained earnings
resulting from the Company's first quarter 2003 earnings net of dividend
payouts.
The Company's total risk-weighted capital ratio was 11.03% at June 30, 2003,
comparable to 11.08% at and December 31, 2002, both well-above minimum
regulatory capital requirements. Total risk-based capital was $163.5 million at
June 30, 2003, an increase of $6.1 million from $157.4 million at December 31,
2002.
Other Matters
The Company disclosed in its 2003 Annual Report on Form 10-K that the OCC began
Safety & Soundness Examinations at NBG and BNB in early January 2003 and that
management was undertaking significant remedial measures in credit
administration, compliance and organizational structure to address the issues
identified in those examinations.
On April 30, 2003, at examination exit meetings with the senior managements of
NBG and BNB, the OCC outlined proposed findings and provided a written summary
of issues requiring attention in the areas of regulatory compliance, credit risk
management and internal controls.
On August 13, 2003 the OCC delivered its Report of Examination with respect to
each of NBG and BNB for the period ended September 30, 2002 (each an "ROE" and
collectively the "ROEs") to the Boards of Directors of NBG and BNB. The NBG ROE
was based on financial information as of September 30, 2002, updated to December
31, 2002, where possible, and the BNB ROE was based on financial information as
of September 30, 2002, updated to March 31, 2003, where possible.
The ROEs conclude that both NBG and BNB require improvement in board and
management supervision and have less than satisfactory asset quality, although,
in the case of both banks, the ROEs concluded that the allowance for loan and
lease losses is adequate. The ROEs also found that in both banks, capital is
strained, although earnings are satisfactory and liquidity is adequate.
Regulatory violations were identified at both banks, including in the case of
NBG, violations of affiliate transaction regulations, Regulation O (extensions
of credit to insiders), applicable real estate lending and appraisal
regulations, and call report inaccuracies. In the case of BNB, a violation was
identified as a result of dividend payments following the acquisition of BNB in
2001. All of the regulatory violations identified have either already been
corrected or are in the process of being corrected by management of the banks.
As a consequence of these findings, both ROEs state the banks will lose their
"well managed" status and "satisfactory" composite ratings, and that enforcement
actions are being recommended for both banks. In the case of NBG, the OCC has
indicated that it is considering whether to impose civil money penalties
("CMPs"), and that a decision will be made within the next month.
Also on August 13, 2003 the OCC initiated enforcement actions against both banks
by delivering drafts of proposed formal agreements to the Boards of NBG and BNB
(each an "Agreement" and collectively the "Agreements"). Each of the Agreements,
if entered into by the directors of the banks, would require the banks, among
other things, to: appoint a Compliance Committee of the Board; develop,
implement and ensure compliance with a written plan outlining actions to be
taken to address regulatory recommendations set forth in each ROE; review and
assess the capabilities of management; develop and implement a three year
capital plan that requires Tier 1 Leverage Capital equal to at least 8% of
risk-weighted assets, Tier 1 Risk Based Capital equal to at least 10%, and Total
Risk Based Capital equal to
23
at least 12%; develop various policies and programs to reduce credit risk and
identify problem loans, including revised written loan policies, written
policies and procedures governing supervision and control of nonaccrual loans,
ensuring that proper collateral documentation is maintained on all loans and
reviewing the adequacy of the Allowance for Loan Losses. The Agreements would
also require NBG and BNB to adopt dividend policies that would permit them to
declare dividends only when they are in compliance with their approved capital
plan and the provisions of 12 U.S.C. Section 56 and 60, and upon prior written
notice to (but not consent of) the Assistant Deputy Comptroller.
The NBG Agreement would also require the Board to adopt, implement and ensure
adherence to a written policy on extensions of overdraft credit and limit the
circumstances under which NBG would be permitted to directly or indirectly
extend credit to its affiliates, or transfer assets between NBG and its
affiliates, and would require the bank to engage an independent appraiser to
provide written or updated real property collateral appraisals where required.
The BNB Agreement would also require its Board of Directors to adopt, implement
and ensure adherence to a written action plan outlining proposed corrective
action addressing each item recommended in the pre-existing Matters Requiring
Attention (MRA) pertaining to Interest Rate Risk Measurement and Monitoring
Systems. The Agreements are under review by the Boards of Directors of NBG and
BNB, and the OCC has requested the Boards to forward comments and be prepared to
sign agreements in substantially this form by August 28, 2003.
The banks are important sources of funds to the Company and, if they are unable,
or limited in their ability, to pay dividends to the Company, that would
adversely affect the Company's ability to pay dividends to its shareholders.
Formal OCC enforcement actions, once entered into, are made public by the OCC
and, together with any CMPs that may be assessed, could have adverse effects on
NBG and BNB, such as making it more difficult for them to attract and retain
qualified directors, making them ineligible to accept brokered deposits without
FDIC approval, increasing their expenses associated with complying with the
ROEs' recommendations and damaging their reputations. These actions also could
have adverse effects on the Company, including without limitation reducing its
access to capital, reducing its liquidity and damaging its reputation. Because
the OCC reports conclude that NBG and BNB are not entitled to "well-managed" and
"well-capitalized" status, the Company may lose its financial holding company
(FHC) status under the Bank Holding Company Act, which would mean that until the
banks have corrected the conditions that resulted in the loss of their "well
managed" status, the Company may not engage in any additional financial
activities other than those authorized for bank holding companies which do not
have FHC status, without prior written approval of the Federal Reserve Board.
The Company is evaluating the implications of the loss of the banks'
"well-managed" and "well-capitalized" status and any consequences that may flow
from that change in status.
The findings in the ROEs are consistent with discussions the Company has had
with the OCC and the disclosures in its 2002 Annual Report on Form 10K and
Quarterly Report March 31, 2003 on Form 10Q. The ROEs did not identify any
nonperforming assets that were not disclosed in the Company's Quarterly Report
March 31, 2003 on Form 10Q or contained in the Company's Second Quarter 2003
earnings press release July 22, 2003. To address the issues noted the Company
and the banks have taken the following actions to date:
o The Board of NBG has appointed a new President and new Senior Lender.
o The Board of BNB has created and filled a new Senior Lender position.
o The Company has engaged a new external loan review firm and revised the
scope of the engagement.
o In September 2002 the Company created and filled a new Senior Credit
administration position at the holding company level.
24
o In the first quarter of 2003 the Company created and filled a new Senior
Credit Risk Management position and credit analysis function at the
holding company level that supports the loan underwriting process.
o In the first half of 2003 the Company created and filled positions of a
new loan workout department at the holding company level to manage all
classified credits.
o The Company has revised its lending policy in the areas of approval
authorities, insider lending, transactions with affiliates, real estate
appraisals, review of the allowance for loan losses, and terms and
collateral on selected classes of credit.
o To enhance capital levels NBG has not paid a dividend in 2003 and the
Company contributed an additional $1,000,000 in capital. At June 30, 2003
NBG had a tier 1 capital ratio of 6.65% and a total risk based capital
ratio of 10.16%.
o To enhance capital levels BNB has not paid a dividend since its first
quarter 2003 dividend. At June 30, 2003 BNB had a tier 1 leverage ratio of
5.65% and a total risk based capital ratio of 10.87%.
o BNB has instituted new procedures to test the validity of assumptions made
in its interest rate risk measuring and monitoring systems.
Following the review and finalization of the formal agreements by the Boards of
NBG and BNB, the Company will work closely with bank management and the OCC to
ensure compliance and will utilize these agreements as a basis for strengthening
the management and capital structure of the banks.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
The principal objective of the Company's interest rate risk management is to
evaluate the interest rate risk inherent in certain assets and liabilities,
determine the appropriate level of risk to the Company given its business
strategy, operating environment, capital and liquidity requirements and
performance objectives, and manage the risk consistent with the guidelines
approved by the Company's Board of Directors. The Company's senior management is
responsible for reviewing with the Board its activities and strategies, the
effect of those strategies on the net interest margin, the fair value of the
portfolio and the effect that changes in interest rates will have on the
portfolio and exposure limits. Senior Management develops an Asset-Liability
Policy that meets strategic objectives and regularly reviews the activities of
the subsidiary banks. Each subsidiary bank board adopts an Asset-Liability
Policy within the parameters of the overall FII Asset-Liability Policy and
utilizes an asset/liability committee comprised of senior management of the bank
under the direction of the bank's board.
Management of the Company's interest rate risk requires the selection of
appropriate techniques and instruments to be utilized after considering the
benefits, costs and risks associated with available alternatives. Since the
Company does not utilize derivative instruments, management's techniques usually
consider one or more of the following: (1) interest rates offered on products,
(2) maturity terms offered on products, (3) types of products offered, and (4)
products available to the Company in the wholesale market such as advances from
the FHLB.
The Company uses a net interest income and economic value of equity model as one
method to identify and manage its interest rate risk profile. The model is based
on expected cash flows and repricing characteristics for all financial
instruments and incorporates market-based assumptions regarding the impact of
changing interest rates on these financial instruments. Assumptions based on the
historical behavior of deposit rates and balances in relation to changes in
interest rates are also incorporated into the model. These assumptions are
inherently uncertain and, as a result, the model cannot precisely measure net
interest income or precisely predict the impact of fluctuations in interest
rates on net interest income. Actual results will differ from simulated results
due to timing, magnitude, and frequency of interest rate changes as well as
changes in market conditions and management strategies. The Company has
experienced no significant changes in market risk due to changes in interest
rates since the Company's Annual Report on Form 10-K as of December 31, 2002,
dated March 14, 2003, as filed with the Securities and Exchange Commission.
Management also uses a static gap analysis to identify and manage the Company's
interest rate risk profile. Interest sensitivity gap ("gap") analysis measures
the difference between the assets and liabilities repricing or maturing within
specific time periods.
Item 4. Controls and Procedures
Under the supervision and with the participation of the Company's management,
including the Chief Executive Officer and Chief Financial Officer, the Company
has evaluated the effectiveness of the design and operation of its disclosure
controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the
Exchange Act) as of the end of the period covered by this quarterly report.
Based upon that evaluation, the Chief Executive Officer and Chief Financial
Officer concluded that, as of the end of the period covered by this quarterly
report, the Company's disclosure controls and procedures are effective to ensure
that information required to be disclosed in the reports that the Company files
or submits under the Securities Exchange Act of 1934 is recorded, processed,
summarized and reported, within the time periods specified in the Securities and
Exchange Commission's rules and forms. There has been no change in the Company's
internal control over financial reporting during the most recent fiscal quarter
that has materially affected, or is reasonably likely to materially affect, the
Company's internal control over financial reporting.
25
PART II -- OTHER INFORMATION
Item 2. Changes in Securities
(c) On October 22, 2001 the Company acquired the Burke Group, Inc.
("BGI"). BGI's shareholders received cash and shares of the
Company's Common Stock which were not registered under the
Securities Act of 1933 in reliance upon the exemption provided in
Section 4(2) of the Act. On April 1, 2003 the Company issued an
additional 62,387 shares of its Common Stock to BGI's former
shareholders based on BGI's achievement of performance criteria for
the period ending December 31, 2002 also in reliance upon the
exemption provided in Section 4(2) of the Securities Act.
Item 4. Submission of Matters to a Vote of Security Holders
At the Company's Annual Meeting of Shareholders held May 7, 2003,
shareholders elected the directors listed below for a term of three years. The
voting results were as follows:
Number of Votes
---------------
Broker
Nominee For Withheld Abstain Non-Votes
- ------- --- -------- ------- ---------
Bryan G. vonHahmann 8,743,925 405,052 -- --
John R. Tyler, Jr. 8,713,088 435,889 -- --
James H. Wyckoff 8,415,255 733,722 -- --
James E. Stitt 8,739,425 409,552 -- --
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits.
Exhibit 11.1 Computation of Per Share Earnings*
Exhibit 31.1 Certification Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002
Exhibit 31.2 Certification Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002
Exhibit 32.1 Certification Pursuant to 18 U.S.C. Section 1350,
as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
Exhibit 32.2 Certification Pursuant to 18 U.S.C. Section 1350,
as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
* Data required by Statement of Financial
Accounting Standards No. 128, Earnings per
Share, is provided in note 4 to the
consolidated financial statements in this
report.
(b) Reports on Form 8-K.
Pursuant to Regulation FD under item 9, the Company filed a Form 8-K
on April 17, 2003.
26
Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
August 14, 2003 FINANCIAL INSTITUTIONS, INC.
Date Signatures
- ---- ----------
August 14, 2003 /s/ Peter G. Humphrey
----------------------------------
Peter G. Humphrey
President, Chief Executive Officer
(Principal Executive Officer),
Chairman of the Board and Director
August 14, 2003 /s/ Ronald A. Miller
----------------------------------
Ronald A. Miller
Senior Vice President
and Chief Financial Officer
(Principal Accounting Officer)
27