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EX-23 - EXHIBIT 23 - VSB BANCORP INCex_23.htm
EX-21 - EXHIBIT 21 - VSB BANCORP INCex_21.htm
EX-31.1 - EXHIBIT 31.1 - VSB BANCORP INCex31_1.htm
EX-32.1 - EXHIBIT 32.1 - VSB BANCORP INCex32_1.htm
EX-32.2 - EXHIBIT 32.2 - VSB BANCORP INCex32_2.htm
EX-31.2 - EXHIBIT 31.2 - VSB BANCORP INCex31_2.htm

 UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2010
 
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD

COMMISSION FILE NUMBER 0-50237

VSB Bancorp, Inc.
(Exact name of registrant as specified in its charter)
 
New York
(State or other jurisdiction of incorporation or organization)
 
11 - 3680128
(I. R. S. Employer Identification No.)
 
4142 Hylan Boulevard, Staten Island, New York 10308
(Address of principal executive offices)
 
(718) 979-1100
Issuer’s telephone number
 
Common Stock
(Title of Class)
 
Indicate by check mark whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act 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 o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K o.
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer o
Accelerated Filer o
Non-Accelerated Filer o
Smaller Reporting Company x
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):
Yes o No x

The aggregate market value of the voting stock held by non-affiliates of the registrant at June 30, 2010 was $15,186,204.

Number of shares of the registrant’s common stock outstanding as of March 10, 2011: 1,825,009 shares.
 
 
 

 
 
Documents incorporated by reference:

Portions of the registrant’s definitive proxy statement filed on or about March 28, 2011 into Part III of this Form 10-K.

Forward-Looking Statements

When used in this Form 10-K, or in any written or oral statement made by us or our officers, directors or employees, the words and phrases “will result,” “expect,” “will continue,” “anticipate,” “estimate,” “project,” or similar terms are intended to identify “forward-looking statements.” A variety of factors could cause our actual results and experiences to differ materially from the anticipated results or other expectations expressed in any forward-looking statements. Some of the risks and uncertainties that may affect our operations, performance, development and results, the interest rate sensitivity of our assets and liabilities, and the adequacy of our loan loss allowance, include, but are not limited to:
 
 
deterioration in local, regional, national or global economic conditions which could result in, among other things, an increase in loan delinquencies, a decrease in property values, or a change in the real estate turnover rate;
 
changes in market interest rates or changes in the speed at which market interest rates change;
 
changes in laws and regulations affecting the financial service industry;
 
changes in the public’s perception of financial institutions in general and banks in particular;
 
changes in competition; and
 
changes in consumer preferences by our customers or the customers of our business borrowers.
 
Please do not place undue reliance on any forward-looking statement, which speaks only as of the date made. There are many factors, including those described above, that could affect our future business activities or financial performance and could cause our actual future results or circumstances to differ materially from those we anticipate or project. We do not undertake any obligation to update any forward-looking statement after it is made.
 
 
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PART I

Item 1. Description of Business.

Business of VSB Bancorp, Inc.

VSB Bancorp, Inc. (referred to using terms such as “we,” “us,” or the “Company”) became the holding company for Victory State Bank (the “Bank”), a New York chartered commercial bank, upon the completion of a reorganization of the Bank into the holding company form of organization. The reorganization was effective in May 2003. All the outstanding stock of Victory State Bank was exchanged for stock of VSB Bancorp, Inc. on a three for two basis so that the stockholders of Victory State Bank became the owners of VSB Bancorp, Inc. and VSB Bancorp, Inc. owns all the stock of Victory State Bank. The common stock we issued in the transaction qualifies as exempt securities under Section 3(a)(12) of the Securities Act of 1933. Our primary business is owning all of the issued and outstanding stock of the Bank. Our common stock is listed on the NASDAQ Global Market. We trade under the symbol “VSBN”.

The main office of the Company and the Bank is at 4142 Hylan Boulevard, Staten Island, New York 10308, telephone (718) 979-1100. We maintain an Internet web site at www.victorystatebank.com.

Victory State Bank

Victory State Bank is a New York State chartered commercial bank, founded in November 1997. The Bank is supervised by the New York State Banking Department and the Federal Deposit Insurance Corporation (“FDIC”). The Bank’s principal business has been and continues to be attracting commercial deposits from primarily the general public and investing those deposits, together with funds generated from operations and repayments on existing investments, primarily in loans for business purposes and investment securities. The Bank’s revenues are derived principally from interest on our commercial loan and investment securities portfolios. The Bank’s primary sources of funds are deposits and principal and interest payments on loans and investment securities.

Victory State Bank serves its primary market of Staten Island, New York through its five banking offices. The Bank opened its original main office in the Oakwood section of Staten Island in November 1997 which was closed in February 2007 as the lease expired at that location; its first branch was opened in the West Brighton section of Staten Island in June 1999; its second branch in the St. George section of Staten Island in January 2000; its third branch in the Dongan Hills section of Staten Island in December 2002 and its fourth branch in the Rosebank section of Staten Island in April 2006. In February 2007, the Bank opened its new main office in the Great Kills section of Staten Island. The Bank’s deposits are insured by the Federal Deposit Insurance Corporation up to the maximum amounts permitted by law. Victory State Bank also serves its customers through its website, www.victorystatebank.com.

Market Area and Competition

Victory State Bank has been, and continues to be, a community-oriented, state-chartered commercial bank offering a variety of traditional financial services to meet the needs of the communities in which it operates. Management considers our reputation for customer service as its major competitive advantage in attracting and retaining customers in its market area.

Our primary market area is concentrated in the neighborhoods surrounding our branches in the New York City Borough of Staten Island. Management believes that our branch offices are located in communities that can generally be characterized as stable, residential neighborhoods of predominantly one- to four-family residences and middle income families.

From 1990 to 2000, Staten Island’s population grew to 443,728 from 378,977, or a 17% increase. According to U.S. Census Department estimates, this growth rate has slowed, with the population estimated to have increased by only an additional 10.8% through July 1, 2009. The decline in the growth rate has itself accelerated, with the Census Department’s estimated year to year rate of increase generally declining throughout this decade. There was a modest shift from the 20 to 44 year age group to the 45 to 64 year age group during the decade of the 1990s. As a percentage of population, the 45 to 64 year age group increased from 19.8% to 23.4% during the decade. The Census Department estimates that this trend continued through at least 2009, when the 45 to 64 year age group increased to 27.1% of the total population. The largest age group continued to be the 20 to 44 age group, at 34.6% of total population in 2009, down from 37.0% in 2000.
 
 
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However, the population news is not all negative when compared to the rest of New York State. Most notably, Staten Island fairs the highest among all 62 New York Counties when natural internal population growth is excluded and migration into the county is estimated. The U.S. Census estimates that net migration into the county was the highest in the entire state. Only 27 counties had an estimated net migration into the county during the period from the end of the 2000 census through July 1, 2009, and Staten Island was the best of those.

Median household income increased to $55,039 from $50,064 during the decade of the 90’s. Per capita income in 1999 was $23,905 in Staten Island, slightly higher than $23,389, the per capita income of New York State. One third of the households in Staten Island had household income of more than $75,000 in 1999. These income levels compare favorably with the national household median of $41,994 and the national per capita median of $21,587. The Census Department has not published comparable data for recent years, but management believes that median household income continues to be strong and that these income levels in Staten Island provide satisfactory support for personal home ownership, in turn supporting the home building industry, which is a major industry focus for Victory State Bank. However, recent economic disruption will have an adverse effect on local income levels because of increased unemployment, a reduction in wage increases, and possible wage reductions for employed persons. Although according to the United States Bureau of Labor Statistics, the unemployment rate in Staten Island and the New York metro area is below the national average, the unemployment rate has stabilized in the past year and may increase in the future as financial service firms and public sector employers report continuing layoffs.

Until the recent decline in the residential housing market, the median sales price of existing single family homes increased steadily from 2000 through 2006. According to the New York State Association of Realtors, the median price increased from $211,000 to $425,000 during that period. According to a report by the Center for an Urban Future, this means that the cost of a single family home on Staten Island is now out of reach to many middle-class families. As the population grew during the 1990s, total housing units increased as well, to 163,993 in 2000, as compared to 139,726 in 1990, an increase of 17.4%. However, perhaps confirming the reduction in affordability to the middle class, the growth in housing units has slowed, with an estimated 180,104 housing units at June 30, 2009, an increase of 9.9% since April 1, 2000. This slowing growth presents challenges to management because of our focus on the home building industry and related sectors of the local economy.

Declines in the residential housing market in the past few years creates problems faced by Staten Island, its residents and its businesses. According to Zillow.com, a real estate information service, the estimated median home value has increased 3.1% in the past year. Although there was an increase in the past year, the overall home values are still substantially lower than in 2007. The Center for an Urban Future report already noted an increase in foreclosures on Staten Island during 2006 which exceeded the increase in the rest of New York City. The decline in the price of homes and the economic downturn may accelerate this increase in foreclosed properties, which could exacerbate the decline in real estate values.

The New York City metropolitan area has a high density of financial institutions, many of which are significantly larger and have greater financial resources than we have, and all of which are our competitors to varying degrees. Our competition for loans comes principally from commercial banks, savings banks and insurance companies. Our most direct competition for deposits has come from commercial banks and savings banks. In addition, we face competition for deposits from non-bank institutions such as brokerage firms and insurance companies in such areas as short-term money market funds, corporate and government securities funds, mutual funds and annuities.
 
 
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Risk Factors

Bank lending is an inherently risky business. A substantial portion of our assets are invested in loans, and loans necessarily present many risks. We must first rely on our borrowers to repay their loans, and if they are unable to do so, we must rely on the value of the collateral, if any, for the loan. Changing business conditions, increases in unemployment, personal problems that a borrower may experience, changes in the regulations that apply to a borrower’s business, changes in the political climate or in public policy, and many other factors outside our control, could adversely affect the ability of our borrowers to repay their loans or the value of the collateral we have received. Although we seek to reduce these risks through underwriting procedures that we believe are prudent, it is impossible for us to completely eliminate the risks which arise from making loans except by eliminating our lending operations.

The current turmoil in the economy in general and among financial institutions in particular could adversely affect our customers and thus have an indirect adverse effect on us. The economy in the United States, including the economy in Staten Island, was, and may still be, in a recession. There is substantial stress on many financial institutions and financial products. The federal government has intervened by making hundreds of billions of dollars in capital contributions to the banking industry. We draw a substantial portion of our customer base from local businesses, especially those in the building trades and related industries. Some of our customers have been adversely affected by the economic downturn, and if the recession continues, or the recovery is slow, it will become more difficult for us to conduct prudent and profitable business in our community.

Making permanent residential mortgage loans is not a material part of our business, and our investments in mortgage-backed securities and collateralized mortgage obligations have been made with a view towards avoiding the types of securities that are backed by low quality mortgage-related assets. However, one of the primary focuses of our local business is receiving deposits from, and making loans to, businesses involved in the construction and building trades industry on Staten Island. Construction loans represented a significant component of our loan portfolio, reaching 39.8% of total loans at year end 2005. As we monitored the economy and the strength of the local construction industry, we elected to reduce our portfolio of construction loans, which totaled 7.2% of total loans at December 31, 2010. However, developers and builders provide not only a source of loans, but they also provide us with deposits and other business. If the weakness in the economy continues or worsens, then that could have a substantial adverse effect on our customers and potential customers, making it more difficult for us to find satisfactory loan opportunities and low-cost deposits. This could compel us to invest in lower yielding securities instead of higher-yielding loans and could also reduce low cost funding sources such as checking accounts and require that we replace them with higher cost deposits such as time deposits. Either or both of those shifts could reduce our net income.

Fluctuations in interest rates could have an adverse affect on our profitability. Our principal source of income is the difference between the interest income we earn on interest-earning assets, such as loans and securities, and our cost of funds, principally interest paid on deposits. These rates of interest change from time to time, depending upon a number of factors, including general market interest rates. However, the frequency of the changes varies among different types of assets and liabilities. For example, for a five-year loan with an interest rate based upon the prime rate, the interest rate may change every time the prime rate changes. In contrast, the rate of interest we pay on a five-year certificate of deposit adjusts only every five years, based upon changes in market interest rates.

In general, during periods of changing market interest rates, the interest rates we pay on deposits adjust more slowly than the interest rates we earn on loans because our loan portfolio consists primarily of loans with interest rates that fluctuate based upon the prime rate. In contrast, although many of our deposit categories have interest rates that could adjust immediately, such as interest checking accounts and savings accounts, changes in the interest rates on those accounts are at our discretion. Thus, the rates on those accounts, as well as the rates we pay on certificates of deposit, tend to adjust more slowly. As a result, the declines in market interest rates that occurred through the end of 2008 initially had an adverse effect on our net income because the yields we earn on our loans declined more rapidly than our cost of funds. However, many of our prime-based loans had minimum interest rates, or floors, below which the interest rate does not decline despite further decreases in the prime rate. As our loans reached their interest rate floors, our loan yields stabilized while our deposit costs continued to decline. This had a positive effect on our net interest income. When market interest rates begin increasing, which we expect will occur at some point in the future, we anticipate an initial adverse effect on our net income. We anticipate that this will occur because our deposit rates should begin to rise while loan yields remain relatively steady until the prime rate increases sufficiently that our loans begin to reprice above their interest rate floors. Once our loan rates exceed the interest rate floors, increases in market interest rates should increase our net interest income because our cost of deposits should probably increase more slowly than the yields on our loans. However, customer preferences and competitive pressures may negate this positive effect because customers may choose to move funds into higher-earning deposit types as higher interest rates make them more attractive, or competitors offer premium rates to attract deposits. We also have a substantial portfolio of investment securities with fixed rates of interest, most of which are mortgage-backed securities with an estimated average life of not more than 5 years.
 
 
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The limited trading market for our common stock may make it difficult for stockholders to sell their stock for full value. Our common stock is listed on the NASDAQ Global Market, which listing was effective on August 4, 2008. We continue to trade under the symbol “VSBN.” We listed on the Global Market in the hope that it would increase the trading market in our stock and make it easier for individuals to buy and sell our stock. However, our stock does not trade every day and the average daily trading volume is limited. During the twelve months ended February 28, 2011, there were trades reported on only 77 out of 253 trading days, or less than one out of every three trading days. Our average daily trading volume during that period was 591 shares for all trading days and 1,942 shares per day for the 77 days on which trades occurred. During the twelve months ended February 28, 2011, 11.4% of all reported trading volume represented stock repurchases by us pursuant to our announced stock repurchase programs. We currently have approximately 149 stockholders of record and we believe based upon reports we have received from broker/dealers, that there are approximately an additional 250 stockholders who own their shares in street name.

The geographic concentration of our loans increases the risk that adverse economic conditions could affect our net income. Substantially all of our loans are mortgage loans on property located in Staten Island, New York, or loans to residents of or businesses on Staten Island. Staten Island has experienced an economic down turn in recent years. In addition, due to the importance of the home building trade on Staten Island, the recent adverse conditions in the residential real estate market has had an additional negative impact on many local businesses that make up our core customer base. A continued economic slow-down or decline in the local economy could have an adverse effect on us for a number of reasons. Adverse economic conditions could hurt the ability of our borrowers to repay their loans. If real estate values decline, reductions in the value of real estate collateral could make it more difficult for us to recover the full amount due on loans which go into default. Furthermore, economic difficulties can also increase deposit outflows as customers must use savings to pay bills. This could increase our cost of funds because of the need to replace the deposit outflow. All of these factors might combine to reduce significantly our net income.

Adverse financial results of other financial institutions could adversely affect our net income or our reputation. In the past three years, there have been many failures and near-failures among financial institutions. The number of FDIC-insured banks that have failed has increased, and the FDIC insurance fund reserve ratio, representing the ratio of the fund to the level of insured deposits, has declined due to losses caused by bank failures. As a result, the FDIC has increased its deposit insurance premiums on remaining institutions, including well-capitalized institutions like Victory State Bank, in order to replenish the insurance fund. If bank failures continue to occur, and more so if the level of failures increases, the FDIC insurance fund will further decline, and the FDIC is likely to continue to impose higher premiums on healthy banks. Thus, despite the prudent steps we may take to avoid the mistakes made by other banks, our costs of operations may increase as a result of those mistakes by others.

Our FDIC regular insurance premium was $345,226 in 2010 compared to $268,015 in 2009 (excluding the $101,950 special assessment described below), an increase of 28.8%. The FDIC also imposed a special assessment in 2009 on all FDIC-insured banks equal to 5 basis points on total assets minus Tier 1 capital. Our special assessment in 2009 amounted to $101,950. As required by The Dodd –Frank Wall Street Reform and Consumer Protection Law (the “Dodd-Frank” Act), the FDIC has recently revised its deposit insurance premium assessment rates. Our Bank, even though we are in the lowest regulatory risk category, will be subject to an assessment rate between five (5) and nine (9) basis points per annum. In general, the rates are applied to our bank’s total assets less tangible capital, in contrast to the former rule which applied the assessment rate to our level of deposits.
 
 
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Despite the deposit insurance premium change and the special assessment, the fund created to pay the cost of resolving failed banks currently has a negative balance. The Dodd-Frank Act requires that the FDIC must increase the ratio of the FDIC insurance fund to estimated total insured deposits to 1.35% by September 30, 2020. The FDIC believes that most banks will pay a lower total assessment under the new system than under the former system, and it appears likely that will apply to Victory State Bank. However, if bank failures in the future exceed FDIC estimates, or other estimates that the FDIC makes turn out to be incorrect, and the losses to the insurance fund increase, the FDIC could be forced to increase insurance premiums. Such an increase would increase our non-interest expense.

Changes in the federal or state regulation of financial institutions could have an adverse effect on future operations. Federal and New York State banking laws and regulations have a substantial, regular and every-day effect on our business. Federal and state regulatory authorities have extensive discretion in connection with their supervision of Victory State Bank, such as the right to impose restrictions on operations and the insistence that we increase our allowance for loan losses. Any change in the regulatory structure or statutes or regulations applicable to banks, bank holding companies, or their competitors, whether by the Congress, the FDIC, the Federal Reserve System, the New York State legislature, the New York State Banking Department or any other regulator, could have a material impact on our operations and profitability.

The substantial decline in the national housing market and the advent of the increase in bank failures over the past few years has spawned many statutes and regulations affecting Banks, including the 2,000+ pages of the Dodd-Frank Act and the hundreds of regulations adopted or to be adopted to implement its provisions. There are constantly new proposals to further change the laws that affect our business. Notably, the Dodd-Frank Act creates a Consumer Financial Protection Bureau that will have broad authority to restrict our flexibility in dealing with consumer transactions and our ability to charge fees for bank services. The final implementation of the Dodd-Frank Act through regulatory enactments and the actions of the Consumer Financial Protection Bureau could have a significant negative effect on our income and our expenses in a manner and a level that we cannot predict.

There have recently been changes at both the state and the federal level in the laws and regulations applicable to residential mortgage lenders and other entities in the residential real estate business. We are not a residential mortgage lender and we do not expect that these proposals, if adopted, will have a direct negative effect on us. However, the proposals could reduce residential development, increase the cost of housing, and restrict the ability of small local businesses in that sector to compete with larger companies with greater resources. That could have an adverse effect on our customer base. Furthermore, proposals to permit what are commonly known as “cram downs” in bankruptcies involving residential mortgage loans could have a direct adverse effect on the value of the collateral for existing residential mortgage loans, and thus an indirect effect on mortgage-backed securities in which we invest.

Delays in foreclosure proceedings may adversely affect our ability to realize upon the value of collateral. The length of time it takes to prosecute a foreclosure action and be able to sell real estate collateral in New York has substantially lengthened. It is not unusual for it to take more than a full year from the date a foreclosure action is commenced until the property is sold even in uncontested cases, and some uncontested cases can take as long as two years. This problem, if it continues or gets worse, could have a substantial adverse effect on the value of the Bank’s collateral for loans in default. Especially in the case of construction loans, where property value deterioration during a lengthy foreclosure is more likely, the inability to realize upon collateral increases the loss to the Bank in the event of a default.

We operate in an extremely competitive environment. We operate in one of the most competitive environments for financial products in the world. Many of the world’s largest financial institutions have offices in our local communities, and they have far greater financial resources than we have. Furthermore, in 2010, federal law was changed to allow any bank, regardless of where it is headquartered, to open a branch throughout most of the United States, and now Staten Island is open to unrestricted branching. This could increase competition.
 
 
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The loss of key personnel could impair our future success. Our future success depends in part on the service of our executive officer, other key management officers, as well as our staff, and our ability to continue to attract, motivate, and retain additional highly qualified employees. The loss of one or more of our key personnel or our inability to timely recruit replacements for such personnel, or otherwise attract, motivate, or retain qualified personnel could have an adverse effect on our business, operating results and financial condition.

Lending Activities

Loan Portfolio Composition. Our loan portfolio consists primarily of commercial mortgage loans and unsecured commercial loans. Unsecured commercial loans include loans with personal guaranties or personal obligations in all cases, and, in some cases, may also include loans with illiquid personal property collateral. At December 31, 2010, we had total unsecured commercial loans outstanding of $12,924,378, or 15.8% of total loans, and commercial real estate loans of $58,204,596, or 71.1% of total loans. There were $5,874,500 of construction loans secured by real estate, $5,387,500 of which were construction loans to businesses for the construction of either commercial property or residential property for sale, representing 6.6% of total loans. Other loans in our portfolio principally included commercial loans secured by assets other than real estate totaling $1,393,532 or 1.7% of total loans at December 31, 2010; residential mortgage loans of $2,460,114, or 3.0% of total loans and consumer non-mortgage loans of $533,860 or 0.7% of total loans. Although we generally do not make traditional permanent residential mortgage loans, we occasionally make residential mortgage loans to the principals of commercial customers. For the year ended December 31, 2010, approximately $61,645,509, or 75.4%, of loans for business purposes had adjustable interest rates based on the prime rate of interest.

The following table sets forth the composition of our loan portfolio in dollar amounts and in percentages at the dates indicated. None of these loans are loans to or in foreign countries.
 
      At December 31,  
   
2010
 
2009
 
2008
 
2007
 
2006
 
       
%
     
%
     
%
     
% of
     
% of
 
      Amount  
of Total
  Amount  
of Total
 
Amount
 
of Total
 
Amount
 
Total
 
Amount
 
Total
 
                                           
Commercial loans:
                                         
Commercial secured
  $ 1,393,532   1.7 % $ 1,138,308   1.4 % $ 1,177,796   1.8 % $ 1,171,152   1.9 % $ 1,231,880   1.8 %
Commercial unsecured
    12,924,378   15.8     10,966,874   13.9     9,558,296   14.4     10,981,044   17.5     10,882,002   16.3  
Total commercial loans
    14,317,910   17.5     12,105,182   15.3     10,736,092   16.2     12,152,196   19.4     12,113,882   18.1  
Real Estate loans:
                                                   
Commercial
    58,204,596   71.1     48,767,729   61.7     39,918,879   60.1     31,607,039   50.6     33,215,627   49.9  
Residential
    2,460,114   3.0     2,914,956   3.7     2,548,159   3.8     2,314,716   3.7     165,801   0.2  
Total real estate loans
    60,664,710   74.1     51,682,685   65.4     42,467,038   63.9     33,921,755   54.3     33,381,428   50.1  
Construction loans:
                                                   
Commercial
    5,387,500   6.6     10,964,000   13.9     10,996,432   16.5     13,585,698   21.7     17,552,797   26.4  
Owner occupied one-to-four family
    487,000   0.6     2,294,000   2.9     900,000   1.4     1,523,895   2.4     1,825,000   2.7  
Total construction loans
    5,874,500   7.2     13,258,000   16.8     11,896,432   17.9     15,109,593   24.1     19,377,797   29.1  
Other loans:
                                                   
Consumer loans
    533,860   0.7     532,498   0.7     599,293   0.9     566,356   0.9     826,528   1.2  
Other loans
    386,750   0.5     1,455,224   1.8     757,481   1.1     827,122   1.3     974,278   1.5  
Total other loans
    920,610   1.2     1,987,722   2.5     1,356,774   2.0     1,393,478   2.2     1,800,806   2.7  
                                                     
Total loans
    81,777,730   100.0 %   79,033,589   100.0 %   66,456,336   100.0 %   62,577,022   100.0 %   66,673,913   100.0 %
                                                     
Less:
                                                   
Unearned discounts, net and deferred loan fees, net
    239,506         199,433         209,684         203,944         263,236      
Allowance for loan losses
    1,277,220         1,063,454         987,876         927,161         1,128,824      
Loans, net
  $ 80,261,004       $ 77,770,702       $ 65,258,776       $ 61,445,917       $ 65,281,853      
 
 
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The following table sets forth our loan originations and principal repayments for the periods indicated. We did not purchase or sell any loans in 2010, 2009 or 2008.

   
Year Ended
   
Year Ended
   
Year Ended
 
   
December 31,
   
December 31,
   
December 31,
 
   
2010
   
2009
   
2008
 
Commercial Loans (gross):
                 
At beginning of period
  $ 12,105,182     $ 10,736,092     $ 12,152,196  
Commercial loans originated:
                       
Secured
    1,484,940       1,178,006       1,841,943  
Unsecured
    34,313,999       30,778,779       30,451,244  
Total commercial loans
    35,798,939       31,956,785       32,293,187  
Principal repayments
    (33,586,211 )     (30,587,695 )     (33,709,291 )
At end of period
  $ 14,317,910     $ 12,105,182     $ 10,736,092  
                         
Real Estate loans:
                       
At beginning of period
  $ 51,682,685     $ 42,467,038     $ 33,921,755  
Real estate loans originated:
                       
Commercial
    21,034,000       16,934,000       12,217,500  
Residential
          535,000       4,180,000  
Total real estate loans
    21,034,000       17,469,000       16,397,500  
Principal repayments
    (12,051,975 )     (8,253,353 )     (7,852,217 )
At end of period
  $ 60,664,710     $ 51,682,685     $ 42,467,038  
Construction loans
                       
At beginning of period
  $ 13,258,000     $ 11,896,432     $ 15,109,593  
Construction loans originated
    4,460,000       5,938,000       8,422,000  
Principal repayments
    (11,843,500 )     (4,576,432 )     (11,635,161 )
At end of period
  $ 5,874,500     $ 13,258,000     $ 11,896,432  
Other loans (gross):
                       
At beginning of period
  $ 1,987,722     $ 1,356,774     $ 1,393,478  
Other loans originated
    479,555       798,536       769,067  
Principal repayments
    (1,546,667 )     (167,588 )     (805,771 )
At end of period
  $ 920,610     $ 1,987,722     $ 1,356,774  
 
Loan Maturity. The following table shows the contractual maturity of our loans at December 31, 2010. As we have decreased construction loans as a percentage of our loan portfolio and increased other real estate mortgage loans, we have increased the average contractual maturity of our loan portfolio. However, to limit interest rate risk, we have continued to concentrate our efforts principally on the origination of loans with adjustable interest rates and minimum interest rate floors.

      At December 31, 2010  
   
Commercial
   
Commercial
               
Other
       
   
Unsecured
   
Secured
   
Construction
   
Real Estate
   
Loans
   
Total
 
Amounts due:
                                   
Within one year
  $ 8,452,240     $ 1,042,114     $ 3,454,500     $ 10,672,348     $ 433,298     $ 24,054,500  
After one year:
                                               
One to five years
    4,332,005       351,418       2,420,000       8,429,312       487,312       16,020,047  
After five years
    140,133                   41,563,050             41,703,183  
Total amount due
    12,924,378       1,393,532       5,874,500       60,664,710       920,610       81,777,730  
                                                 
Less:
                                               
Unearned fees
          342       40,585       198,579             239,506  
Allowance for loan losses
    520,953       13,486       52,138       660,536       30,107       1,277,220  
Loans, net
  $ 12,403,425     $ 1,379,704     $ 5,781,777     $ 59,805,595     $ 890,503     $ 80,261,004  

 
9

 
 
The following table sets forth at December 31, 2010, the dollar amount of all loans, due after December 31, 2011, and whether such loans have fixed or variable interest rates.
 
   
Due After December 31, 2011
 
   
Fixed
   
Variable
   
Total
 
                   
Commercial Business Loans:
                 
Unsecured
  $ 104,080     $ 4,368,058     $ 4,472,138  
Secured
    152,520       198,898       351,418  
Real Estate
                       
Commercial
    6,897,071       51,307,525       58,204,596  
Residential
    2,460,114             2,460,114  
Construction
          2,420,000       2,420,000  
Other loans
    487,312             487,312  
Total loans
  $ 10,101,097     $ 58,294,481     $ 68,395,578  
 
Commercial Business Lending. We originate commercial business loans directly to the professional and business community in our market area. We target small to medium sized businesses and professionals such as lawyers, doctors and accountants. Applications for commercial business loans are obtained primarily from the efforts of our directors and senior management, who have extensive contacts in the local business community, or from branch referrals. As of December 31, 2010, commercial business loans totaled $14,317,910 or 17.5% of total loans.

Commercial business loans we originate generally have terms of five years or less and have adjustable interest rates tied to the Wall Street Journal Prime Rate plus a margin. A majority of our commercial business loans have terms of less than one year and one of the challenges facing management is the constant effort to originate commercial business loans as existing loans are repaid. Such loans may be secured or unsecured. Secured commercial business loans can be collateralized by receivables, inventory and other assets. All these loans are either loans to individuals for which they have personal liability or loans to entities backed by the personal guarantee of principals of the borrower. The loans generally have shorter maturities and higher yields than real estate mortgage loans. Management has extensive experience in originating commercial business loans within our marketplace.

Commercial business loans generally carry the greatest credit risks of the loans in our portfolio because repayment is more dependent on the success of the business operations of the borrower. Some of these loans are unsecured and those that are secured frequently have collateral that rapidly depreciates or is difficult to control in the event of a default.

Commercial Real Estate Lending. We originate commercial real estate loans that are generally secured by properties used for business purposes such as retail stores, other mixed-use (business and residential) properties, restaurants, light industrial buildings and small office buildings located in our primary market area. Our commercial real estate loans are generally made in amounts up to 70% of the appraised value of the property. These loans are most commonly made with terms up to five years with interest rates that adjust to 100 or 150 basis points above the floating prime rate, but we have recently increased our guidelines to include 20 year fully amortizing loans. A significant portion of these loans are subject to an interest rate floor ranging between 7.00% and 8.00%. Our underwriting standards consider the collateral of the borrower, the net operating income of the property and the borrower’s expertise, credit history and profitability. We require personal guarantees from the borrower or the principals of the borrowing entity. At December 31, 2010, our commercial real estate loans totaled $60,664,710, or 74.1% of total loans.
 
Loans secured by commercial real estate are generally larger and have traditionally been considered to involve greater risks than one-to-four family residential mortgage loans, but generally lesser risks than commercial business loans. Because payments on loans secured by commercial real estate properties are often dependent on the successful operation and management of the properties, repayment of such loans may be subject to adverse conditions in the real estate market or the economy, to a greater extent than other types of loans. We seek to minimize these risks through our lending policies and underwriting standards, which restrict new originations of such loans to our primary lending area and qualify such loans on the basis of the property’s income stream, collateral value and debt service ratio.
 
 
10

 
 
Construction Lending. Our construction loans primarily have been made to builders and developers to finance the construction of one- to four-family residential properties and, to a lesser extent, multi-family residential and commercial use real estate properties. Our policies provide that construction loans may be made in amounts up to the lesser of 80% of the total hard and soft costs of the project. We generally require personal guarantees. Construction loans generally are made with prime-based interest rates with terms up to 18 months. Loan proceeds are disbursed in increments as construction progresses and as inspections warrant. At December 31, 2010, our construction loans totaled $5,874,500 or 7.2% of total loans. This represents a reduction of our construction loan portfolio over the past three years as economic conditions in the construction industry caused us to be more cautious in originating these loans while also reducing the number of satisfactory loan opportunities available to us.

Construction loans on non-owner occupied real estate generally carry greater credit risks than permanent mortgage loans on comparable completed properties because their repayment is more dependent on the borrower’s ability to sell or rent units under construction and the general as well as local economic conditions. Because payments on construction loans are often dependent on the successful completion of construction project and the management of the project, repayment of such loans may be subject to adverse conditions in the real estate market or the economy, to a greater extent than other types of loans. In addition, in the event of a default, buildings under construction may deteriorate rapidly and it may be more difficult to realize upon the value of the building compared to an existing building that is ready for occupancy or already rented to third party tenants.

Loan Approval Procedures and Authority. All unsecured loans in excess of $250,000 and all secured loans over $400,000 are reviewed and approved by the Loan Committee, which consists of seven directors of Victory State Bank, prior to commitment. Smaller loans may be approved by underwriters designated by the Bank’s Chief Executive Officer. Consumer loans not secured by real estate and unsecured consumer loans, depending on the amount of the loan and the loan to value ratio, where applicable, require the approval of the Bank’s Chief Lending Officer and/or Chief Executive Officer.

Upon receipt of a completed loan application from a prospective borrower, we order a credit report and we verify other information. If necessary, we request additional financial information. An independent appraiser we designate performs an appraisal of the real estate intended to secure the proposed loan. The Board of Victory State Bank annually approves the independent appraisers and approves the Bank’s appraisal policy. It is our policy to obtain title insurance on all real estate first mortgage loans and on substantially all subordinate mortgage loans. Borrowers must also obtain hazard insurance prior to closing. Some borrowers are required to make monthly escrow deposits which we then use to pay items such as real estate taxes.

Delinquencies and Classified Assets

Delinquent Loans. Our collection procedures for mortgage loans include sending a past due notice at 15 days and a late notice after payment is 30 days past due. In the event that payment is not received after the late notice, letters are sent or phone calls are made to the borrower. We attempt to obtain full payment or work out a repayment schedule with the borrower to avoid foreclosure. Generally, we authorize foreclosure proceedings when a loan is over 90 days delinquent. We record property acquired in foreclosure as real estate owned at the lower of its appraised value less costs to dispose, or cost. We cease to accrue interest on all loans 90 days past due and reverse all accrued but unpaid interest when the loan becomes non-accrual. We continue to accrue interest on construction loans that are 90 days past the maturity date of the loan if we expect the loan to be paid in full in the next 60 days and all interest is paid up to date.

The collection procedures for non-mortgage other loans generally include telephone calls to the borrower after ten days of the delinquency and late notices at 15 and 25 days past due. Letters and telephone calls generally continue until the matter is referred to a collection attorney or resolved. After the loan is 90 days past due, the loan is referred to counsel and is written-off.
 
 
11

 

Classified Assets. Federal regulations and our Loan Review and Risk Rating Policy provide for the classification of loans and other assets we consider to be of lesser quality as “Substandard”, “Doubtful” or “Loss” assets. An asset is considered “Substandard” if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. “Substandard” assets include those characterized by the “distinct possibility” that the insured institution will sustain “some loss” if the deficiencies are not corrected. Assets classified as “Doubtful” have all of the weaknesses inherent in those classified “Substandard” with the added characteristic that the weaknesses present make “collection or liquidation in full,” on the basis of currently existing facts, conditions, and values, “highly questionable and improbable.” Assets classified as “Loss” are those considered “uncollectible” and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. Assets which do not currently expose us to sufficient risk to warrant classification but which possess weaknesses are designated “Special Mention” by management.

At December 31, 2010, we had twenty three (23) loans, in the aggregate amount of $4,739,884, designated as special mention. We had twenty one (21) loans, in the aggregate amount of $7,937,828, classified as substandard, nineteen of which, in the aggregate amount of $7,900,122, are secured by real estate. At December 31, 2009, special mention loans totaled $11,191,987 and substandard loans totaled $4,098,640. The Bank actively monitors all special mention loans to seek to avoid deterioration in the quality of the loan. The Bank is actively collecting the substandard loans and expects to collect substantially all the amounts due. We had no loans classified as doubtful or loss at December 31, 2010.

When we classify an asset as Substandard or Doubtful, we provide, as part of our general allowance for loan losses, an amount management deems prudent to recognize the risks pertaining to the asset. A general allowance represents a loss allowance which has been established to recognize the inherent risk associated with lending activities, but which, unlike a specific allowance, has not been allocated to particular problem assets. When we classify an asset as “Loss,” we either establish a specific allowance for losses equal to 100% of the amount of the asset or charge off that amount.

Victory State Bank’s Loan Review Officer and Board of Directors regularly review problem loans and review all classified assets on a quarterly basis. We believe our policies are consistent with the regulatory requirements regarding classified assets. Our determination as to the classification of our assets and the amount of our valuation allowances is subject to review by the New York State Banking Department and the FDIC, which can order the establishment of additional general or specific loss allowances.

The following table sets forth delinquencies in our loan portfolio at the dates indicated:

      At December 31, 2010  
   
60-89 Days
   
90 Days or more
 
   
Number
   
Principal
    Number    
Principal
 
                                 
Commercial real estate
    2     $ 277,960       12     $ 4,064,281  
Commercial unsecured
    2       42,708       2       37,706  
Real Estate - Residential
                3       2,276,306  
Total
    4     $ 320,668       17     $ 6,378,293  
Delinquent loans to total loans
            0.39 %             7.80 %

      At December 31, 2009  
   
60-89 Days
   
90 Days or more
 
   
Number
   
Principal
   
Number
   
Principal
 
                                 
Commercial real estate
    9     $ 3,848,990       7     $ 1,176,114  
Commercial construction
                2       480,000  
Commercial unsecured
    4       61,907       1       41,037  
Real Estate - Residential
    3       2,299,322              
Total
    16     $ 6,210,219       10     $ 1,697,151  
Delinquent loans to total loans
            7.86 %             2.15 %

 
12

 
 
    At December 31, 2008  
   
60-89 Days
   
90 Days or more
 
   
Number
   
Principal
   
Number
   
Principal
 
                                 
Commercial real estate
    2     $ 207,047       5     $ 1,453,846  
Commercial construction
                2       480,000  
Commercial unsecured
                7       345,221  
Total
    2     $ 207,047       14     $ 2,279,067  
Delinquent loans to total loans
            0.31 %             3.43 %

    At December 31, 2007  
   
60-89 Days
   
90 Days or more
 
   
Number
   
Principal
   
Number
   
Principal
 
                                 
Commercial real estate
    2     $ 1,406,936       3     $ 459,371  
Commercial construction
    2       2,944,000       6       2,505,134  
Commercial unsecured
    1       300,000       2       14,970  
Other
                1       5,877  
Total
    5     $ 4,650,936       12     $ 2,985,352  
Delinquent loans to total loans
            7.43 %             4.77 %

    At December 31, 2006  
   
60-89 Days
   
90 Days or more
 
   
Number
   
Principal
   
Number
   
Principal
 
                                 
Commercial real estate
        $       3     $ 773,924  
Commercial unsecured
    2       29,648       1       20,709  
Other
    1       9,676              
Total
    3     $ 39,324       4     $ 794,633  
Delinquent loans to total loans
            0.06 %             1.19 %

Loans 90 days or more past due represent non-accrual loans and loans that are contractually past due maturity but are still accruing interest. Loans past due 90 or more and still on accrual were $0 for 2010, 2009 and 2008, $2,025,000 for 2007 and $585,000 for 2006.

Non-performing Assets. The following table sets forth information about our non-performing assets at December 31, 2010, 2009 and 2008.

   
At December 31,
   
At December 31,
   
At December 31,
 
   
2010
   
2009
   
2008
 
Non-performing assets:
                 
Commercial loans:
                 
Unsecured
  $ 37,706     $ 41,037     $ 345,221  
Commercial real estate
    4,064,281       1,176,114       1,453,846  
Residential real estate
    2,276,306              
Construction
          480,000       480,000  
                         
Total non-performing assets
  $ 6,378,293     $ 1,697,151     $ 2,279,067  
                         
Non-performing loans to total loans
    7.80 %     2.15 %     3.43 %
Non-performing loans to total assets
    2.71 %     0.72 %     1.07 %
Non-performing assets to total assets
    2.71 %     0.72 %     1.07 %

 
13

 
 
The gross interest income that would have been recorded in 2010 if the non-accrual loans had been current in accordance with their original terms was $469,484. The amount of interest income on those loans that was included in net income for 2010 was $344,630.

The following table sets forth the aggregate carrying value of our assets classified as Substandard, Doubtful and Loss according to asset type:
 
    At December 31, 2010  
   
Substandard
   
Doubtful
 
   
Number
   
Amount
   
Number
   
Amount
 
Classification of assets:
                       
Commercial Loans:
                       
Unsecured
    2     $ 37,706           $  
Commercial Real Estate
    16       5,623,816              
Residential Real Estate
    3       2,276,306              
Total loans
    21     $ 7,937,828              
 
No assets were classified as Loss at year end 2010 or 2009.
 
Non-Performing Loans

Management closely monitors non-performing loans and other assets with potential problems on a regular basis. We had seventeen non-performing loans, totaling $6,378,293 at December 31, 2010, compared to ten non-performing loans, totaling $1,697,151, at December 31, 2009. We believe that the increase was the result of the effect of adverse economic conditions on some of our borrowers. The following is information about the seven largest non-performing loans, totaling $5,517,790, or 86.5% of our non-performing loans, in outstanding principal balance at December 31, 2010. Management believes it has taken appropriate steps with a view towards maximizing recovery and minimizing loss, if any, on these loans.
 
 
$2,403,245 in two loans to a retail business, which are fully secured by commercial real estate collateral. We have entered into a modified repayment arrangement with the borrower and we have obtained confessions of judgment. We have collected a large portion of their arrears and the borrower has agreed to pay all remaining arrears over the upcoming year. The borrower is current in payments under the modified payment terms. We maintain the personal guaranties of the principals on these loans.
 
$2,200,000 in two residential mortgage loans that are fully secured. We have entered into modified repayment arrangements with the borrowers and we have obtained confessions of judgment. We have collected a large portion of their arrears and the borrowers have agreed to pay all remaining arrears over the upcoming year. The borrowers are current in payments under the modified payments terms.
 
$371,818 in a loan to a local business in which we are a participant in the loan with another bank. We are not the lead lender. The loan is in arrears and the lead lender has commenced a foreclosure action. The loan is secured by a first mortgage on a commercial building, a security interest in the business, and the personal guaranties of the principals.
 
$270,787 in a net loan to a local business, which is secured by a first mortgage on commercial real estate collateral. We have entered into modified repayment arrangements with the borrowers and we have obtained confessions of judgment. We maintain a security interest in the business as well as the personal guaranty of the principal. The borrower is current under the modified payments terms.
 
$271,940 in a net loan to a local business, which is secured by a first mortgage on two parcels of commercial real estate. The loan has been sent to our attorneys for collection. We also have a security interest in the business as well as the personal guaranty of the principal.

 
14

 
 
From time to time, as in the case of the first two loan relationships described above, the Bank will enter into agreements with borrowers to modify the terms of their loans when we believe that a modification will maximize our recovery. In most cases, we do not agree to reduce the rate of interest or forgive the repayment of principal when we agree to loan modification, and we did not do so in any of the modifications described above. Instead, we seek to modify terms on an interim basis to allow the borrower to reduce payments for a short duration and thus give the borrower an opportunity to get back on its feet.

If loans with modifications are on non-accrual status when they are modified, we do not immediately restore them to accruing status. For those loans, as well as other loans on non-accrual status when the borrower makes payments, we initially record payments received either as a reduction of principal or as interest received on a cash basis. The choice between those alternatives depends upon the magnitude of the concessions, if any, we have given to the borrower, the nature of the collateral and the related loan to value ratio, and other factors affecting the likelihood that we will continue to receive regular payments. After a period of consistent on-time performance, the loan may be restored to accruing status. The length of on-time performance required to restore a loan to accruing status varies from a minimum of six months on loans with minor modifications or less-severe weaknesses to as long as a year or more on loans for which we have granted more significant concessions to the borrower or which otherwise have more significant weaknesses.

Allowance for Loan Losses

It is our policy to provide a valuation allowance for probable incurred losses on loans based on our past loan loss experience, known and inherent risks in the loan portfolio, adverse situations which may affect the borrower’s ability to repay, estimated value of underlying collateral and current economic conditions in our lending area. The allowance is increased by provisions for loan losses charged to earnings and is reduced by charge-offs, net of recoveries. While management uses available information to estimate losses on loans, future additions to the allowance may be necessary based upon any changes in economic conditions or if our loan portfolio increases. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance for loan losses. Such agencies may require the Bank to recognize additions to the allowance based on judgments different from those of management. Management believes, based upon all relevant and available information, that the allowance for loan losses is appropriate.

When analyzing whether the level of the allowance for loan losses is appropriate, management considers performing loans in our loan portfolio that have no material identified weaknesses. Management establishes an amount equal to a fixed percentage of the performing loans in each of our five principal loan categories to be included in the allowance to cover inherent weaknesses in the broad category of loans. The fixed percentages are based upon historical loss experience in each category, the state of the economy, special risks in that particular category, and other factors that management deems relevant. Management also analyzes each loan that has been identified as having specific weaknesses to determine the appropriate level of the allowance for that loan. This analysis considers both the general factors which are considered in assessing performing loans as well as specific facts pertinent to each loan, such as collateral value, borrower’s income and ability to repay, payment history, the reasons for and length of the delinquency, and the value of any credit support. Although loans may be analyzed individually or in groups to determine the allowance, the entire allowance is available for any losses that occur.

One important data point in evaluating the appropriateness of the allowance as it relates to problem real estate loans is the value of the real estate collateral. A loan is considered a problem loan when we believe it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. Those loans generally include loans past due at least 90 days and loans otherwise classified as Substandard or Doubtful as described above. For problem real estate loans over $100,000, we obtain a new appraisal of the real estate at least annually. For smaller loans, we take the original appraisal and adjust the valuation based upon changing conditions, if any. We then adjust the value for costs of sale and carrying costs to measure the weakness in the loan as part of our overall evaluation of the appropriateness of our allowance for loan losses.
 
 
15

 

In order to assist in determining the appropriate allowance, an independent loan review firm, senior management and the Bank’s Board of Directors review the allowance for loan losses quarterly. If they determine that the allowance is inappropriate, then management increases or decreases the provision for loan losses to bring the allowance to the appropriate level.

As of December 31, 2010, our allowance for loan losses was $1,277,220 or 1.56% of total loans. Based upon all relevant and presently available information, management believes that the allowance for loan losses is appropriate. We continue to monitor and modify the level of the allowance for loan losses in order to maintain the allowance at a level which management considers appropriate.

The following table sets forth the activity in our allowance for loan losses:
 
   
For the Year Ended December 31,
 
   
2010
   
2009
   
2008
   
2007
   
2006
 
                               
Allowance for Loan Losses:
                             
Balance at beginning of period
  $ 1,063,454     $ 987,876     $ 927,161     $ 1,128,824     $ 1,153,298  
Charge-offs:
                                       
Real estate loans:
                                       
Commercial
          (110,241 )                  
Commercial loans:
                                       
Unsecured
    (15,765 )     (412,112 )     (483,326 )     (254,986 )     (62,181 )
Consumer loan
    (4,863 )     (18,606 )     (7,959 )           (17,511 )
Other loans
    (2,084 )     (15,679 )     (3,503 )     (8,639 )     (28,111 )
Total charge-offs
    (22,712 )     (556,638 )     (494,788 )     (263,625 )     (107,803 )
Recoveries
    96,478       72,216       270,503       66,962       148,329  
Net (charge-offs) / recoveries
    73,766       (484,422 )     (224,285 )     (196,663 )     40,526  
Provision charged to income
    140,000       560,000       285,000       (5,000 )     (65,000 )
Balance at end of period
  $ 1,277,220     $ 1,063,454     $ 987,876     $ 927,161     $ 1,128,824  
                                         
Ratio of net charge-offs / (recoveries) during the period to average loans outstanding during the period
    -0.09 %     0.68 %     0.35 %     0.32 %     -0.06 %
Ratio of allowance for loan losses to total loans at the end of period
    1.56 %     1.35 %     1.49 %     1.48 %     1.69 %
Ratio of allowance for loan losses to non-performing loans at the end of the period
    20.02 %     62.66 %     43.35 %     96.56 %     538.61 %
Ratio of allowance for loan losses to non-performing assets at the end of the period
    20.02 %     62.66 %     43.35 %     96.56 %     538.61 %
 
The following table sets forth the allocation of our allowance for loan losses among each of the categories listed.

   
At December 31,
   
At December 31,
   
At December 31,
   
At December 31,
   
At December 31,
 
   
2010
   
2009
   
2008
   
2007
   
2006
 
         
% of Loans
         
% of Loans
         
% of Loans
         
% of Loans
         
% of Loans
 
         
in Category
         
in Category
         
in Category
         
in Category
         
in Category
 
         
to
         
to
         
to
         
to
         
to
 
   
Amount
   
Total Loans
   
Amount
   
Total Loans
   
Amount
   
Total Loans
   
Amount
   
Total Loans
   
Amount
   
Total Loans
 
                                                             
Allowance:
                                                           
Commercial loans:
                                                           
Unsecured
  $ 520,953     15.8 %   $ 460,474     13.9 %   $ 372,803     14.4 %   $ 330,355     17.5 %   $ 337,054     16.3 %
Secured
    13,486     1.7       8,124     1.4       7,451     1.8       19,877     1.9       10,859     1.8  
Commercial real estate
    653,362     71.1       418,215     61.7       449,525     60.1       345,407     50.6       518,620     49.9  
Residential real estate
    7,174     3.0       40,302     3.7       25,686     3.8       15,887     3.7       12,501     0.2  
Construction loans
    52,138     7.2       71,968     16.8       100,737     17.9       166,437     24.1       198,901     29.1  
Other loans
    30,107     1.2       64,371     2.5       31,674     2.0       49,198     2.2       50,889     2.7  
Total allowances
  $ 1,277,220     100.0 %   $ 1,063,454     100.0 %   $ 987,876     100.0 %   $ 927,161     100.0 %   $ 1,128,824     100.0 %

 
16

 
 
Investment Activities

State-chartered banking institutions have the authority to invest in various types of liquid assets, including United States Treasury Obligations, securities of various federal agencies, certain certificates of deposits of insured banks and savings institutions, certain bankers’ acceptances, repurchase agreements and federal funds. Additionally, it is appropriate for us to maintain investments for ongoing liquidity needs and we have maintained liquid assets at a level believed to be adequate to meet our normal daily activities.

Our investment policy, established by the Board of Directors of Victory State Bank and implemented by its Asset/Liability Committee, attempts to provide and maintain liquidity, generate a favorable return on investments without incurring undue interest rate and credit risk, and complement our lending activities. Although we classify most of our securities portfolio as available for sale, it is our practice to retain most of our securities until they mature.

Our policies generally limit investments to government and federal agency securities or AAA rated securities, including corporate debt obligations, which are investment grade with weighted average lives of seven years or less. Our policies provide that all investment purchases be ratified by the Bank’s Board and may only be initiated by the President or Chief Financial Officer of the Bank. Investment securities consist of collateralized mortgage obligations (“CMO”) with estimated average lives, based upon prepayment assumptions that management believes are reasonable, of 4.5 years or less, mortgage-backed securities (“MBS”) with maturities of seven years or less and U.S. Agency notes with a maturity of less than 15 years. These CMOs and MBSs are backed by federal agencies such as Federal National Mortgage Association (“FNMA”) and the Federal Home Loan Mortgage Corporation (“FHLMC”) or are “AAA” rated whole loan securities. No investment securities in our portfolio have experienced ratings down grades. At December 31, 2010, we had investment securities with a cost basis of $118,655,349 and a fair value of $121,307,907. All investment securities at December 31, 2010, were either CMOs or MBSs. The entire investment portfolio at December 31, 2010 was classified as available for sale and is accounted on a fair value basis with changes in fair value included as other comprehensive income.

The following table sets forth certain information regarding the amortized cost and fair values of the investment securities, available for sale portfolio at the dates indicated. The excess of fair value over amortized cost at year end 2010 is the result of the effect of recent low market interest rates on the value of previously-purchased investment securities. If market interest rates were to increase, we anticipate that this excess would decrease and, under certain circumstances depending upon the timing of securities purchases and the rate of increase in interest rates, amortized cost may exceed fair value.

    At December 31,  
   
2010
   
2009
   
2008
 
   
Amortized
   
Fair
   
Amortized
   
Fair
   
Amortized
   
Fair
 
   
Cost
   
Value
   
Cost
   
Value
   
Cost
   
Value
 
                                     
Investments securities, available for sale
                                   
FNMA
  $ 3,428,696     $ 3,571,217     $ 4,855,213     $ 5,040,820     $ 6,646,320     $ 6,690,593  
FHLMC
                            37,411       37,643  
GNMA
    4,092,912       4,081,112       1,265,428       1,321,240       1,576,764       1,632,790  
Whole Loan MBS
    1,212,246       1,235,501       1,860,603       1,856,893       2,620,965       2,559,037  
Collateralized mortgage obligations
    109,921,495       112,420,077       102,933,529       105,693,451       108,331,330       109,368,525  
                                                 
    $ 118,655,349     $ 121,307,907     $ 110,914,773     $ 113,912,404     $ 119,212,790     $ 120,288,588  

 
17

 
 
The table below sets forth certain information regarding the amortized cost, weighted average yields and stated maturities of our investment securities at December 31, 2010 and 2009.

    At December 31, 2010  
       
Weighted
     
Weighted
     
Weighted
     
Weighted
     
   
Less Than
 
Average
 
1 To 5
 
Average
 
5 To 10
 
Average
 
Over 10
 
Average
     
   
1 Year
 
Yield
 
Years
 
Yield
 
Years
 
Yield
 
Years
 
Yield
 
Total
 
                                               
Investment Securities:
                                             
FNMA
  $ 576,009   4.22 %   $ 477,176   5.17 %   $ 1,302,618   4.71 %   $ 1,072,893   2.69 %   $ 3,428,696  
FHLMC
                                     
GNMA
                    1,023,986   4.47       3,068,926   1.46       4,092,912  
Whole Loan MBS
                    1,212,246   4.84               1,212,246  
Collateralized Mortgage Obligations
            953,858   5.69       24,826,571   4.61       84,141,066   3.28       109,921,495  
                                                         
Total
  $ 576,009   4.22 %   $ 1,431,034   5.52 %   $ 28,365,421   4.62 %   $ 88,282,885   3.21 %   $ 118,655,349  
 
    At December 31, 2009  
       
Weighted
     
Weighted
     
Weighted
     
Weighted
     
   
Less Than
 
Average
 
1 To 5
 
Average
 
5 To 10
 
Average
 
Over 10
 
Average
     
   
1 Year
 
Yield
 
Years
 
Yield
 
Years
 
Yield
 
Years
 
Yield
 
Total
 
                                               
Investment Securities:
                                             
FNMA
  $   %   $ 1,390,603   4.49 %   $ 1,682,752   4.42 %   $ 1,781,857   3.95 %   $ 4,855,212  
FHLMC
                                     
GNMA
                    1,265,428   4.38               1,265,428  
Whole Loan MBS
                    1,860,603   4.64               1,860,603  
Collateralized Mortgage Obligations
            1,941,530   4.82       37,530,714   4.43       63,461,286   4.32       102,933,530  
                                                         
Total
      %   $ 3,332,133   4.68 %   $ 42,339,497   4.44 %   $ 65,243,143   4.31 %   $ 110,914,773  
 
Source of Funds

General. Deposits are the primary source of our funds for use in lending, investing and for other general purposes. In addition to deposits, we obtain funds from principal repayments and prepayments on loans and securities. Loan and securities repayments are a relatively stable source of funds, while deposit inflows and outflows as well as unscheduled prepayments are influenced by general interest rates and money market conditions.

Deposits. We offer a variety of deposit accounts having a range of interest rates and terms. Our deposits consist of non-interest bearing checking accounts, money market accounts, time deposit (“certificate”) accounts, statement savings and NOW accounts. The flow of deposits is influenced significantly by general economic conditions, changes in money market rates, prevailing interest rates and competition. Our deposits are obtained primarily from the areas in which our offices are located. We do not actively solicit certificate accounts in excess of $100,000, nor do we use brokers to obtain deposits. However, in connection with our efforts in establishing banking development districts in Staten Island, we accept large balance municipal deposits as part of the New York State and New York City banking development district programs. These municipal deposits total $35 million, are at a subsidized rate, and mature on a quarterly or an annual basis. There can be no assurance that the Bank will be able to retain these municipal deposits or be able to renew them at subsidized rates as compared to current market rates at that time. Management constantly monitors our deposit accounts and, based on historical experience, management believes it will retain a large portion of such accounts upon maturity. Deposit account terms we offer vary according to the minimum balance required, the time periods that the funds must remain on deposit and the interest rates, among other factors. In determining the characteristics of the deposit account programs we offer, we consider potential profitability, matching terms of the deposits with loan products, the attractiveness to the customers and the rates offered by our competitors.
 
 
18

 

Our focus on customer service, primarily for the business and professional community in our marketplace, has facilitated our retention of non-interest bearing checking accounts and low costing NOW and savings accounts, which generally have interest rates substantially less than certificate of deposits. At December 31, 2010, these types of low cost deposit accounts amounted to $116,484,532, or 55.2% of total deposits.

The following table presents deposit activity for the periods indicated.

   
Year Ended
   
Year Ended
   
Year Ended
 
   
December 31,
   
December 31,
   
December 31,
 
   
2010
   
2009
   
2008
 
                   
Beginning balance
  $ 210,986,086     $ 188,109,449     $ 176,334,443  
Net increase/(decrease) before interest credited
    (4,600,492 )     21,511,428       9,646,073  
Interest credited on deposits
    1,021,063       1,365,209       2,128,933  
                         
Ending balance
  $ 207,406,657     $ 210,986,086     $ 188,109,449  
 
The following table provides information regarding the remaining term to maturity of our time deposits over $100,000 at December 31, 2010:

Maturity Period
 
Amount
 
       
Three months or less
  $ 34,689,845  
Over three through six months
    14,833,103  
Over six through 12 months
    2,174,782  
Over 12 months
    910,059  
Total
  $ 52,607,789  
 
The following table presents by various rate categories, the amount and the periods to maturity of the certificate accounts outstanding at December 31, 2010.

         
Over Six Mos.
   
Over One Year
   
Over Two Years
             
   
Six Months
   
Through One
   
Through Two
   
Through Three
   
Over Three
       
   
And Less
   
Year
   
Years
   
Years
   
Years
   
Total
 
Certificate accounts:
                                   
0.00% to 0.99%
  $ 38,209,021     $ 770,867     $ 148,918     $     $ 2,212,222     $ 41,341,028  
1.00% to 1.99%
    15,664,184       3,034,746       710,535       469,163       36,000       19,914,628  
2.00% to 2.99%
    137,683             108,608             1,361,132       1,607,423  
3.00% to 3.99%
                      404,000             404,000  
4.00% to 4.99%
    208,825       21,902       147,156                   377,883  
    $ 54,219,713     $ 3,827,515     $ 1,115,217     $ 873,163     $ 3,609,354     $ 63,644,962  
 
Borrowings

We do not routinely utilize borrowings as a source of funds. At December 31, 2010 and 2009, we had no outstanding borrowings.

Personnel

As of December 31, 2010, we had 45 full-time employees and 18 part-time employees. These employees are not represented by a collective bargaining unit and we consider our relationship with our employees to be good.
 
 
19

 

REGULATION AND SUPERVISION

Regulation of VSB Bancorp, Inc.

VSB Bancorp, Inc., is a New York corporation and is subject to and governed by the New York Business Corporation Law. It is a bank holding company and thus is subject to regulation, supervision, and examination by the Federal Reserve.

Bank Holding Company Regulation. As a bank holding company, we are required to file periodic reports and other information with the Federal Reserve and the Federal Reserve may conduct examinations of us.

We are subject to capital adequacy guidelines of the Federal Reserve. The guidelines apply on a consolidated basis and require bank holding companies to maintain a minimum ratio of Tier 1 capital to total assets of 4.0%. The minimum ratio is 3.0% for the most highly rated bank holding companies. The Federal Reserve’s capital adequacy guidelines also require bank holding companies to maintain a minimum ratio of qualifying total capital to risk-weighted assets of 8.0%, and a minimum ratio of Tier 1 capital to risk-weighted assets of 4.0%. As of December 31, 2010, the ratio of Tier 1 capital to total assets was 10.13%, the ratio of Tier 1 capital to risk-weighted assets was 25.20%, and the ratio of qualifying total capital to risk-weighted assets was 26.45%.

Our ability to pay dividends can be restricted if overall capital falls below levels established by the Federal Reserve’s guidelines.

Federal Reserve approval is required if we seek to acquire direct or indirect ownership or control of 5% or more of the voting shares of a bank or bank holding company. We must obtain Federal Reserve approval before we acquire all or substantially all the assets of a bank or merge or consolidate with another bank holding company. These provisions also would apply to a bank holding company that sought to acquire 5% or more of the common stock of or to merge or consolidate with us.

Bank holding companies like us may not engage in activities other than banking and activities so closely related to banking or managing or controlling banks as to be a proper incident thereto. Federal Reserve regulations contain a list of permissible non-banking activities that are closely related to banking or managing or controlling banks and the Federal Reserve has identified a limited number of additional activities by order. These activities include lending activities, certain data processing activities, and securities brokerage and investment advisory services, trust activities and leasing activities. A bank holding company must file an application or a notice with the Federal Reserve prior to acquiring more than 5% of the voting shares of a company engaged in such activities. A bank holding company that is well capitalized and well managed and meets other conditions may provide notice after making the acquisition.

We have the right to elect to be treated as a financial holding company if the Bank is well capitalized and well managed and has at least a satisfactory record of performance under the Community Reinvestment Act. Financial holding companies that meet certain conditions may engage in activities that are financial in nature or incidental to financial activities, or activities that are complementary to a financial activity and do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally. Federal law identifies certain activities that are deemed to be financial in nature, including non-banking activities currently permissible for bank holding companies to engage in both within and outside the United States, as well as insurance and securities underwriting and merchant banking activities. The Federal Reserve may identify additional activities that are permissible financial activities. No prior notice to the Federal Reserve is required for a financial holding company to acquire a company engaged in these activities or to commence these activities directly or indirectly through a subsidiary.

We have not elected to be treated as a financial holding company since we have no current plans to use the authority to engage in expanded activities. However, we may elect to do so in the future.
 
 
20

 

The Dodd-Frank Wall Street Reform and Consumer Protection Law

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Law was adopted. It has been described as the greatest legislative change in the supervision of financial institutions since the 1930s. Its effect on Victory State Bank and VSB Bancorp, Inc. cannot now be judged with certainty because the law requires over 200 regulatory rulemakings and over 50 agency studies. However, we believe that the following areas, among others, will be or may be significant to our future operations:
 
 
1.
The law exempts smaller reporting companies filing with the Securities and Exchange Commission, such as our company, from the internal controls attestation rules of Section 404(b) of the Sarbanes-Oxley Act. Thus far, we have incurred expenses to prepare for compliance but we have not been governed by Section 404(b) due to temporary SEC extensions of the compliance deadline. The permanent exemption means that we will not be required to incur the expense of actual compliance as long as we continue to qualify as a smaller reporting company.
     
 
2.
Securities brokers may not vote shares held in “street name” unless they receive instructions from their customers on the election of directors, executive compensation or any other significant matter, as determined by the SEC. This may increase our costs of holding annual stockholder meetings if it becomes necessary for us to retain the services of a proxy solicitor to increase shareholder participation in our meetings or to obtain approval of matters that the Board presents to stockholders.
     
 
3.
At least every three years, we will be required to submit to our stockholders, for a non-binding vote, our executive compensation. This requirement may increase the cost of holding some stockholder meetings. The law also requires that the SEC implement other requirements for enhanced compensation disclosures. The SEC adopted a temporary exemption for smaller reporting companies, such as our company, until annual meetings occurring on or after January 21, 2013.
     
 
4.
The law includes a number of changes to expand FDIC insurance coverage, as well as changes to the premiums banks must pay for insurance coverage, and the requirements applicable to the reserve ratio (the ratio of the deposit insurance fund to the amount of insured deposits). One important change is that, in the future, deposit insurance premiums we pay will be based upon total assets minus tangible capital, rather than based upon deposits. Since we do not use material borrowings to provide funds for asset growth, and we do not have material intangible assets that are excluded from capital such as goodwill, we anticipate that our share of the total deposit premiums to be collected may decrease as the result of this change. However, other factors, such as required replenishment of the current reserve fund, which has a negative reserve ratio and which must be increased to 1.35% of total insured deposits in the next ten years, as well as future failures of banks that may further deplete the fund, may result in an increase in our future deposit insurance premium. The FDIC must provide an offset for smaller banks negating the adverse effect of requiring a reserve ratio in excess of 1.15%, but reaching even the 1.15% ratio may require additional burdens on smaller banks. The FDIC approved final regulations implementing these changes on February 25, 2011, effective April 1, 2011. According to the FDIC, the substantial majority of banks will see reduced deposit insurance premiums as a result of the new rules. We believe that will be the case for us as long as all other relevant factors remain unchanged.
     
 
5.
The law increases the amount of each customer’s deposits that are subject to FDIC insurance. The general limit has been permanently increased from $100,000 to $250,000. In addition, non-interest bearing transaction accounts will be fully insured, without limit, from December 31, 2010 to January 1, 2013.
     
 
6.
The law repeals the prohibition on paying interest on demand deposit accounts, effective in July 2011. Interest-free demand deposits represent a substantial portion of our deposit base. Once the prohibition on paying interest on such deposits becomes effective, competitive pressures may require that we offer interest checking accounts to businesses in order to retain deposits. That could have a direct adverse effect on our cost of funds. Although current market interest rates are very low, and such deposits are unlikely to carry high rates of interest, an increase in market interest rates could result in significant additional costs in order to maintain the level of such deposits.
 
 
21

 
 
 
7.
The law makes interstate branching by banks much easier than in the past. We have no plans to branch outside New York State, but the law facilitates out of state banks branching into our market area, thus increasing competition.
     
 
8.
The law creates a new federal agency – the Consumer Financial Protection Bureau– which will have substantial authority to regulate consumer financial transactions. Our loans are primarily made to businesses rather than individual consumers, so the bureau will not have a direct effect on many of our loan transactions. However, the bureau also has authority to regulate other non-loan consumer transactions, such as deposits and electronic banking transactions. The implementation of new consumer regulations may increase our operating costs in a manner we cannot predict until regulations are adopted.
 
Statutory Restrictions on Acquisition of VSB Bancorp, Inc., and Victory State Bank

Applicable provisions of the New York Banking Law, the federal Bank Holding Company Act, and other federal statutes, restrict the ability of persons or entities to acquire control of a bank holding company. Under the Change in Bank Control Act, persons who intend to acquire control of a bank holding company, either directly or indirectly or through or in concert with one or more persons must give 60 days’ prior written notice to the Federal Reserve. “Control” would exist when an acquiring party directly or indirectly has voting control of at least 25% of our voting securities or the power to direct our management or policies. Under Federal Reserve regulations, a rebuttable presumption of control would arise with respect to an acquisition where, after the transaction, the acquiring party has ownership control, or the power to vote at least 10% (but less than 25%) of our common stock.

The New York Banking Law requires prior approval of the New York Banking Board before any action is taken that causes any company to acquire direct or indirect control of a banking institution that is organized in the State of New York. The term “control” is defined generally to mean the power to direct or cause the direction of the management and policies of the banking institution and is presumed to exist if the company owns, controls or holds with power to vote 10% or more of the voting stock of the banking institution.

Section 912 of the New York Business Corporation Law, known as the New York Anti-Takeover Law, restricts the ability of interested stockholders to engage in business combinations with a New York corporation. In general terms, Section 912 prohibits any New York corporation covered by the statute from merging with an interested shareholder (i.e., one who owns 20% or more of the outstanding voting stock) for five years following the date on which the interested shareholder first acquired 20% of the stock, unless before that date the Board of Directors of the corporation had approved either the merger or the interested shareholder’s stock purchase.

Section 912 defines an interested stockholder as the beneficial owner, directly or indirectly, of 20% or more of the outstanding voting stock of a corporation; and certain other entities that have owned 20% or more of a corporation’s stock during the past five years. A business combination is defined as a merger, consolidation, sale of 10% or more of the assets, or similar transaction.

Unless an interested stockholder waits five years after becoming an interested stockholder to engage in a business combination, the business combination is prohibited unless our Board of Directors has approved either (a) the business combination or (b) the acquisition of stock by the interested stockholder, before the interested stockholder acquired its 20% interest. Even though the interested stockholder waits five years, the business combination is prohibited unless either:
 
(i)           the business combination or the acquisition of stock by the interested stockholder was approved by the Board of Directors before the interested stockholder acquired its 20% interest;
 
 
22

 

(ii)           the business combination is approved by a majority vote of all outstanding shares of stock not beneficially owned by the interested stockholder or its affiliates or associates at a meeting held at least five years after the interested stockholder becomes an interested stockholder; or

(iii)           the price paid for common stock acquired in the business combination is, in general terms, at least as much as the greater of (a) highest price paid by the interested stockholder for any stock since the interested stockholder first owned 5% of the stock of the corporation, or (b) the market value of the stock as of the date of announcement of the business combination; and the price paid for stock other than common stock is subject to comparable minimum standards.

Regulation of Victory State Bank

The Bank is subject to extensive regulation and examination by the New York State Banking Department (“Department”), as its chartering authority, and by the FDIC, as the insurer of its deposits. The federal and state laws and regulations which are applicable to banks regulate, among other things, the scope of their business, their investments, their reserves against deposits, the timing of the availability of deposited funds and the nature and amount of and collateral for certain loans. The Bank must file reports with the Department and the FDIC concerning its activities and financial condition, in addition to obtaining regulatory approvals prior to entering into certain transactions such as establishing branches and mergers with, or acquisitions of, other depository institutions. There are periodic examinations by the Department and the FDIC to test the Bank’s compliance with various regulatory requirements. This regulation and supervision establishes a comprehensive framework of activities in which an institution can engage and is intended primarily for the protection of the insurance fund and depositors. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such regulation, whether by the Department, the FDIC or as a result of the enactment of legislation, could have a material adverse impact on the Bank and its operations.

Capital Requirements

The FDIC imposes capital adequacy standards on state-chartered banks, which, like the Bank, are not members of the Federal Reserve System.

The FDIC’s capital regulations establish a minimum 3.0% Tier I leverage capital requirement for the most highly-rated state-chartered, non-member banks, with an additional cushion of at least 100 basis points for all other state-chartered, non-member banks, which effectively will increase the minimum Tier I leverage ratio for such other banks to 4.0%. Under the FDIC’s regulation, the highest-rated banks are those that the FDIC determines are not anticipating or experiencing significant growth and have well diversified risk, including no undue interest rate risk exposure, excellent asset quality, high liquidity, good earnings and, in general, which are considered a strong banking organization and are rated composite 1 under the Uniform Financial Institutions Rating System. Tier I or core capital is defined as the sum of common stockholders’ equity (including retained earnings), non-cumulative perpetual preferred stock and related surplus, and minority interests in consolidated subsidiaries, minus all intangible assets other than certain qualifying supervisory goodwill and certain mortgage servicing rights.

The FDIC also requires that banks meet a risk-based capital standard. The risk-based capital standard for banks requires the maintenance of a ratio of total capital (which is defined as Tier I capital and supplementary capital) to risk-weighted assets of 8.0% and Tier I capital to risk-weighted assets of 4%. In determining the amount of risk-weighted assets, all assets, plus certain off-balance sheet assets, are multiplied by a risk-weight of 0% to 100%, based on the risks the FDIC believes are inherent in the type of asset or item. The components of Tier I capital are the same as for the leverage capital standard. The components of supplementary capital include certain perpetual preferred stock, certain mandatory convertible securities, certain subordi­nated debt and intermediate preferred stock and general allowances for loan and lease losses. Allowance for loan and lease losses includable in supplementary capital is limited to a maximum of 1.25% of risk-weighted assets. Overall, the amount of capital counted toward supplementary capital cannot exceed 100% of core capital.
 
 
23

 
 
The FDIC has an additional, higher capital level, known as well-capitalized. In order to be classified as well-capitalized, a bank must have a Tier 1 leverage ratio of at least 5%, a Tier 1 risk-based capital ratio of at least 6% and a total risk-based capital ratio of at least 10%. Furthermore, anecdotal evidence indicates that in recent regulatory examinations and in informal discussions with regulators the FDIC has been urging banks to maintain even higher levels of capital during the current period of economic difficulty.
 
At December 31, 2010, the Bank exceeded all of the capital ratio standards for a well-capitalized bank.

The following table shows the Bank’s actual capital amounts and ratios.

                       
To be well-capitalized
             
For capital
 
under prompt corrective
    Actual  
adequacy purposes
 
action provisions
   
Amount
 
Ratio
 
Amount
 
Ratio
 
Amount
 
Ratio
                               
As of December 31, 2010
                             
  Tier 1 Capital                                    
 (to Average Assets)
  $ 24,062,000   9.96 %   $ 9,664,133   4.00 %   $ 12,080,167   5.00 %
  Tier 1 Capital                                     
(to Risk Weighted Assets)
    24,062,000   24.63 %     3,907,400   4.00 %     5,861,100   6.00 %
  Total Capital                                    
(to Risk Weighted Assets)
    25,284,000   25.88 %     7,814,800   8.00 %     9,768,500   10.00 %
 
There have been a number of recent proposals and suggestions by regulators, politicians and commentators that the capital ratio standards should be increased. Our current capital ratios are more than sufficient to satisfy any reasonably anticipated increase. However, an increase in the amount of capital that the Bank must maintain in order to support a given level of assets would reduce the amount of leverage that our capital could support. This might adversely affect our ability to increase our level of interest-earning assets.

Activities and Investments of New York-Chartered Banks.

The Bank derives its lending, investment and other authority primarily from the applicable provisions of New York State Banking Law and the regulations of the Department, as limited by FDIC regulations and other federal laws and regulations. See “Activities and Investments of FDIC Insured State-Chartered Banks” below. These New York laws and regulations authorize the Bank to invest in real estate mortgages, consumer and commercial loans, certain types of debt securities, including certain corporate debt securities and obligations of federal, State and local governments and agencies, and certain other assets. A bank’s aggregate lending powers are not subject to percentage of asset limitations, although there are limits applicable to single borrowers. A New York-chartered bank may also exercise trust powers upon approval of the Department. The Bank does not have trust powers.

The New York Banking Board has the power to adopt regulations that enable state chartered banks to exercise the rights, powers and privileges permitted for a national bank. The Bank has not engaged in material activities authorized by such regulations.
 
 
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With certain limited exceptions, the Bank may not make loans or extend credit for commercial, corporate or business purposes (including lease financing) to a single borrower, the aggregate amount of which would be in excess of 15% of the Bank’s net worth, on an unsecured basis, and 25% of the net worth if the excess is collateralized by readily marketable collateral or collateral otherwise having a value equal to the amount by which the loan exceeds 15% of the Bank’s net worth. Theses limits do not apply to loans made by VSB Bancorp, Inc. directly at the holding company level. The Bank currently complies with all applicable loans-to-one-borrower limitations and VSB Bancorp, Inc. has not made any loans in its own name except for its loan to its Employee Stock Ownership Plan.

Activities and Investments of FDIC-Insured State-Chartered Banks.

The activities and equity invest­ments of FDIC-insured, state-chartered banks are generally limited to those that are permissible for national banks. Under regulations dealing with equity investments, an insured state bank generally may not directly or indirectly acquire or retain any equity investment of a type, or in an amount, that is not permissible for a national bank. An insured state bank is not prohibited from, among other things, (i) acquiring or retaining a majority interest in a subsidiary, (ii) investing as a limited partner in a partnership the sole purpose of which is direct or indirect investment in the acquisition, rehabilitation or new construction of a qualified housing project, provided that such limited partnership investments may not exceed 2% of the bank’s total assets, (iii) acquiring up to 10% of the voting stock of a company that solely provides or reinsures directors’, trustees’ and officers’ liability insurance coverage or bankers’ blanket bond group insurance coverage for insured depository institutions, and (iv) acquiring or retaining the voting shares of a depository institution if certain requirements are met. In addition, an FDIC-insured state-chartered bank may not directly, or indirectly through a subsidiary, engage as “principal” in any activity that is not permissible for a national bank unless the FDIC has determined that such activities would pose no risk to the insurance fund of which it is a member and the bank is in compliance with applicable regulatory capital requirements.

Regulatory Enforcement Authority

Applicable banking laws include substantial enforcement powers available to federal banking regulators. This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease-and-desist or removal orders and to initiate injunctive actions against banking organizations and institution-affiliated parties, as defined. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions or inactions may provide the basis for enforcement action, including misleading or untimely reports filed with regulatory authorities.

Under the New York State Banking Law, the Department may issue an order to a New York-chartered banking institution to appear and explain an apparent violation of law, to discontinue unauthorized or unsafe practices and to keep prescribed books and accounts. Upon a finding by the Department that any director, trustee or officer of any banking organization has violated any law, or has continued unauthorized or unsafe practices in conducting the business of the banking organization after having been notified by the Department to discontinue such practices, such director, trustee or officer may be removed from office by the Department after notice and an opportunity to be heard. The Bank does not know of any past or current practice, condition or violation that might lead to any proceeding by the Department against the Bank or any of its directors or officers. The Department also may take possession of a banking organization under specified statutory criteria.

Prompt Corrective Action.

Section 38 of the Federal Deposit Insurance Act (“FDIA”) provides the federal banking regulators with broad power to take “prompt corrective action” to resolve the problems of undercapitalized institutions. The extent of the regulators’ powers depends on whether the institution in question is “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” A bank is deemed to be (i) “well capitalized” if it has total risk-based capital ratio of 10.0% or more, has a Tier I risk-based capital ratio of 6.0% or more, has a Tier I leverage capital ratio of 5.0% or more and is not subject to specified requirements to meet and maintain a specific capital level for any capital measure, (ii) “adequately capitalized” if it has a total risk-based capital ratio of 8.0% or more, a Tier I risk-based capital ratio of 4.0% or more and a Tier I leverage capital ratio of 4.0% or more (3.0% under certain circumstances) and does not meet the definition of “well capitalized,” (iii) “undercapitalized” if it has a total risk-based capital ratio that is less than 8.0%, a Tier I risk-based capital ratio that is less than 4.0% or a Tier I leverage capital ratio that is less than 4.0% (3.0% under certain circumstances), (iv) “significantly undercapitalized” if it has a total risk-based capital ratio that is less than 6.0%, a Tier I risk-based capital ratio that is less than 3.0% or a Tier I leverage capital ratio that is less than 3.0%, and (v) “critically undercapitalized” if it has a ratio of tangible equity to total assets that is equal to or less than 2.0%. The regulations also provide that a federal banking regulator may, after notice and an opportunity for a hearing, reclassify a “well capitalized” institution as “adequately capitalized” and may require an “adequately capitalized” institution or an “undercapitalized” institution to comply with supervisory actions as if it were in the next lower category if the institution is in an unsafe or unsound condition or engaging in an unsafe or unsound practice. The federal banking regulator may not, however, reclassify a “significantly undercapital­ized” institution as “critically undercapitalized.”
 
 
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An institution generally must file a written capital restoration plan which meets specified requirements, as well as a performance guaranty by each company that controls the institution, with an appropriate federal banking regulator within 45 days of the date that the institution receives notice or is deemed to have notice that it is “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” Immediately upon becoming undercapitalized, an institution becomes subject to statutory provisions, which, among other things, set forth various mandatory and discretionary restrictions on the operations of such an institution.

At December 31, 2010, the Company and the Bank had capital levels which qualified them as “well-capitalized” institutions.

FDIC Insurance

The Bank is a member of the FDIC. As insurer, the FDIC is authorized to conduct examinations of, and to require reporting by, FDIC-­insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious threat to the FDIC.

In the past three years, there have been many failures and near-failures among financial institutions. The number of FDIC-insured banks that have failed has increased, and the FDIC insurance fund reserve ratio, representing the ratio of the fund to the level of insured deposits, has declined due to losses caused by bank failures. As a result, the FDIC has increased its deposit insurance premiums on remaining institutions, including well-capitalized institutions like Victory State Bank, in order to replenish the insurance fund. If bank failures continue to occur, and more so if the level of failures increases, the FDIC insurance fund may further decline, and the FDIC would be required to continue to impose higher premiums on healthy banks. Thus, despite the prudent steps we may take to avoid the mistakes made by other banks, our costs of operations may increase as a result of those mistakes by others.

Our FDIC regular insurance premium was $345,226 in 2010 compared to $268,015 in 2009 (excluding the $101,950 special assessment described below), an increase of 28.8%. The FDIC also imposed a special assessment in 2009 on all FDIC-insured banks equal to 5 basis points on total assets minus Tier 1 capital. Our special assessment in 2009 amounted to $101,950. As required by The Dodd –Frank Wall Street Reform and Consumer Protection Law (the “Dodd-Frank” Act), the FDIC has recently revised its deposit insurance premium assessment rates. Our Bank, even though we are in the lowest regulatory risk category, will be subject to an assessment rate between five (5) and nine (9) basis points per annum. In general, the rates are applied to our bank’s total assets less tangible capital, in contrast to the former rule which applied the assessment rate to our level of deposits.

Despite the deposit insurance premium change and the special assessment, the fund created to pay the cost of resolving failed banks currently has a negative balance. The Dodd-Frank Act requires that the FDIC must increase the ratio of the FDIC insurance fund to estimated total insured deposits to 1.35% by September 30, 2020. The FDIC believes that most banks will pay a lower total assessment under the new system than under the former system, and it appears likely that will apply to Victory State Bank. However, if bank failures in the future exceed FDIC estimates, or other estimates that the FDIC makes turn out to be incorrect, and the losses to the insurance fund increase, the FDIC could be forced to increase insurance premiums. Such an increase would increase our non-interest expense.
 
 
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As a result of the Dodd-Frank Act, non-interest bearing demand deposits, together with certain attorney trust account deposits commonly known in New York as IOLA accounts, will have the benefit of unlimited federal deposit insurance until December 31, 2012. Since the Dodd-Frank Act also authorized banks to pay interest on commercial demand deposits beginning in June 2011, commercial depositors will have to choose between earning interest on their demand deposits or having the benefit of unlimited deposit insurance coverage. In addition, the increase in the general FDIC insurance limit from $100,000 to $250,000 was made permanent.

The FDIC may terminate the deposit insurance of any insured depository institution, including the Bank, if it determines, after a hearing, that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. Management is aware of no existing circumstances that would result in termination of the Bank’s deposit insurance.

Troubled Asset Relief Program and Capital Purchase Program

In late 2008, the United States Department of the Treasury implemented a Capital Purchase Program (“CPP”) under the Troubled Asset Relief Program (“TARP”) pursuant to which the Treasury purchased preferred stock from approved institutions, with certain limitations and restrictions. The TARP CPP was entirely voluntary. VSB Bancorp, Inc. and Victory State Bank had, at the time of announcement, and still have, strong capital (Tier 1 Capital ratio in excess of 9% and Total Risk Based Capital ratio in excess of 20%). We did not originate or invest in subprime mortgages, nor in FNMA and FHLMC preferred stock. Upon reviewing all of the details of the Treasury’s TARP CPP, we elected not to participate in it. We have continued to make loans to creditworthy customers throughout 2010 as we increased the size of our loan portfolio, so our decision to refuse the federal government’s TARP CPP money did not have an adverse effect on our ability to make loans.

Brokered Deposits

Under federal law and applicable regulations, (i) a well capitalized bank may solicit and accept, renew or roll over any brokered deposit without restriction, (ii) an adequately capitalized bank may not accept, renew or roll over any brokered deposit unless it has applied for and been granted a waiver of this prohibition by the FDIC and (iii) an undercapitalized bank may not (x) accept, renew or roll over any brokered deposit or (y) solicit deposits by offering an effective yield that exceeds by more than 75 basis points the prevailing effective yields on insured deposits of comparable maturity in such institution’s normal market area or in the market area in which such deposits are being solicited. The term “undercapitalized insured depository institution” is defined to mean any insured depository institution that fails to meet the minimum regulatory capital requirement prescribed by its appropriate federal banking agency. The FDIC may, on a case-by-case basis and upon application by an adequately capitalized insured depository institution, waive the restriction on brokered deposits upon a finding that the acceptance of brokered deposits does not constitute an unsafe or unsound practice with respect to such institution. The Bank had no brokered deposits outstanding at December 31, 2010.

Community Reinvestment and Consumer Protection Laws

In connection with its lending activities, the Bank is subject to a variety of federal laws designed to protect borrowers and promote lending to various sectors of the economy and population. Included among these are the Home Mortgage Disclosure Act, Real Estate Settlement Procedures Act, Truth-in-Lending Act, Equal Credit Opportunity Act, Fair Credit Reporting Act and Community Reinvestment Act (“CRA”).
 
 
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The CRA requires FDIC insured banks to define the assessment areas that they serve, identify the credit needs of those assessment areas and take actions that respond to the credit needs of the community. The FDIC must conduct regular CRA examinations of the Bank and assign it a CRA rating of “outstanding,” “satisfac­tory,” “needs improvement” or “unsatisfactory.” The Bank is also subject to provisions of the New York State Banking Law which impose similar obligations to serve the credit needs of its assessment areas. The New York Banking Department makes a biennial written assessment of a bank’s compliance, and makes the assessment available to the public. Federal and New York State laws both require consideration of these ratings when reviewing a bank’s application to engage in certain transactions, including mergers, asset purchases and the establishment of branch offices. A negative assessment may serve as a basis for the denial of any such application. The Bank has received “Satisfactory” ratings from both the New York Banking Department and the FDIC.

The Dodd-Frank Act created a new federal Consumer Financial Protection Bureau (“Bureau”) with broad authority to regulate and enforce consumer protection laws. The Bureau will assume those responsibilities on July 21, 2011. The Bureau has the authority to participate in regulatory examinations and to adopt regulations under numerous existing federal consumer protection statutes. The Bureau may also decide that a particular consumer financial product or service, or the manner in which it is offered, is an unfair, deceptive, or abusive act or practice. If the Bureau so decides, it has the authority to outlaw such act or practice. Since the Bureau is just in its formative stages and has not yet exercised any of its authority to regulate, examine or enforce consumer laws, it is impossible to predict its effect on our company.

Limitations on Dividends

The payment of dividends by the Bank is subject to various regulatory requirements. Under New York State Banking Law, a New York-chartered stock bank may declare and pay dividends out of its net profits, unless there is an impairment of capital, but approval of the Superintendent of Banks is required if the total of all dividends declared in a calendar year would exceed the total of its net profits for that year combined with its retained net profits of the preceding two years, subject to certain adjustments.

Miscellaneous

The Bank is subject to restrictions on loans to its non-bank subsidiaries, on investments in the stock or securities thereof, on the taking of such stock or securities as collateral for loans to any borrower, and on the issuance of a guarantee or letter of credit on behalf of the Bank or its non-bank subsidiaries. The Bank also is subject to restrictions on most types of transactions with the Bank or its non-bank subsidiaries, requiring that the terms of such transactions be substantially equivalent to terms of similar transactions with non-affiliated firms.

Assessments

Banking institutions are required to pay assessments to both the FDIC and the NYSBD to fund their operations. The assessments are based upon the amount of the Bank’s total assets. The Bank must also pay an examination fee to the NYSBD when they conduct an examination. The Bank paid federal and state assessments and examination fees of $385,829 in 2010, including $227,294 that was previously prepaid in 2009.

Transactions with Related Parties

The Bank’s authority to engage in transactions with related parties or “affiliates” (i.e., any entity that controls or is under common control with an institution, including the Bank) or to make loans to certain insiders is limited by Sections 23A and 23B of the Federal Reserve Act. Section 23A limits the aggregate amount of transactions with any individual affiliate to 10% of the capital and surplus of the institution and also limits the aggregate amount of transactions with all affiliates to 20% of the institution’s capital and surplus.
 
 
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Loans to affiliates must be secured by collateral with a value that depends on the nature of the collateral. The purchase of low quality assets from affiliates is generally prohibited. Loans and asset purchases with affiliates, must be on terms and under circumstances, including credit standards, that are substantially the same or at least as favorable to the institution as those prevailing at the time for comparable transactions with nonaffiliated companies. In the absence of comparable transactions, such transactions may only occur under terms and circumstances, including credit standards that in good faith would be offered to or would apply to nonaffiliated companies.

The Bank’s authority to extend credit to executive officers, directors and 10% shareholders, as well as entities controlled by such persons, is currently governed by Regulation O of the Federal Reserve Board. Regulation O generally requires such loans to be made on terms substantially similar to those offered to unaffiliated individuals (except for preferential loans made in accordance with broad based employee benefit plans), places limits on the amount of loans the Bank may make to such persons based, in part, on the Bank’s capital position, and requires certain approval procedures to be followed.

Standards for Safety and Soundness

FDIC regulations require that Victory State Bank adopt procedures and systems designed to foster safe and sound operations in the areas of internal controls, information systems, internal and audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, asset quality, earnings and compensation, fees and benefits. Among other things, these regulations prohibit compensation and benefits and arrangements that are excessive or that could lead to a material financial loss. If Victory State Bank fails to meet any of these standards, it will be required to submit to the FDIC a plan specifying the steps that will be taken to cure the deficiency. If it fails to submit an acceptable plan or fails to implement the plan, FDIC the will require it or VSB Bancorp, Inc. to correct the deficiency and until corrected, may impose restrictions on them.

The FDIC has also adopted regulations that require Victory State Bank to adopt written loan policies and procedures that are consistent with safe and sound operation, are appropriate for the size of the Bank, and must be reviewed by the Bank’s Board of Directors annually.