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EX-32 - EXHIBIT 32 - FNB BANCORP/CA/ex32.htm
EX-31.2 - EXHIBIT 31.2 - FNB BANCORP/CA/ex31_2.htm
EX-31.1 - EXHIBIT 31.1 - FNB BANCORP/CA/ex31_1.htm
EX-23.1 - EXHIBIT 23.1 - FNB BANCORP/CA/ex23_1.htm
 

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, 2017, or
   
o Transition report pursuant to Section 13 or 15 (d) of Securities Exchange Act of 1934

Commission File No. 000-49693

FNB BANCORP

(Exact name of registrant as specified in its charter)

California   91-2115369
(State or other jurisdiction of incorporation or organization)   (IRS Employer ID Number)
     
975 El Camino Real, South San Francisco, California   94080
(Address of principal executive offices)   (Zip code)

(650) 588-6800

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:   None
Securities registered pursuant to Section 12(g) of the Act:    
Title of Class:     Common Stock, no par value
     

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes o No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes o No x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark whether the registrant has submitted electronically and posted on its Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). 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 the 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 or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o Accelerated filer x Non-accelerated filer o
Smaller reporting company o

Emerging growth company o

 
     

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x

Aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant, computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter: $102,868,236

Number of shares outstanding of each of the registrant’s classes of common stock, as of February 01, 2017

No par value Common Stock – 7,459,847 shares outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

The following documents are incorporated by reference into this Form 10-K: Part III, Items 10 through 14 from Registrant’s definitive proxy statement for the 2018 annual meeting of shareholders.

 
 
  TABLE OF CONTENTS    
       
      PAGE
PART I      
Item 1 Business   3
Item 1A Risk Factors   16
Item 1B Unresolved Staff Comments   21
Item 2 Properties   21
Item 3 Legal Proceedings   22
Item 4 Mine Safety Disclosures   22
       
PART II      
Item 5 Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Securities   23
Item 6 Selected Financial Data    25
Item 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations   26
Item 7A Quantitative and Qualitative Disclosures about Market Risk   41
Item 8 Financial Statements and Supplementary Data    43
Item 9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   115
Item 9A Controls and Procedures   115
Item 9B Other Information   117
       
PART III      
Item 10 Directors, Executive Officers and Corporate Governance   118
Item 11 Executive Compensation   118
Item 12 Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   118
Item 13 Certain Relationships and Related Transactions, and Director Independence   118
Item 14 Principal Accounting Fees and Services   118
       
PART IV      
Item 15 Exhibits and Financial Statement Schedules   119
(a) (1) Financial Statements, Listed and Included in Part II, Item 8   119

(a) (2)

Financial Statement Schedules. Not Applicable   119
(a) (3) Index to Exhibits   119

Item 16

Form 10-K Summary

  126
  Signatures   127
  Exhibit 23.1 – Consent of Independent Registered Public Accounting Firm   128
  Exhibit 31 – Rule 13a-14(a)/15d-14(a) Certifications   129
  Exhibit 32 – Section 1350 Certifications   131
2
 

PART I

ITEM 1. BUSINESS

Forward-Looking Statements: Certain matters discussed or incorporated by reference in this Annual Report on Form 10-K including, but not limited to, matters described in “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations,” are “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended. Such forward-looking statements may contain words related to future projections including, but not limited to, words such as “believe,” “expect,” “anticipate,” “intend,” “may,” “will,” “should,” “could,” “would,” and variations of those words and similar words that are subject to risks, uncertainties and other factors that could cause actual results to differ materially from those projected. Factors that could cause or contribute to such differences include, but are not limited to, the following: (1) variances in the actual versus projected growth in assets; (2) return on assets; (3) loan and lease losses; (4) expenses; (5) changes in the interest rate environment including interest rates charged on loans, earned on securities investments and paid on deposits; (6) competition effects; (7) fee and other noninterest income earned; (8) general economic conditions nationally, regionally, and in the operating market areas of FNB Bancorp (the “Company”) including State and local issues being addressed in California; (9) changes in the regulatory environment; (10) changes in business conditions and inflation; (11) changes in securities markets; (12) data processing problems; (13) a decline in real estate values in the operating market areas of the Company; (14) the effects of terrorism, the threat of terrorism or the impact of the current military conflicts, and the conduct of the war on terrorism by the United States and its allies, worsening financial and economic conditions, natural disasters, and disruption of power supplies and communications; and (15) changes in accounting standards, tax laws or regulations and interpretations of such standards, laws or regulations, as well as other factors. The factors set forth under “Item 1A – Risk Factors” in this report and other cautionary statements and information set forth in this report should be read carefully, considered and understood as being applicable to all related forward-looking statements contained in this report when evaluating the business prospects of the Company and its subsidiary.

Forward-looking statements are not guarantees of performance. By their nature, they involve risks, uncertainties and assumptions. Actual results and shareholder values in the future may differ significantly from those expressed in forward-looking statements. You are cautioned not to put undue reliance on any forward-looking statement. Any such statement speaks only as of the date of the report, and in the case of any documents that may be incorporated by reference, as of the date of those documents. We do not undertake any obligation to update or release any revisions to any forward-looking statements, or to report any new information, future event or other circumstances after the date of this report or to reflect the occurrence of unanticipated events, except as required by law. However, your attention is directed to any further disclosures made on related subjects in our subsequent reports filed with the Securities and Exchange Commission on Forms 10-K, 10-Q and 8-K.

Recent Development – Proposed Merger with TriCo Bancshares

 

As announced by the Company on December 11, 2017 and reported in the Company’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on December 12, 2017 (the “Current Report”), the Company has entered into an Agreement and Plan of Merger and Reorganization dated December 11, 2017 (the “Merger Agreement”), pursuant to which the Company would merge with and into TriCo Bancshares, a California corporation (“TriCo”), with TriCo being the surviving corporation. Immediately thereafter, the Company’s subsidiary bank, First National Bank of Northern California, would be merged with and into TriCo’s subsidiary bank, Tri Counties Bank. Under the terms of the Merger Agreement, the Company shareholders would receive a fixed exchange ratio of 0.9800 shares of TriCo common stock for each share of Company common stock, providing the Company shareholders with aggregate ownership on a pro forma basis of approximately 24% of the common stock of the combined company. Holders of the Company’s outstanding in-the-money stock options would receive cash, net of applicable taxes withheld, for the value of their unexercised stock options. The merger is expected to qualify as a tax-free exchange for shareholders who receive shares of TriCo common stock. The transactions contemplated by the Merger Agreement are expected to close in the second or third quarter of 2018, pending approvals of the Company shareholders and the TriCo shareholders, the receipt of all necessary regulatory approvals, and the satisfaction of other closing conditions which are customary for such transactions. For additional information, reference should be made to the text of the Agreement and Plan of Merger and Reorganization, filed as an exhibit to the Current Report, and to other information regarding TriCo and the Company, their respective businesses and the status of their proposed merger, as reported from time to time in other filings with the Securities and Exchange Commission.

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Overview

 

FNB Bancorp (the “Company”) is a bank holding company registered under the Bank Holding Company Act of 1956, as amended. The Company was incorporated under the laws of the State of California on February 28, 2001. As a bank holding company, the Company is authorized to engage in the activities permitted under the Bank Holding Company Act of 1956, as amended, and regulations thereunder. Its principal office is located at 975 El Camino Real, South San Francisco, California, 94080, and its telephone number is (650) 588-6800. The Company owns all of the issued and outstanding shares of common stock of First National Bank of Northern California (“the Bank”), a national banking association. The Company has no other subsidiary.

The Bank was organized in 1963 as “First National Bank of Daly City.” In 1995, the shareholders approved a change in the name to “First National Bank of Northern California.” The administrative headquarters of the Bank is located at 975 El Camino Real, South San Francisco, California. The Bank presently operates twelve full service banking offices in the cities of Daly City, South San Francisco, Millbrae, Pacifica, Half Moon Bay, San Mateo, Redwood City, Pescadero, San Francisco and Sunnyvale. The Bank’s primary business is servicing the business and commercial banking needs of individuals and small to mid-sized businesses within San Mateo, San Francisco and Santa Clara Counties. The Bank is chartered under the laws of the United States and is governed by the National Bank Act, and as a national bank is a member of the Federal Reserve System. The Federal Deposit Insurance Corporation insures the deposits of the Bank up to the applicable legal limits, currently $250,000 per separately insured depositor. The Bank is subject to regulation, supervision and regular examination by the Office of the Comptroller of the Currency. The regulations of the Federal Deposit Insurance Corporation, the Board of Governors of the Federal Reserve System, and the Office of the Comptroller of the Currency govern many aspects of the Bank’s business and activities, including investments, loans, borrowings, branching, mergers and acquisitions, reporting and numerous other areas. The Bank is also subject to applicable provisions of California law to the extent those provisions are not in conflict with or preempted by federal banking law. See “Supervision and Regulation” below.

National banks that are well capitalized, have a higher overall rating and a satisfactory CRA rating, and are not subject to an enforcement order, may engage in activities related to banking through operating subsidiaries subject to an expedited application process. In addition, a national bank may apply to the Office of the Comptroller of the Currency to engage in an activity through a subsidiary in which the Bank itself may not engage.

The Bank offers a broad range of services to individuals and businesses in its primary service area, including a full line of business financial products and specialized services such as courier, appointment banking and business internet banking. The Bank offers personal and business checking and savings account, including individual interest-bearing negotiable orders of withdrawal (“NOW”), money market accounts and/or accounts combining checking and savings accounts with automatic transfer capabilities, IRA accounts, time certificates of deposit, direct deposit services and computer cash management with access through the internet. The Bank also makes available commercial loans and standby letters of credit, construction loans, accounts receivable financing, inventory financing, automobile loans, home improvement loans, residential real estate loans, commercial loans and lines of credit, commercial real estate loans and lines of credit, Small Business Administration loans, equipment financing, leasehold improvement financing and consumer loans and lines of credit. In addition, the Bank sells cashier’s checks, offers automated teller machine (ATM) services that are tied in with statewide and national payment networks and offers other customary commercial banking services.

Most of the Bank’s deposits are obtained from commercial and non-profit businesses, professionals and individuals. As of December 31, 2017, the Bank had a total of 20,986 deposit accounts. The Bank has obtained some deposits through brokers for which it pays a broker fee. As of December 31, 2017, the Bank had $264,000 in such deposits.

Employees

At December 31, 2017, the Company employed 167 persons on a full time equivalent basis. The Company believes its employee relations are good. The Company is not a party to any collective bargaining agreement.

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Market Area

 

The Bank’s market area consists primarily of the counties of San Francisco, San Mateo and Santa Clara. Based on latest available reports from the U. S. Department of Commerce Bureau of Economic Analysis, per capita incomes in the counties of San Francisco, San Mateo and Santa Clara for the year 2016 were $110,418, $105,721 and $88,920, respectively.

Management believes per capita income levels grew at single digit growth rates during the year ended December 31, 2017, based upon expected economic activity levels and overall employment prospects. Unemployment data published by the California Employment Development Department reported unemployment levels in December 2017 of 2.3% in San Francisco County, 2.0% in San Mateo County, 2.6% in Santa Clara County, and 5.0% for the State of California. The unemployment levels in San Francisco County were 2.8%, in San Mateo County they were 2.8%, in Santa Clara County they were 3.4% and for the State of California, 5.0% in December 2016. In December 2015, San Francisco County unemployment was 3.3%, San Mateo County was 3.1%, Santa Clara County was 3.7% and the State of California was 5.8%.

A report from the California Employment Development Department (“EDD”), based on information published by America’s Labor Market Information System (ALMIS) Employer Database 2018 1st Edition, lists the following major employers in San Francisco County: Bechtel, California Pacific Medical Center, Deloitte, Ernst & Young, Federal Reserve Bank, Golden Gate University, Kaiser Permanente Medical Center, Laguna Honda Hospital & Rehabilitation Center, Pacific Gas & Electric, San Francisco Chronicle, San Francisco State University, UCSF-Medical Center, U.S. Veterans Medical Center and University of California-San Francisco.

The following were listed as major employers in San Mateo County: Electronic Arts, Inc., Facebook, Inc., Fisher Investments, Franklin Templeton Investments, Genentech, Inc., Gilead Sciences, Kaiser Permanente Medical Group, Mills-Peninsula Medical Center, Oracle Corp., San Francisco International Airport, San Mateo County Behavior, SRI International, U. S. Interior Department, and Visa International Services Association. The major labor force in San Francisco County and San Mateo County is represented by the service industries, including financial services, educational and health services, professional and business services, leisure and hospitality, biotech, technology and state government.

The following were listed as major employers in Santa Clara County: Adobe Systems, Inc., Advanced Micro Devices, Inc., Apple Inc., Applied Materials, Avaya, Inc., Christopher Ranch, Inc., Cisco Systems Inc., E Bay Inc., Great America Pavilion, Hewlett-Packard Co., Intel Corp, Lockheed Martin Space Systems, Microsoft Corp, NASA, Net App Inc, Prime Materials, SAP Center at San Jose, Silicon Valley Sports & Entertainment, Stanford University School of Medicine and VA Medical Center-Palo Alto.

At December 31, 2017, the Company had total assets of $1,265,238,000, net loans of $829,766,000, deposits of $1,050,295,000 and stockholders’ equity of $119,280,000. The Company competes with approximately 120 other banking or savings institutions in its San Francisco, San Mateo and Santa Clara County service area. The Company’s market share of Federal Deposit Insurance Corporation insured deposits in the service area of Santa Clara County is less than 0.03%; of San Mateo County is approximately 2.13%, and 0.08% in the San Francisco County market area (based upon the most recent information available from the Federal Deposit Insurance Corporation through June 30, 2017). See “Competitive Data” below.

Competition

General Competitive Factors. In order to compete with the financial institutions in their primary service areas, community banks use the flexibility that has come to define independent community banking. This includes an emphasis on service, local promotional activity and extensive use of the personal contacts of the employees, officers and directors of the Bank. The Bank’s management and employees have developed thorough a knowledge of local businesses and markets.

Community banks also seek to provide special services and programs for individuals in their primary service area who are employed in the agricultural, professional and business fields. These services include loans for equipment, furniture and tools used in the operation and expansion of their businesses. In the event there are customers whose loan demands exceed their respective lending limits, they seek to arrange for such loans on a participation basis with other financial institutions.

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Banking is a business that depends on interest rate differentials. In general, the difference between the interest rate paid by a bank to obtain their deposits and other borrowings and the interest rate received by a bank on loans extended to customers and on securities held in a bank’s investment portfolio comprise the major portion of a bank’s earnings. The Bank competes with savings and loan associations, credit unions, other financial institutions and other entities for funds.

 

The interest rate differentials of a bank, and therefore its earnings, are affected not only by general economic conditions, but also by statutes, as implemented by federal and state agencies. The Federal Reserve Board can and does implement national monetary policy, such as seeking to curb inflation and combat recession, by its open market operations in United States government securities and adjustments to the discount rates applicable to borrowing by banks from the Federal Reserve banks.

These activities influence growth of bank loans, investments and deposits and also affect interest rates charged on loans and paid on deposits. The nature and timing of any future changes in monetary policies and their impact on the Bank are not predictable.

Competitive Data. In its market area, the Bank competes for deposit and loan customers with other banks (including those with much greater resources), thrifts and credit unions, finance companies and other financial service providers. Larger banks may have a competitive advantage because of higher lending limits and major advertising and marketing campaigns, along with significant investment banking, trust and insurance operations.

For borrowers requiring loans in excess of the Bank’s legal lending limits, the Bank has offered, and intends to offer in the future, such loans on a participating basis with other insured financial institutions, retaining the portion of such loans which are within its legal lending limits. As of December 31, 2017, the Bank’s aggregate legal lending limit to a single borrower and such borrower’s related business interests were $19,129,000 on an unsecured basis and $31,882,000 on a fully secured basis, computed based on the Bank’s December 31, 2017 Total Risk-Based Capital of $127,528,000. The Bank’s business is concentrated in its service area, which primarily encompasses San Mateo County and Santa Clara County and the City and County of San Francisco. The economy of the Bank’s service area is dependent upon government, manufacturing, tourism, retail sales, population growth and smaller, service-oriented businesses.

Based upon the most recent information made available by the FDIC Summary of Deposits at June 30, 2017, there were 29 commercial and savings banking institutions in San Mateo County with a total of $38,477,689,000 in deposits. The Bank had a total of 8 offices in San Mateo County with total deposits of $817,835,000 at the same date. There were 45 banking and savings institutions in the City and County of San Francisco with a total of $212,299,667,000 in deposits. The Bank had a total of 4 offices in the City and County of San Francisco with total deposits of $167,319,000. There were 45 commercial and savings banking institutions in Santa Clara County with a total of $134,865,696,000 in deposits. The Bank had one office in Santa Clara County with total deposits of $39,209,000.

Website Information

The Company and the Bank maintain an Internet website at http://www.fnbnorcal.com which allows access to the Company’s financial reports that have been filed with the SEC. The Company’s annual report on Form 10-K and quarterly reports on Form 10-Q and amendments to those reports, filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, are made available free of charge on or through such website as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission. Also filed and made available through the SEC’s website located at http://www.sec.gov are the Form 8-K and Section 16 reports of ownership and changes in ownership of the Company’s common stock which are filed with the Securities and Exchange Commission by the directors and executive officers of the Company and by any persons who own more than 10 percent of the outstanding shares of such stock. Information on the Company’s website is not incorporated by reference into this report.

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SUPERVISION AND REGULATION

General

FNB Bancorp. The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the “Bank Holding Company Act”), and is registered as such with, and subject to supervision and regulation by, the Board of Governors of the Federal Reserve System (the “Board of Governors”). As a registered bank holding company, the Company is required to file quarterly and annual reports with the Board of Governors, along with such additional information as the Board of Governors may require. The Company is also a bank holding company within the meaning of the California Financial Code and, as such, is subject to examination by, and may be required to file reports with, the California Department of Business Oversight.

The common stock of the Company is subject to the registration requirements of the Securities Act of 1933, as amended, and the qualification requirements of the California Corporate Securities Law of 1968, as amended. FNB Bancorp has registered its common stock under Section 12 (g) of the Securities Exchange Act of 1934, as amended. The Company is also subject to the periodic reporting requirements of Section 13 of the Securities Exchange Act of 1934, as amended, which include, but are not limited to, annual, quarterly and other current reports required to be filed with the Securities and Exchange Commission. The common stock of the Company is traded on the Nasdaq Global Select Market under the trading symbol, “FNBG.”

The California Corporate Disclosure Act requires publicly traded corporations incorporated or qualified to do business in California to disclose information about their past history, auditors, directors and officers. Consequently, the Company files disclosures annually with the California Secretary of State as to the name of the Company’s independent auditor, the compensation paid to each of its directors and the five most highly compensated non-director executive officers, any loans made to a director or executive officer at a “preferential” loan rate, whether any director or executive officer has been convicted of fraud or has filed in bankruptcy and any material pending legal proceedings other than ordinary routine litigation.

The Company is required to obtain the approval of the Board of Governors before it may acquire all or substantially all of the assets of any bank, or ownership or control of the voting shares of any bank if, after giving effect to such acquisition of shares, the Company would own or control more than 5% of the voting shares of such bank. The Bank Holding Company Act prohibits the Company from acquiring any voting shares of, or interest in, all or substantially all of the assets of a bank located outside the State of California unless such an acquisition is specifically authorized by the laws of the state in which such bank is located. Any such interstate acquisition is also subject to the provisions of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994.

The Company, and any non-bank subsidiary which it may acquire or organize, are deemed to be “affiliates” of the Bank within the meaning of that term as defined in the Federal Reserve Act. This means, for example, that there are limitations (a) on loans by the Bank to its affiliates, and (b) on investments by the Bank in affiliates’ stock as collateral for loans to any borrower. The Company and the Bank are also subject to certain restrictions with respect to engaging in the underwriting, public sale and distribution of securities.

In addition, regulations of the Board of Governors under the Federal Reserve Act require that reserves be maintained by the Bank in conjunction with any liability of the Company under any obligation (promissory note, acknowledgment of advance, banker’s acceptance or similar obligation) with a weighted average maturity of less than seven (7) years to the extent that the proceeds of such obligations are used for the purpose of supplying funds to the Bank for use in its banking business, or to maintain the availability of such funds.

As provided in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, a bank holding company (such as the Company) must serve as a source of financial strength for any subsidiary of the bank holding company that is a depository institution (such as the Bank) and the federal banking agencies are directed to issue joint rules to carry out this mandate. The term “source of financial strength” means the ability to provide financial assistance to the depository institution in the event of the financial distress of the institution. See “Impact of Certain Legislation and RegulationDodd-Frank Wall Street Reform and Consumer Protection Act of 2010” below.

First National Bank of Northern California. As a national banking association licensed under the national banking laws of the United States, the Bank is regularly examined by the Office of the Comptroller of the Currency and is further subject to supervision and regulation by the Federal Deposit Insurance Corporation and the Board of Governors of the Federal Reserve System.

This supervision and regulation includes comprehensive reviews of all major aspects of the Bank’s business and condition, including its capital ratios, allowance for possible loan losses and other factors. However, no inference should be drawn that such authorities have approved any such factors. The Bank is required to file reports with the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation. The Bank’s deposits are insured by the Federal Deposit Insurance Corporation up to the applicable legal limits.

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The Company and the Bank are also subject to the applicable provisions of California law to the extent those provisions are not in conflict with or preempted by Federal banking law. This includes regulations of the California Department of Business Oversight.

 

General. Bank holding companies, such as the Company, and commercial banks, such as the Bank, are subject to extensive supervision and regulation by federal and state regulators. Various and multiple requirements and restrictions under federal and state law affect our operations, as summarized below.

Capital Standards

Risk-Based Capital. The Board of Governors, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation have adopted risk-based capital guidelines for evaluating the capital adequacy of bank holding companies and banks. The guidelines were designed to make capital requirements sensitive to differences in risk profiles among banking organizations, to take into account off-balance sheet exposures and to aid in making the definition of bank capital uniform internationally. Under the risk-based guidelines and prior to amendments to the capital rules effective January 1, 2015, as described below in “Basel III - New Capital and Prompt Corrective Action Regulations,” the Company and the Bank were required to maintain capital equal to at least 8% of its assets and commitments to extend credit, weighted by risk, of which at least 4% was required to consist primarily of common equity (including retained earnings) and the remainder was to consist of subordinated debt, cumulative preferred stock, or a limited amount of loan and lease loss reserves.

Assets, commitments to extend credit, and off-balance sheet items were categorized according to risk and certain assets considered to present less risk than others permitted maintenance of capital at less than the 8% ratio. For example, most home mortgage loans were placed in a 50% risk category and therefore required maintenance of capital equal to 4% of those loans, while commercial loans were placed in a 100% risk category and therefore required maintenance of capital equal to 8% of those loans.

Under the risk-based capital guidelines, assets reported on an institution’s balance sheet and certain off-balance sheet items are assigned to risk categories, each of which has an assigned risk weight. Capital ratios are calculated by dividing the institution’s qualifying capital by its period-end risk-weighted assets. The guidelines established two categories of qualifying capital: Tier 1 capital (core capital including common shareholders’ equity and noncumulative perpetual preferred stock) and Tier 2 capital (supplementary capital which includes, among other items, limited life (and in the case of banks, cumulative) preferred stock, mandatory convertible securities, subordinated debt and a limited amount of reserve for credit losses. Each institution was required to maintain a minimum risk-based capital ratio (including Tier 1 and Tier 2 capital) of 8%, of which at least half was to be Tier 1 capital.

 

A leverage capital standard was adopted as a supplement to the risk-weighted capital guidelines. Under the leverage capital standard, an institution was required to maintain a minimum ratio of Tier 1 capital to the sum of its quarterly average total assets and quarterly average reserve for loan losses, less intangible assets not included in Tier 1 capital. Period-end assets may be used in place of quarterly average total assets on a case-by-case basis. A minimum leverage ratio was also adopted for bank holding companies as a supplement to the risk-weighted capital guidelines. The leverage ratio establishes a minimum Tier 1 ratio of 3% (Tier 1 capital to total assets) for the highest rated bank holding companies or those that have implemented the risk-based capital market risk measure. All other bank holding companies must maintain a minimum Tier 1 leverage ratio of 4% with higher leverage capital ratios required for bank holding companies that have significant financial and/or operational weakness, a high-risk profile, or are undergoing or anticipating rapid growth.

Effective January 1, 2015, the risk-based capital regulations described above were amended to the extent described below in “Basel III - New Capital and Prompt Corrective Action Regulations.”

Basel III – New Capital and Prompt Corrective Action Regulations. “Basel III” refers to a comprehensive set of reform measures developed by the Bank for International Settlements to strengthen the regulation, supervision and risk management of the banking sector. In July 2013, the federal bank regulatory agencies issued interim final rules that revised and replaced the risk-based capital requirements (summarized above) in order to implement the Basel III regulatory capital reforms released by the Basel Committee on Banking Supervision and changes required by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The Basel III reforms reflected in the final rules include an increase in the risk-based capital requirements and certain changes to capital components, as well as changes to the calculation and categories of risk-weighted assets. For example, changes to risk weighted assets include increasing the original risk weight to 150% on assets past due 90 days or more or on nonaccrual, utilizing loan to value ratios in the risk weighting of mortgage loans and assigning a 150% risk weight to certain higher risk commercial real estate loans.

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Effective January 1, 2015, bank holding companies with consolidated assets of $1 billion or more and banks like the Bank must comply with new minimum capital ratio requirements to be phased-in between January 1, 2015 and January 1, 2019, which consist of the following: (i) a new common equity Tier 1 capital to total risk weighted assets ratio of 4.5%; (ii) a Tier 1 capital to total risk weighted assets ratio of 6% (increased from 4%); (iii) a total capital to total risk weighted assets ratio of 8% (unchanged); and (iv) a Tier 1 capital to adjusted average total assets (“leverage”) ratio of 4%.

 

In addition, a “capital conservation buffer” is established which when fully phased-in will require maintenance of a minimum of 2.5% of common equity Tier 1 capital to total risk weighted assets in excess of the regulatory minimum capital ratio requirements described above. The 2.5% buffer will increase the minimum capital ratios to (i) a common equity Tier 1 capital ratio of 7%, (ii) a Tier 1 capital ratio of 8.5%, and (iii) a total capital ratio of 10.5%. The new buffer requirement will be phased-in between January 1, 2016 and January 1, 2019. If the capital ratio levels of a banking organization fall below the capital conservation buffer amount, the organization will be subject to limitations on (i) the payment of dividends; (ii) discretionary bonus payments; (iii) discretionary payments under Tier 1 instruments; and (iv) engaging in share repurchases.

 

Transition for New Ratios and Capital Definitions for Community Banks
             
           2019 and 
Years (as of Jan. 1)  2017   2018   Thereafter 
Minimum CET1 ratio   4.500   4.500   4.500
Capital Conservation buffer   1.250%   1.875%   2.500%
CET1 plus capital conservation buffer   5.750%   6.375%   7.000%
Phase-in of deduction from CET1 *   80.000%   100.000%   100.000%
Minimum Tier 1 capital   6.000%   6.000%   6.000%
Minimum Tier 1 capital plus capped conservation buffer   7.250%   7.875%   8.500%
Minimum total capital   8.000%   8.000%   8.000%
Minimum total capital plus conservation buffer   9.250%   9.875%   10.500%
                
* Including threshold deduction items that are over the limits               

  

The federal bank regulatory agencies also implemented changes to the prompt corrective action framework, described below in “Prompt Corrective Action,” which are designed to place restrictions on insured depository institutions if their capital ratios begin to show signs of weakness. These changes took effect beginning January 1, 2015 and require insured depository institutions to meet the following increased capital ratio requirements in order to qualify as “well capitalized:” (i) a new common equity Tier 1 capital ratio of 6.5%; (ii) a Tier 1 capital ratio of 8%; (iii) a total capital ratio of 10%; and (iv) a Tier 1 leverage ratio of 5%. In order to qualify as “adequately capitalized,” institutions must have (i) a new common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1 capital ratio of 6%; (iii) a total capital ratio of 8%; and (iv) a Tier 1 leverage ratio of 4%. See also the additional requirements of the prompt corrective action framework discussed below in “Prompt Corrective Action.”

 

Management believes that the Bank is in compliance with the minimum capital requirements, including the fully phased-in capital conservation buffer requirement, based upon its capital position at December 31, 2017. See “Capital” under “Management’s Discussion and Analysis of Financial Condition and the Results of Operations” set forth in Item 7 below and Note 19 “Regulatory Matters” in the “Financial Statements and Supplementary Data” set forth in Item 8 below.

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Prompt Corrective Action

 

The Board of Governors, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation have adopted regulations implementing a system of prompt corrective action pursuant to Section 38 of the Federal Deposit Insurance Act and Section 131 of the FDIC Improvement Act of 1991 (“FDICIA”). Prior to amendments to the capital rules effective January 1, 2015, as described above in “Basel III - New Capital and Prompt Corrective Action Regulations,” the regulations established five capital categories with the following characteristics: (1) “Well capitalized” - consisting of institutions with a total risk-based capital ratio of 10% or greater, a Tier 1 risk-based capital ratio of 6% or greater and a leverage ratio of 5% or greater, and the institution is not subject to an order, written agreement, capital directive or prompt corrective action directive; (2) “Adequately capitalized” - consisting of institutions with a total risk-based capital ratio of 8% or greater, a Tier 1 risk-based capital ratio of 4% or greater and a leverage ratio of 4% or greater, and the institution does not meet the definition of a “well capitalized” institution; (3) “Undercapitalized” - consisting of institutions with a total risk-based capital ratio less than 8%, a Tier 1 risk-based capital ratio of less than 4%, or a leverage ratio of less than 4%; (4) “Significantly undercapitalized” - consisting of institutions with a total risk-based capital ratio of less than 6%, a Tier 1 risk-based capital ratio of less than 3%, or a leverage ratio of less than 3%; (5) “Critically undercapitalized” - consisting of an institution with a ratio of tangible equity to total assets that is equal to or less than 2%.

The regulations established procedures for classification of financial institutions within the capital categories, and for filing and reviewing capital restoration plans required under the regulations and procedures for issuance of directives by the appropriate regulatory agency, among other matters. The regulations imposed restrictions upon all institutions to refrain from certain actions which would cause an institution to be classified within any one of the three “undercapitalized” categories, such as declaration of dividends or other capital distributions or payment of management fees, if following the distribution or payment the institution would be classified within one of the “undercapitalized” categories. In addition, institutions which are classified in one of the three “undercapitalized” categories are subject to certain mandatory and discretionary supervisory actions. Mandatory supervisory actions include (1) increased monitoring and review by the appropriate federal banking agency; (2) implementation of a capital restoration plan; (3) total asset growth restrictions; and (4) limitations upon acquisitions, branch expansion, and new business activities without prior approval of the appropriate federal banking agency. Discretionary supervisory actions may include (a) requirements to augment capital; (b) restrictions upon affiliate transactions; (c) restrictions upon deposit gathering activities and interest rates paid; (d) replacement of senior executive officers and directors; (e) restrictions upon activities of the institution and its affiliates; (f) requiring divestiture or sale of the institution; and (g) any other supervisory action that the appropriate federal banking agency determines is necessary to further the purposes of the regulations. Further, the federal banking agencies may not accept a capital restoration plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital. In addition, for a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee that the institution will comply with such capital restoration plan. The aggregate liability of the parent holding company under the guaranty is limited to the lesser of (i) an amount equal to 5 percent of the depository institution’s total assets at the time it became undercapitalized, and (ii) the amount that is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it were “significantly undercapitalized.” FDICIA also restricts the solicitation and acceptance of and interest rates payable on brokered deposits by insured depository institutions that are not “well capitalized.” An “undercapitalized” institution is not allowed to solicit deposits by offering rates of interest that are significantly higher than the prevailing rates of interest on insured deposits in the particular institution’s normal market areas or in the market areas in which such deposits would otherwise be accepted.

Any financial institution which is classified as “critically undercapitalized” must be placed in conservatorship or receivership within ninety days of such determination unless it is also determined that some other course of action would better serve the purposes of the regulations. Critically undercapitalized institutions are also prohibited from making (but not accruing) any payment of principal or interest on subordinated debt without prior regulatory approval and regulators must prohibit a critically undercapitalized institution from taking certain other actions without prior approval, including (1) entering into any material transaction other than in the usual course of business, including investment expansion, acquisition, sale of assets or other similar actions; (2) extending credit for any highly leveraged transaction; (3) amending articles or bylaws unless required to do so to comply with any law, regulation or order; (4) making any material change in accounting methods; (5) engaging in certain affiliate transactions; (6) paying excessive compensation or bonuses; and (7) paying interest on new or renewed liabilities at rates which would increase the weighted average costs of funds beyond prevailing rates in the institution’s normal market areas.

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On November 18, 2014, the Federal Deposit Insurance Corporation adopted the “Assessments Final Rule” which revises the FDIC’s risk-based deposit insurance assessment system to reflect changes in the regulatory capital rules, effective commencing January 1, 2015. For smaller financial institutions (with total assets less than $1 billion and which are not custodial banks), the Assessments Final Rule revised and conformed capital ratios and ratio thresholds to the new prompt corrective action capital ratios and ratio thresholds for “well capitalized” and “adequately capitalized” evaluations which were adopted by the federal banking agencies as part of the Basel III capital regulations. Consequently, effective January 1, 2015, the prompt corrective action regulations were amended to the extent described above in “Basel III – New Capital and Prompt Corrective Action Regulations.”

 

Uniform Rating System

The Federal Financial Institutions Examination Council (“FFIEC”) utilizes the Uniform Financial Institutions Rating System (“UFIRS”), commonly referred to as “CAMELS,” to classify and evaluate the soundness of financial institutions. Bank examiners use the CAMELS measurements to evaluate capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risk.

Effective January 1, 2005, bank holding companies such as the Company became subject to evaluation and examination under a revised bank holding company rating system.

 

The federal financial institution agencies have established bases for analysis and standards for assessing financial institution’s capital adequacy in conjunction with the risk-based and Basel III capital guidelines, including analysis of interest rate risk, concentrations of credit risk, risk posed by non-traditional activities, and factors affecting overall safety and soundness. The safety and soundness standards for insured financial institutions include analysis of (1) internal controls, information systems and internal audit systems; (2) loan documentation; (3) credit underwriting; (4) interest rate exposure; (5) asset growth; (6) compensation, fees and benefits; and (7) excessive compensation for executive officers, directors or principal shareholders which could lead to material financial loss. If an agency determines that an institution fails to meet any standard, the agency may require the financial institution to submit to the agency an acceptable plan to achieve compliance with the standard. If the agency requires submission of a compliance plan and the institution fails to timely submit an acceptable plan or to implement an accepted plan, the agency will require the institution to correct the deficiency. The agencies may elect to initiate enforcement action in certain cases rather than rely on an existing plan, particularly where failure to meet one or more of the standards could threaten the safe and sound operation of the institution.

 

CRA Compliance

Community Reinvestment Act (“CRA”) regulations evaluate banks’ lending to low and moderate income individuals and businesses across a four-point scale from “outstanding” to “substantial noncompliance,” and are a factor in regulatory review of applications to merge, establish new branches or form bank holding companies. In addition, any bank rated in “substantial noncompliance” with the CRA regulations may be subject to enforcement proceedings. The Bank has a current rating of “satisfactory” for CRA compliance.

FDIC Insurance

The Federal Deposit Insurance Corporation (“FDIC”) is an independent federal agency that insures deposits of federally insured banks (such as the Bank) and savings institutions up to prescribed limits through the Deposit Insurance Fund (“DIF”). All depository accounts of the Bank are covered by FDIC insurance up to established maximum limits (currently $250,000 per separately insured depositor). The amount of FDIC assessments paid by each DIF member institution for insurance coverage is based on its risk profile as measured by regulatory capital ratios and other supervisory factors. In 2011, as required by the Dodd-Frank Act, the FDIC revised the assessment rates and the deposit insurance assessment base used to calculate premiums paid to DIF. The amount of FDIC assessments paid by each DIF member institution for insurance coverage is now based on an average/total assets less average tangible equity, defined as Tier 1 capital and an institution’s risk profile as measured by regulatory capital ratios and other supervisory factors, with assessments ranging from 2.5 to 9 basis points for institutions in the lowest risk category to 30 to 45 basis points for those in the highest risk category.

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Dividends

 

FNB Bancorp. The Company’s ability to pay cash dividends is subject to restrictions set forth in the California General Corporation Law. Funds for payment of any cash dividends by the Company could be obtained from its investments, equity sales or dividends received from the Bank. The Bank’s ability to pay cash dividends to the Company is subject to restrictions imposed under the National Bank Act and regulations promulgated by the Office of the Comptroller of the Currency. The Company has paid cash dividends for each quarter of operations commencing with the second quarter of 2002. Future dividends will continue to be determined after consideration of the Company’s earnings, financial condition, future capital funds, regulatory requirements and other relevant factors.

The California General Corporation Law provides that neither a corporation nor any of its subsidiaries shall make a distribution to the corporation’s shareholders unless the board of directors has determined in good faith either of the following: (1) the amount of retained earnings of the corporation immediately prior to the distribution equals or exceeds the sum of (A) the amount of the proposed distribution plus (B) the preferential dividends arrears amount; or (2) immediately after the distribution, the value of the corporation’s assets would equal or exceed the sum of its total liabilities plus the preferential rights amount. The good faith determination of the board of directors may be based upon (1) financial statements prepared on the basis of reasonable accounting practices and principles, (2) a fair valuation, or (3) any other method reasonable under the circumstances; provided, that a distribution may not be made if the corporation or subsidiary making the distribution is, or is likely to be, unable to meet its liabilities (except those whose payment is otherwise adequately provided for) as they mature. The term “preferential dividends arrears amount” means the amount, if any, of cumulative dividends in arrears on all shares having a preference with respect to payment of dividends over the class or series to which the applicable distribution is being made, provided that if the articles of incorporation provide that a distribution can be made without regard to preferential dividends arrears amount, then the preferential dividends arrears amount shall be zero. The term “preferential rights amount” means the amount that would be needed if the corporation were to be dissolved at the time of the distribution to satisfy the preferential rights, including accrued but unpaid dividends, of other shareholders upon dissolution that are superior to the rights of the shareholders receiving the distribution, provided that if the articles of incorporation provide that a distribution can be made without regard to any preferential rights, then the preferential rights amount shall be zero.

The Board of Governors generally prohibits a bank holding company from declaring or paying a cash dividend which would impose undue pressure on the capital of subsidiary banks or would be funded only through borrowing or other arrangements that might adversely affect a bank holding company’s financial position. The Federal Reserve Board policy is that a bank holding company should not continue its existing rate of cash dividends on its common stock unless its net income is sufficient to fully fund each dividend and its prospective rate of earnings retention appears consistent with its capital needs, asset quality and overall financial condition.

First National Bank of Northern California. As the Bank’s sole shareholder, the Company is entitled to receive dividends when and as declared by the Bank’s Board of Directors, out of funds legally available therefore, subject to the restrictions set forth in the National Bank Act.

The payment of cash dividends by the Bank may be subject to the approval of the Office of the Comptroller of the Currency, as well as restrictions established by federal banking law and the FDIC. Approval of the Office of the Comptroller of the Currency is required if the total of all dividends declared by the Bank’s Board of Directors in any calendar year will exceed the Bank’s net profits for that year combined with its retained net profits for the preceding two years, less any required transfers to surplus or to a fund for the retirement of preferred stock.

Additionally, the FDIC and/or the Office of the Comptroller of the Currency, might, under some circumstances, place restrictions on the ability of a bank to pay dividends.

Impact of Certain Legislation and Regulation

Gramm-Leach-Bliley Act of 1999. The Gramm-Leach-Bliley Act of 1999 (the “GLB Act”) eliminated most of the remaining depression-era “firewalls” between banks, securities firms and insurance companies which were established by the Banking Act of 1933, also known as the Glass-Steagall Act (“Glass-Steagall”). Glass-Steagall sought to insulate banks as depository institutions from the perceived risks of securities dealing and underwriting, and related activities. The GLB Act repealed Section 20 of Glass-Steagall, which prohibited banks from affiliating with securities firms. Bank holding companies that can qualify as “financial holding companies” can now, among other matters, acquire securities firms or create them as subsidiaries, and securities firms can now acquire banks or start banking activities through a financial holding company. The GLB Act includes provisions which permit national banks to conduct financial activities through a subsidiary that are permissible for a national bank to engage in directly, as well as certain activities authorized by statute, or that are financial in nature or incidental to financial activities to the same extent as permitted to a “financial holding company” or its affiliates. This liberalization of United States banking and financial services regulation applies both to domestic institutions and foreign institutions conducting business in the United States. Consequently, the common ownership of banks, securities firms and insurance is now possible, as is the conduct of commercial banking, merchant banking, and investment management, securities underwriting and insurance within a single financial institution using a structure authorized by the GLB Act. Neither the Company nor the Bank has determined whether or when it may seek to acquire and exercise new powers or activities under the GLB Act.

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Financial holding companies are also permitted to engage in activities that are complementary to financial activities if the Board of Governors determines that the activity does not pose a substantial risk to the safety or soundness of depository institutions or the financial system in general. These standards expand upon the list of activities “closely related to banking” which have defined the permissible activities of bank holding companies under the Bank Holding Company Act. One further effect of the Act was to require that federal financial institution and securities regulatory agencies prescribe regulation to implement the policy that financial institutions must respect the privacy of their customers and protect the security and confidentiality of customers’ non-public personal information. These regulations require, in general, that financial institutions (1) may not disclose non-public information of customers to non-affiliated third parties without notice to their customers, who must have an opportunity to direct that such information not be disclosed; (2) may not disclose customer account numbers except to consumer reporting agencies; and (3) must give prior disclosure of their privacy policies before establishing new customer relationships.

 

The Patriot Act. On October 26, 2001, President Bush signed the USA Patriot Act (the “Patriot Act”), which included provisions pertaining to domestic security, surveillance procedures, border protection, and terrorism laws to be administered by the Secretary of the Treasury. Title III of the Patriot Act entitled, “International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001” includes amendments to the Bank Secrecy Act which expand the responsibilities of financial institutions in regard to anti-money laundering activities with particular emphasis upon international money laundering and terrorism financing activities through designated correspondent and private banking accounts.

The Patriot Act contains various provisions that affect the operations of financial institutions by encouraging cooperation among financial institutions, regulatory authorities and law enforcement authorities with respect to individuals, entities and organizations engaged in, or reasonably suspected of engaging in, terrorist acts or money laundering activities. The Company and the Bank are not currently aware of any account relationships between the Bank and any foreign bank or other person or entity which would not be in compliance with the Patriot Act.

Certain surveillance provisions of the Patriot Act expired on June 1, 2015 but were renewed the next day by the passage of the USA Freedom Act on June 2, 2015 and extended through 2019. However, the provision under which the National Security Agency (“NSA”) conducted mass phone data collection on individuals was changed to require the NSA to seek permission from a federal court in order to obtain such data from phone companies.

The effects which the Patriot Act and any amendments to the Patriot Act or any additional legislation enacted by Congress may have upon financial institutions is uncertain; however, such legislation could increase compliance costs and thereby potentially may have an adverse effect upon the Company’s results of operations.

Sarbanes-Oxley Act of 2002. On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”), legislation designed to address certain issues of corporate governance and accountability. Among other matters, key provisions of Sarbanes-Oxley and rules promulgated by the Securities and Exchange Commission pursuant to Sarbanes-Oxley include enhancement of financial disclosures and related certification requirements, rules related to audit committees, auditor independence, ethics requirements, securities trading prohibitions, securities reporting requirements, and securities listing requirements. The Company’s common stock is traded on the Nasdaq Global Select Market and therefore is required to comply with the Nasdaq listing standards in addition to the rules promulgated by the Securities and Exchange Commission pursuant to Sarbanes-Oxley. The effect of Sarbanes-Oxley on the Company is uncertain; however, the Company has incurred, and it is anticipated that it will continue to incur costs to comply with Sarbanes-Oxley and the rules and regulations promulgated pursuant to Sarbanes-Oxley by the Securities and Exchange Commission and other regulatory agencies having jurisdiction over the Company on the issuance and listing of its securities. The Company does not currently anticipate, however, that compliance with Sarbanes-Oxley and such rules and regulations will have a material effect upon its financial position or results of its operations or its cash flows.

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Small Business Jobs Act of 2010. On September 27, 2010, President Obama signed into law the Small Business Jobs Act of 2010 (the “SBJ Act”), which, among other matters, authorized the U.S. Treasury to buy preferred stock or subordinated debt issued by community banks with assets less than $10 billion. On September 15, 2011, as part of the Small Business Lending Fund program established under the SBJ Act, the Company issued and sold to the Secretary of the Treasury a total of 12,600 shares of the Company’s Senior Non-Cumulative Perpetual Preferred Stock, Series C (the “Series C Preferred Stock”) for a purchase price of $12,600,000. The Series C Preferred Stock qualified as Tier 1 capital. All of the $12,600,000 proceeds from the Company’s sale of its Series C Preferred Stock were immediately applied to the Company’s repurchase of outstanding shares of preferred stock which had been issued to the United States Department of the Treasury on February 27, 2009, pursuant to the TARP Capital Purchase Program authorized by the Emergency Economic Stabilization Act of 2008, as amended by the American Recovery and Reinvestment Act of 2009. On May 6, 2013, the Company redeemed 25% of the original issue $12,600,000 of Series C Preferred Stock for a cash payment of $3,150,000. Subsequently, on January 23, 2014, the remaining $9,450,000 of Series C Preferred Stock was redeemed by the Company, also in a cash transaction.

 

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”). The Dodd-Frank Act is intended to restructure the regulation of the financial services sector by, among other things, (i) establishing a framework to identify systemic risks in the financial system implemented by a newly created Financial Stability Oversight Council and other federal banking agencies; (ii) expanding the resolution authority of the federal banking agencies over troubled financial institutions; (iii) authorizing changes to capital and liquidity requirements; (iv) changing deposit insurance assessments; and (v) enhancing regulatory supervision to improve the safety and soundness of the financial services sector. Below is a summary of certain provisions of the Dodd-Frank Act which, directly or indirectly, may affect the Company and the Bank.

·Changes to Capital Requirements. The federal banking agencies are required to establish minimum leverage and risk-based capital requirements for banks and bank holding companies which will not be lower and could be higher than established regulatory capital and leverage standards for insured depository institutions. Under these requirements, trust preferred securities will be excluded from Tier 1 capital unless such securities were issued prior to May 19, 2010 by a bank holding company with less than $15 billion in assets. The Company has no trust preferred securities outstanding. The Dodd-Frank Act requires capital increases in times of economic expansion and decreases in times of economic contraction consistent with safety and soundness.
·Enhanced Regulatory Supervision. The Dodd-Frank Act increases regulatory oversight, supervision and examination of banks, bank holding companies and their respective subsidiaries by the appropriate regulatory agency.
·Consumer Protection. The Dodd-Frank Act created the Consumer Financial Protection Bureau (“CFPB”) within the Federal Reserve System. The CFPB is responsible for establishing and implementing rules and regulations under various federal consumer protection laws governing certain consumer products and services.
·The CFPB has primary enforcement authority over large financial institutions with assets of $10 billion or more, while smaller institutions will be subject to the CFPB’s rules and regulations through the enforcement authority of the federal banking agencies. States are permitted to adopt consumer protection laws and regulations that are more stringent than those laws and regulations adopted by the CFPB and state attorneys general are permitted to enforce consumer protection laws and regulations adopted by the CFPB.
·Deposit Insurance. The Dodd-Frank Act permanently increased the deposit insurance limit for insured deposits to $250,000 per depositor and extended unlimited deposit insurance to non-interest bearing transaction accounts until December 31, 2012. Other deposit insurance changes under the Dodd-Frank Act include (i) amendment of the assessment base used to calculate an insured depository institution’s deposit insurance premiums paid to the Deposit Insurance Fund (“DIF”) by elimination of deposits and substitution of average consolidated total assets less average tangible equity during the assessment period as the revised assessment base; (ii) increasing the minimum designated reserve ratio of the DIF from 1.15% to 1.35% of the estimated amount of total insured deposits; (iii) eliminating the requirement that the FDIC pay dividends to depository institutions when the reserve ratio exceeds certain thresholds; and (iv) repeal of the prohibition upon the payment of interest on demand deposits to be effective one year after the date of enactment of the Dodd-Frank Act.
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·Transactions with Affiliates. The Dodd-Frank Act enhanced the requirements for certain transactions with affiliates under Section 23A and 23B of the Federal Reserve Act, including an expansion of the definition of “covered transactions” and increasing the amount of time for which collateral requirements regarding covered transactions must be maintained.
·Transactions with Insiders. Insider transaction limitations were expanded through the strengthening of loan restrictions to insiders and the expansion of the types of transactions subject to various limits, including derivative transactions, repurchase agreements, reverse repurchase agreements and securities lending or borrowing transactions. Restrictions were also placed on certain asset sales to and from an insider to an institution, including requirements that such sales be on market terms and, in certain circumstances, approved by the institution’s board of directors.
·Enhanced Lending Limitations. The Dodd-Frank Act strengthened the existing limits on a depository institution’s credit exposure to include credit exposure arising from derivative transactions, repurchase agreements, and securities lending and borrowing transactions.
·Debit Card Interchange Fees. The Dodd-Frank Act required that the amount of any interchange fee charged by a debit card issuer with respect to a debit card transaction must be reasonable and proportional to the cost incurred by the issuer. Within nine months of enactment of the Dodd-Frank Act, the Federal Reserve Board was required to establish standards for reasonable and proportional fees which may take into account the costs of preventing fraud. The restrictions on interchange fees, however, do not apply to banks that, together with their affiliates, have assets of less than $10 billion.
·Interstate Branching. The Dodd-Frank Act authorized national and state banks to establish branches in other states to the same extent as a bank chartered by that state would be permitted to branch. Previously, banks could only establish branches in other states if the host state expressly permitted out-of-state banks to establish branches in that state. Accordingly, banks will be able to enter new markets more freely.
·Charter Conversions. Effective one year after enactment of the Dodd-Frank Act, depository institutions that are subject to a cease and desist order or certain other enforcement actions issued with respect to a significant supervisory matter were prohibited from changing their federal or state charters, except in accordance with certain notice, application and other procedures involving the applicable regulatory agencies.
·Compensation Practices. The Dodd-Frank Act provided that the appropriate federal banking regulators must establish standards prohibiting as an unsafe and unsound practice any compensation plan of a bank holding company or other “covered financial institution” that provides an insider or other employee with “excessive compensation” or could lead to a material financial loss to such firm. In June 2010, prior to the enactment of the Dodd-Frank Act, the federal bank regulatory agencies jointly issued the Interagency Guidance on Sound Incentive Compensation Policies (“Guidance”), which requires that financial institutions establish metrics for measuring the risk to the financial institution of such loss from incentive compensation arrangements and implement policies to prohibit inappropriate risk taking that may lead to material financial loss to the institution.
·Corporate Governance. The Dodd-Frank Act has enhanced corporate governance requirements to include (i) requiring publicly traded companies to give shareholders a non-binding vote on executive compensation at their first annual meeting taking place six months after the enactment and at least every three years thereafter and on so-called “golden parachute” payments in connection with approvals of mergers and acquisitions unless previously voted on by shareholders; (ii) authorizing the SEC to promulgate rules that would allow shareholders to nominate their own candidates for election as directors using a company’s proxy materials; (iii) directing the federal banking regulators to promulgate rules prohibiting excessive compensation paid to executives of depository institutions and their holding companies with assets in excess of $1.0 billion, regardless of whether or not the company is publicly traded; and (iv) authorizing the SEC to prohibit broker discretionary voting on the election of directors and on executive compensation matters.
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Many of the requirements under the Dodd-Frank Act are being implemented over an extended period of time and therefore, the nature and extent of regulations that will be issued by various regulatory agencies and the impact such regulations will have on the operations of financial institutions such as the Company and the Bank is unclear. Such regulations resulting from the Dodd-Frank Act may impact the profitability of our business activities, require changes to certain of our business practices, impose upon us more stringent capital, liquidity and leverage ratio requirements or otherwise adversely affect our business. These changes may also require us to invest significant management attention and resources to evaluate and make necessary changes in order to comply with new statutory and regulatory requirements.

 

Volcker Rule. On December 10, 2013, the federal banking agencies jointly issued a final rule implementing the so-called “Volcker Rule” (set forth in Section 619 of the Dodd-Frank Act). The Volcker rule prohibits depository institutions, companies that control such institutions, bank holding companies, and the affiliates and subsidiaries of such banking entities, from engaging as principal for the trading account of the banking entity in any purchase or sale of one or more covered financial instruments (so-called “proprietary trading”) and imposes limitations upon retaining interests in, sponsoring, investing in and transacting with certain investment funds, including hedge funds and private equity funds. The effective date of the final rule restricting proprietary trading was extended to July 21, 2015, and certain other matters were extended to July 21, 2017. Neither the Company nor the Bank engages in activities prohibited by the Volcker Rule and management does not expect the Volcker Rule to have a material impact upon the Company or the Bank. 

 

Tax Cuts and Jobs Act

On December 22, 2017, President Donald Trump signed into law the Tax Cuts and Jobs Act ( the “Act”), which among other things reduced the federal corporate income tax rate to 21% effective January 1, 2018. As a result, the Company has concluded that this Act caused a reduction in the net deferred tax asset of the Company of $3 million, as of December 31, 2017, due to the revaluation of the Company’s net timing differences at the lower statutory income tax rate. The estimated fourth quarter of 2017 earnings impact was $(0.39) per average diluted share outstanding.

 

Future Legislation and Regulations

 

Certain legislative and regulatory proposals that could affect the Company, the Bank, and the banking business in general are periodically introduced before the United States Congress, the California State Legislature and federal and state government agencies. It is not known to what extent, if any, legislative proposals will be enacted and what effect such legislation would have on the structure, regulation and competitive relationships of financial institutions. It is likely, however, that such legislation could subject the Company and the Bank to increased regulation, disclosure and reporting requirements, more competition, and increased costs of doing business. In addition to legislative changes, the various federal and state financial institution regulatory agencies frequently propose rules and regulations to implement and enforce already existing legislation. It cannot be predicted whether or in what form any such rules or regulations will be enacted or the effect that such regulations may have on the Company and the Bank.

 

ITEM 1A. RISK FACTORS

 

In addition to the risks associated with the business of banking generally, as described above under Item 1 (Description of Business), the Company’s business, financial condition, operating results, future prospects and stock price can be adversely impacted by certain risk factors, as set forth below, any of which could cause the Company’s actual results to vary materially from the recent results or from the Company’s anticipated future results.

 

Extensive Regulation of Banking. The Company’s operations are subject to extensive regulation by federal, state and local governmental authorities and are subject to various laws and judicial and administrative decisions imposing requirements and restrictions on part or all of its operations. The Company believes that it is in substantial compliance in all material respects with laws, rules and regulations applicable to the conduct of its business. Because the Company’s business is highly regulated, the laws, rules and regulations applicable to it are subject to regular modification and change. There can be no assurance that these laws, rules and regulations, or any other laws, rules or regulations, will not be adopted in the future, which could make compliance much more difficult or expensive, restrict the Company’s ability to originate, broker or sell loans, further limit or restrict the amount of commissions, interest or other charges earned on loans originated or sold by the Company, or otherwise adversely affect the Company’s results of operations, financial condition, or future prospects.

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Governmental Fiscal and Monetary Policies. The business of banking is affected significantly by the fiscal and monetary policies of the federal government and its agencies. Such policies are beyond the control of the Company. The Company is particularly affected by the policies established by the Board of Governors of the Federal Reserve System in relation to the supply of money and credit in the United States, and the target federal funds rate.

The instruments of monetary policy available to the Board of Governors can be used in varying degrees and combinations to directly affect the availability of bank loans and deposits, as well as the interest rates charged on loans and paid on deposits, and this can and does have a material effect on the Company’s business, results of operations and financial condition. Federal monetary policy may also affect the longer-term inflation rate which directly affects the national and local economy.

The Effects of Legislation in Response to Credit Conditions. Legislation passed at the federal level and/or by the State of California in response to conditions affecting credit markets could cause the Company to experience higher credit losses if such legislation reduces the amount that borrowers are otherwise contractually required to pay under existing loan contracts with the Bank. Such legislation could also result in the imposition of limitations upon the Bank’s ability to foreclose on property or other collateral or make foreclosure less economically feasible. Such events could result in increased loan losses and require a material increase in the allowance for loan losses and thereby adversely affect the Company’s results of operations, financial condition, future prospects, profitability and stock price.

Geographic Concentration. All of the banking offices of the Company are located in the Northern California Counties of San Mateo, Santa Clara and San Francisco. The Company and the Bank conduct business primarily in the San Francisco Bay Area. As a result, our financial condition, results of operations and cash flows are subject to changes in the economic conditions in this area, in addition to statewide economic conditions. Our success depends upon the business activity, population, income levels, deposits and real estate activity in these markets, and adverse economic conditions could reduce our growth rate, or affect the ability of our customers to repay their loans, and generally impact our financial condition and results of operations.

Competition. Increased competition in the market areas served by the Bank may result in reduced loans and deposits. Ultimately, the Bank may not be able to compete successfully against current and future bank and non-bank competitors.

Many competitors offer the banking services that are offered by the Bank in its service area. These competitors include national and super-regional banks, finance companies, investment banking and brokerage firms, credit unions, government-assisted farm credit programs, other community banks and technology-oriented financial institutions offering online services. In particular, the Bank’s competitors include several major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous banking locations and mount extensive promotional and advertising campaigns. Additionally, banks and other financial institutions with larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are thereby able to serve the credit needs of larger customers. Areas of competition include interest rates for loans and deposits, efforts to obtain deposits, and range and quality of products and services provided, including new technology-driven products and services. Technological innovation continues to contribute to greater competition in domestic and international financial services markets as technological advances, such as Internet-based banking services that cross traditional geographic bounds, enable more companies to provide financial services.

The Effects of Changes to FDIC Insurance Coverage Limits and Assessments. FDIC insurance assessments are uncertain and increased premiums may adversely affect the Company’s earnings. The FDIC charges insured financial institutions premiums to maintain the Deposit Insurance Fund. A deterioration in economic conditions would increase expectations for bank failures. In such event, the FDIC would be expected to take control of failed banks and guarantee payment of deposits up to applicable insured limits from the Deposit Insurance Fund. Insurance premium assessments to insured financial institutions may then increase as necessary to maintain adequate funding of the Deposit Insurance Fund. Thus, a deterioration in economic conditions may cause losses which require premium increases to replenish the Deposit Insurance Fund and such increases could adversely impact the Bank’s earnings.

 

Interest Rate Risk. Our earnings and cash flows are largely dependent upon our net interest income. Net interest income is the difference between interest income earned on interest-earning assets, such as loans and securities, and interest expense paid on interest-bearing liabilities, such as deposits and borrowed funds.

17
 

Interest rates are sensitive to many factors outside our control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Board of Governors of the Federal Reserve System, which regulates the supply of money and credit in the United States. Changes in monetary policy, including changes in interest rates, could influence not only the interest we receive on loans and securities and interest we pay on deposits and borrowings, but could also affect (i) our ability to originate loans and obtain deposits, (ii) the fair value of our financial assets and liabilities, and (iii) the average duration of our mortgage-backed securities portfolio. Our portfolio of securities is subject to interest rate risk and will generally decline in value if market interest rates increase, and generally increase in value if market interest rates decline.

 

Technology and Technological Change. The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology will enable efficiency and meeting customers’ changing needs. Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to retain and compete for customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact of the long-term aspect of our business and, in turn, our financial condition and results of operations.

Dependence on Key Officers and Employees. We are dependent on the successful recruitment and retention of highly qualified personnel. Our ability to implement our business strategies is closely tied to the strengths of our executive officers who have extensive experience in the banking industry but who are not easily replaced. In addition, business banking, one of the Company’s principal lines of business, is dependent on relationship banking, in which the Bank personnel develop professional relationships with small business owners and officers of larger business customers who are responsible for the financial management of the companies they represent. If these employees were to leave the Bank and become employed by a local competing bank, we could potentially lose business customers. In addition, we rely on our customer service staff to effectively serve the needs of our consumer customers. We actively recruit for all open positions and management believes that its relations with employees are good.

Growth Strategy. The Company continues to pursue a growth strategy which depends primarily on generating an increasing level of loans and deposits at acceptable risk levels. We may not be able to sustain our growth strategy without establishing new branches or developing new products. We may attempt to expand by opening new branch offices or acquiring other financial institutions or branch offices or through a purchase, in whole or in part, of other financial institutions. This expansion may require significant investments in equipment, technology, personnel and site locations. We cannot assure you of our success in implementing our growth strategy either through expansion of our existing branch system or through mergers and acquisitions, and there may be significant increases in our noninterest expenses, without any corresponding balance sheet growth. Mergers and acquisitions may not add to the growth of the Bank’s loans, deposits or the Bank’s profitability due to integration problems, collateral differences, changes in business conditions, or other unforeseen circumstances.

Commercial Loans. As of December 31, 2017, approximately 7% of our loan portfolio consisted of commercial business loans, which could have a higher degree of risk than other types of loans. Commercial lending is dependent on borrowers making payments on their loans and lines of credit in accordance with the terms of their notes. Worsening economic conditions could make it difficult for many commercial borrowers to make their required loan payments. This credit risk is increased when there is a concentration of principal in a limited number of loans and borrowers, the mobility of collateral, and the increased difficulty of evaluating and monitoring these types of loans. The availability of funds for the repayment of commercial business loans may be substantially dependent on the success of the business itself and the general economic environment. If the cash flow from business operations is reduced, the borrower’s ability to repay the loan may be impaired.

In addition, unlike residential mortgage loans, which generally are made on the basis of the borrower’s ability to make repayment from his or her employment and other income and which are secured by real property whose value tends to be more easily ascertainable, commercial business loans typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business. If the Bank is required to repossess equipment or pursue collection efforts under personal guarantees, there could be a substantial decrease in value of collateral, if any, increased legal costs, and an increased risk of loss on the amount outstanding.

18
 

Real Estate Values. A large portion of the loan portfolio of the Company is dependent on the performance of our real estate loan portfolio. At December 31, 2017, real estate secured loans (including construction loans) served as the principal source of collateral and represented approximately 92% of the Company’s loan portfolio. Within the real estate secured loan portfolio, commercial real estate loans represent 59%, 1 to 4 single family residential loans represent 22%, multi-family residential loans represent 14% and construction loans represent 5% of the total.

 

A substantial decline in the economy in general, coupled with a continued decline in real estate values in the Company’s primary operating market areas could have an adverse effect on the demand for new loans, the ability of borrowers to repay outstanding loans, and the value of real estate and other collateral securing loans. Real estate values have declined, due in part to reduced construction lending, tighter underwriting requirements, and reduced borrower ability to make payments. Real estate loans may pose collection problems, resulting in increased collection expenses, and delays in the ultimate collection of these loans. In addition, acts of nature, including fires, earthquakes and floods, which may cause uninsured damage and other loss of value to real estate that secures these loans, may also negatively impact the Company’s financial condition.

Allowance for Loan and Lease Losses. The Company maintains an allowance for loan losses to provide for inherent loan defaults and non-performance, but its allowance for loan losses may not be adequate to cover actual loan and lease losses. In addition, future provisions for loan and lease losses could materially and adversely affect the Company and therefore the Company’s operating results. The Company’s allowance for loan and lease losses is based on prior experience, as well as an evaluation of the risks in the current portfolio. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates that may be beyond the Company’s control, and these losses current estimates. Federal regulatory agencies, as an integral part of their examination process, review the Company’s loans and the allowance for loan and lease losses. Although we believe that the Company’s allowance for loan and lease losses is adequate to cover inherent future losses, we cannot assure you that we will not further increase the allowance for loan and lease losses or that the regulators will not require us to increase this allowance. Either of these occurrences could materially and adversely affect the Company’s earnings.

 

Other Real Estate Owned (“OREO”). Real estate acquired through, or in lieu of, loan foreclosures is expected to be sold and is recorded at its fair value less estimated costs to sell. The amount, if any, by which the recorded amount of the loan exceeds the fair value (less estimated costs to sell) are charged to the allowance for loan or lease losses, if necessary. The Company’s earnings could be materially and adversely affected by various expenses associated with property ownership, including legal expenses, personnel costs, insurance and taxes, completion and repair costs, valuation adjustments, and environmental related liabilities discussed below. Also, any further decrease in market prices of real estate in our market areas may lead to additional OREO write downs, with a corresponding expense in our income statement. At December 31, 2017 and 2016, our OREO net book value totaled $3,300,000 and $1,427,000, respectively. For additional information, see “Nonperforming Assets” in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and footnotes 7 and 23 to the Company’s 2017 Consolidated Financial Statements in Item 8, herein. One property that was acquired through foreclosure and subsequently sold is subject to contractual performance obligations related to toxic soil and water quality remediation. See “Environmental Related Liabilities” and “Contracts with Performance Obligations” below.

 

Environmental Related Liabilities. In the ordinary course of our business, we may foreclose and take title to real estate and could become subject to environmental related liabilities with respect to these properties. We may be held liable to a government entity or third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination or may be required to investigate or clean-up hazardous or toxic substances, or chemical releases at a property. The costs associated with investigations or remediation activities could be substantial. In addition, as the owner or former owner of a contaminated site, we could become subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. If we become subject to significant environmental liabilities, our business prospects, financial condition, liquidity, results of operations and stock price could be materially and adversely affected. See “Contracts with Performance Obligation” below.

19
 

Contracts with Performance Obligations. The Company utilizes purchase and sale contracts when entering into the purchase or sale of certain assets. Such a contract may contain performance obligations that are imbedded in the terms and conditions of the contract. These performance obligations may require the Company to perform a service or services where the ultimate cost and the length of time required to perform the service or services cannot be predicted with certainty. When these circumstances exist, the Company is required to review all the facts and circumstances related to its performance obligations and use sound business judgement in the quantification of the cost of these performance obligations. On July 12, 2011, we foreclosed on a commercial real estate property that was known to have soil and ground water contamination. Since acquiring title to the property, the property has been held as OREO and the Company has conducted remediation efforts, with the guidance of an environmental consultant and others, in the pursuit of a final remediation plan acceptable to the San Francisco Bay Regional Water Quality Control Board (the “Water Board”). The Company entered into a contract to sell the property to an unrelated third party on February 22, 2018. The sale transaction was completed using a purchase and sale contract that included Company performance obligations. Under the terms of the contract, the buyer of the property obtained title to the property, including the legal right to lease revenue being generated by the property, and the Company agreed to perform certain remediation activities and to continue work with the Water Board toward the objective of obtaining a mutually acceptable final remediation plan for the property. The Company remains responsible for additional remediation costs, assuming further remediation becomes necessary, and could be liable to governmental entities or third parties for future investigation and clean-up costs or other expenses, which could be substantial. The Company has established a contingent liability reserve for this purpose based on future expected cost estimates provided to the Company by its soil engineering and consulting company consultant. If the actual liabilities, costs and expenses related to these obligations are determined to be substantially in excess of the reserve established by the Company, these excess costs could potentially have an adverse material effect on the business prospects, financial condition, liquidity, results of operations and stock price of the Company. See additional information under “Nonperforming Assets” in Item 7 of this report and in footnotes 7 and 23 of the Company’s Consolidated Financial Statements in Item 8 of this report.

 

Limited Trading in our Common Stock and Dilution. The common stock of the Company is listed on the Nasdaq Global Select Market under the trading symbol “FNBG”; however, our trading volume is less than that of larger financial institutions.

 

We are not restricted from issuing additional shares of common stock, or securities that are convertible into or exchangeable for or that represent the right to receive common stock, including stock options. The issuance of substantial amounts of the Company’s newly issued common stock in the public market could be substantially dilutive to shareholders of our common stock and could adversely affect the market price of the Company’s common stock. The Articles of Incorporation of the Company authorize the issuance of 10,000,000 shares of common stock, of which 7,442,279 were issued and outstanding at December 31, 2017. Pursuant to its 1997, 2002 and 2008 Stock Option Plans, at December 31, 2017, there were outstanding options to purchase a total of 455,291 shares of common stock. As of December 31, 2017, no additional stock option grants can be issued as per the terms of the Merger Agreement signed with TriCo on December 11, 2017.

Controls and Procedures. Management regularly reviews and updates the Company’s internal control over financial reporting, disclosure controls and procedures, and corporate governance policies and procedures. We maintain controls and procedures to mitigate risks such as processing system failures or errors and customer or employee fraud, and we maintain insurance coverage for certain of these risks. Any system of controls and procedures, however well designed and operated, is based in part on certain assumptions and provides only reasonable, not absolute, certainty that the objectives of the system will be met. Events could occur which are not prevented or detected by our internal controls, are not insured against, or are in excess of our insurance limits. Any failure or circumvention of our controls and procedures, or failure to comply with regulations related to controls and procedures, could have an adverse effect on our business.

Cybersecurity Losses. The Company is subject to certain operations risks, including, but not limited to, data processing system or cybersecurity failures and customer or employee fraud. The Company maintains a system of internal controls to mitigate against such occurrences and maintains insurance coverage for such risks, but should such an event occur that is not prevented or detected by the Company’s internal controls, uninsured or in excess of applicable insurance limits, it could have a significant adverse impact on the Company’s business, financial condition or results of operations. Additionally, the Company is dependent on network and computer systems. If these systems and their back-up systems were to fail or were breached, the Company could be adversely affected. The company cannot be certain that the continued implementation of safeguards will eliminate the risk of vulnerability to technological difficulties or failures or ensure the absence of a breach of information or security, including as a result of a cybersecurity breach. The bank regulatory agencies have recently emphasized cybersecurity as a critical challenge facing the financial services industry in light of the frequency and sophistication of cyber attacks. The Company and the Bank will continue to enhance their information security programs consistent with regulatory requirements, including reliance on the services of various vendors who provide data processing and communications services to the financial services industry. Nonetheless, if information security is compromised or other technology difficulties or failures occur at the Bank or with one of its vendors, information may be lost or misappropriated, services and operations may be interrupted and the Bank could be exposed to claims from its customers.

20
 

Business Confidence Uncertainty. Terrorist activities in the future and the actions taken by the United States and its allies in combating terrorism on a worldwide basis could adversely impact the Company and the extent of such impact is uncertain. Even more so, the problems in the mortgage and credit markets, the government conservatorship of Fannie Mae and Freddie Mac, as well as large write-offs at some major financial institutions have had a negative impact on the entire financial services industry. Such events have had an adverse effect on the economy in the Company’s market areas.

 

Federal Home Loan Bank Risk. The failure of the Federal Home Loan Bank (“FHLB”) of San Francisco or the national Federal Home Loan Bank System may have a material negative impact on our earnings and liquidity.

Even though the FHLB of San Francisco has announced it does not anticipate that additional capital will be necessary, nor does it believe that its capital level is inadequate to support realized losses in the future, the FHLB of San Francisco could require its members, including the Bank, to contribute additional capital in order to return the FHLB of San Francisco to compliance with capital guidelines.

At December 31, 2017, the Bank held $6.0 million of common stock in the FHLB of San Francisco. Should the FHLB of San Francisco fail, we anticipate that our investment in the FHLB’s common stock would be “other than temporarily” impaired and may have limited value.

At December 31, 2017, the Bank maintained a line of credit with the FHLB of San Francisco with a maximum borrowing capacity of $509,371,400 of which $433,861,400 was available. Advances under the line of credit are secured by a blanket collateral agreement, a pledge of our FHLB common stock and certain other qualifying collateral, such as commercial and mortgage loans. The Bank is highly dependent on the FHLB of San Francisco as the primary source of wholesale funding for immediate liquidity and borrowing needs. The failure of the FHLB of San Francisco or the FHLB system in general, may materially impair our ability to meet our growth plans or to meet short and long term liquidity demands.

 

Tax Changes. The Tax Cuts and Jobs Act enacted on December 22, 2017 has had, and is expected to continue to have, far-reaching and significant effects on the Company, our customers and the U.S. economy. The Act lowered the corporate federal statutory tax rate and eliminated or limited certain federal corporate deductions. It is too early to evaluate all of the potential consequences of the Act but such consequences could include lower commercial customer borrowings, either due to the increase in cash flows as a result of the reduction in the corporate statutory tax rate or the utilization by businesses in certain sectors of alternative non-debt financing and/or early retirement of existing debt. Further, there can be no assurance that any benefits realized by us as a result of the reduction in the corporate federal statutory tax rate will ultimately result in increased net income, whether due to decreased loan yields as a result of competition or to other factors. Uncertainty also exists related to the response of state and other taxing jurisdictions to the Act. Federal income tax treatment of corporations may be further clarified and modified by other legislative, administrative or judicial changes or interpretations at any time. Any such changes could adversely impact our business and operations. 

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

 

None.

ITEM 2. PROPERTIES

Since its incorporation on February 28, 2001, the Company has conducted its operations at the administrative offices of the Bank, located at 975 El Camino Real, South San Francisco, CA 94080.

The Bank owns the land and building at 975 El Camino Real, South San Francisco, CA 94080. The premises consist of a three-story building of approximately 15,000 square feet and off-street parking for employees and customers of approximately 45 vehicles.

21
 

The Buri Buri Branch Office of the Bank is located on the ground floor of the building at 975 El Camino Real, South San Francisco, CA 94080, and administrative offices, including the offices of senior management and credit administration, occupy the second and third floors.

 

The Bank owns the land and two-story building occupied by the Daly City Branch Office (6600 Mission Street, Daly City, CA 94014); the land and two-story building occupied by the Colma Branch Office (1300 El Camino Real, Colma, CA 94014); the land and two-story building occupied by the Redwood City Branch Office (700 El Camino Real, Redwood City, CA 94063); the land and two-story building occupied by the Millbrae Branch Office (1551 El Camino Real, Millbrae, CA 94030); the land and single-story building occupied by the Half Moon Bay Branch Office (756 Main Street, Half Moon Bay, CA 94019); the land and two-story building occupied by the Pescadero Branch Office (239 Stage Road, Pescadero, CA 94060); and the land and one story building occupied by the Sunnyvale Branch Office (425 South Mathilda Avenue, Sunnyvale, CA 94086). All properties include adequate vehicle parking for customers and employees.

The Bank leases premises at 1450 Linda Mar Shopping Center, Pacifica, California 94044, for its Linda Mar Branch Office. This ground floor space is approximately 4,100 square feet. The lease will expire on August 31, 2019.

The Bank leases premises at 6599 Portola Drive, San Francisco, CA 94127, for its Portola Office. The current lease expired June 30, 2012, and the premises are currently leased on a month-to-month basis. The location consists of approximately 1,325 square feet of street level space.

The Bank subleases premises at 2197 Chestnut Street, San Francisco, CA 94123, for its Chestnut Street Branch, which opened for business on April 4, 2011, and consists of 2,150 square feet at street level and approximately 2,000 square feet on the second floor. The sublease ends on July 15, 2024.

The Bank leases premises at 150 East Third Avenue, San Mateo, CA 94401, for its San Mateo Branch Office. The Bank exercised the remaining option to extend the lease term to August 12, 2018. The location consists of approximately 4,000 square feet of ground floor usable commercial space.

The Bank leases premises at 130 Battery Street, San Francisco, CA, 94000, for its Battery Street Branch Office. The lease has been renewed with the maturity extended to February 28, 2023. The location consists of approximately 13,000 square feet, consisting of ground floor, mezzanine and lower level.

The Bank leased a warehouse facility at 450 Cabot Road, South San Francisco, CA 94080. The lease expired February 28, 2011. The facility is currently leased on a month-to-month basis and consists of approximately 7,600 square feet of office/warehouse space.

The foregoing summary descriptions of leased premises are qualified in their entirety by reference to the full text of the lease agreements listed as exhibits to this report.

As of December 31, 2017, the Bank’s net investment in premises and equipment totaled $9,322,000. See Note 9 to the Company’s Consolidated Financial Statements in Item 8 below.

ITEM 3. LEGAL PROCEEDINGS

There are no material legal proceedings adverse to the Company or the Bank to which any director, officer, affiliate of the Company, or 5% shareholder of the Company, or any associate of any such director, officer, affiliate or 5% shareholder of the Company are a party, and none of the foregoing persons has a material interest adverse to the Company or the Bank.

From time to time, the Company and/or the Bank are a party to claims and legal proceedings arising in the ordinary course of business. The Company’s management is not aware of any material pending legal proceedings to which either it or the Bank may be a party or has recently been a party, which will have a material adverse effect on the financial condition or results of operations of the Company and the Bank, taken as a whole.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable. 

22
 

PART II

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

The common stock of the Company is listed on the Nasdaq Global Select Market, with trades quoted under the trading symbol, “FNBG.” There is limited trading in the shares of the common stock of the Company. As of December 31, 2017, the Company had approximately 900 shareholders of common stock of record.

 

The following table summarizes the range of high and low bid information reported on the Nasdaq Global Select Market (since April 13, 2017) and on the OTCQB marketplace during the periods indicated of which management has knowledge, including the per share cash dividends declared for the periods indicated. These over-the-counter quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. All information has been adjusted to reflect all stock dividends and the 3 for 2 stock split that occurred in May 2017. 

   Closing Price of FNB Bancorp   Cash 
   Common Stock   Dividends 
2016  High   Low   Declared (1) 
First Quarter  $19.52   $18.42   $0.10 
Second Quarter   18.50    17.97    0.10 
Third Quarter   19.37    17.78    0.10 
Fourth Quarter   22.67    19.08    0.11 
                
2017               
First Quarter  $24.50   $21.73   $0.11 
Second Quarter   30.00    27.37    0.12 
Third Quarter   34.14    27.10    0.13 
Fourth Quarter   38.62    32.54    0.13 

(1) See “Dividends” (following “FDIC Insurance”) in Item 1 (above), for a description of the limitations applicable to the payment of dividends by the Company. 

23
 

STOCK PERFORMANCE GRAPH

 

Set forth below is a line graph comparing the annual percentage change in the cumulative total return on the Company’s Common Stock with the cumulative total return of the KBW Bank Index and the Russell 2000 Index as of the end of each of the last five fiscal years.

 

The graph assumes that $100.00 was invested on December 31, 2012 in the Company’s Common Stock and each index, and that all dividends were reinvested. Returns have been adjusted for any stock dividends and stock splits declared by the Company. Shareholder returns over the indicated period should not be considered indicative of future shareholder returns.

 

(LINE GRAPH) 

   Period Ending 
Index  12/31/12   12/31/13   12/31/14   12/31/15   12/31/16   12/31/17 
FNB Bancorp   100.00    158.49    164.93    188.46    213.29    358.66 
Russell 2000   100.00    130.95    144.63    142.50    157.34    187.01 
KBW Bank Index   100.00    135.06    144.81    142.51    179.00    208.09 
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ITEM 6 - SELECTED FINANCIAL DATA

 

The following table presents a summary of selected financial information that should be read in conjunction with the Company’s consolidated financial statements and notes thereto included under Item 8 - “FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.”

                     
Dollar amounts in thousands, except  At and for the years ended December 31, 
per share amounts and ratios  2017   2016   2015   2014   2013 
STATEMENT OF EARNINGS DATA                    
Total interest income  $50,218   $45,513   $39,282   $36,859   $37,389 
Total interest expense   3,871    3,069    2,597    2,093    2,395 
Net interest income   46,347    42,444    36,685    34,766    34,994 
(Recovery) provision for loan losses   (360)   150    (305)   (1,020)   1,385 
Net interest income after (recovery) provision for loan losses   46,707    42,294    36,990    35,786    33,609 
Total noninterest income   3,860    4,595    4,496    6,589    4,183 
Total noninterest expenses   30,549    30,692    29,925    27,868    29,028 
Earnings before provision for income taxes   20,018    16,197    11,561    14,507    8,764 
Provision for income taxes   9,307    5,696    3,364    5,098    1,325 
Net earnings   10,711    10,501    8,197    9,409    7,439 
Dividends and discount accretion on preferred stock               170    567 
Net earnings available to common stockholders   10,711    10,501   $8,197   $9,239   $6,872 
PER SHARE DATA - see note (1)                         
Net earnings per share:                         
Basic  $1.46   $1.45   $1.15   $1.32   $1.01 
Diluted  $1.41   $1.42   $1.12   $1.28   $0.98 
Cash dividends per share  $0.61   $0.61   $0.33   $0.27   $0.07 
Weighted average shares outstanding:                         
Basic   7,361,000    7,233,000    7,113,000    6,999,000    6,834,000 
Diluted   7,607,000    7,417,000    7,314,000    7,221,000    6,987,000 
Shares outstanding at period end   7,442,000    7,280,000    7,159,500    7,044,000    6,907,500 
Book value per common share  $16.03   $15.15   $14.55   $13.78   $13.64 
                          
Investment securities   355,857    360,105    329,207    264,881    263,988 
Net loans   829,766    782,485    722,747    583,715    552,343 
Allowance for loan losses   10,171    10,167    9,970    9,700    9,879 
Total assets   1,265,238    1,219,394    1,124,349    917,164    891,930 
Total deposits   1,050,295    1,019,506    983,189    792,194    773,615 
Stockholders’ equity   119,280    110,314    104,162    97,088    94,249 
SELECTED PERFORMANCE DATA                         
Return on average assets (2)   0.85   1.02   0.81   1.02   0.76
Return on average equity (2)   8.86%   10.88%   8.15%   10.16%   7.38%
Net interest margin   3.97%   3.92%   4.06%   4.21%   4.31%
Average loans as a percentage of average deposits   79.69%   73.41%   70.74%   72.83%   70.09%
Average total stockholders’ equity as a percentage of average total assets   9.61%   9.44%   9.96%   10.09%   10.31%
Common dividend payout ratio   33.46%   27.52%   29.85%   19.27%   21.13%
SELECTED ASSET QUALITY RATIOS                         
Net loan (recoveries) charge-offs/ total loans   -0.04%   0.01%   0.08%   -0.14%   0.11%
Allowance for loan losses/Total Loans   1.21%   1.28%   1.36%   1.63%   1.76%
CAPITAL RATIOS (3)                         
Total Regulatory Capital Ratio   12.61%   12.42%   12.76%   14.60%   14.30%
Tier 1 Capital Ratio   11.57%   11.32%   11.54%   13.34%   13.05%
Leverage Ratio   9.09%   9.02%   8.64%   10.30%   9.81%
Common Equity Tier 1 Capital Ratio   11.57%   11.32%   11.54%   N/A    N/A 

 

(1) Per share data has been adjusted for stock dividends and stock splits.                    

(2) Calculated using net earnings available to common shareholders.                

(3) Ratios are for the Company, which are substantially same as the Bank regulatory capital ratios.            

(4) Quarterly cash dividends/share and annual dividends/share may not be the same due to rounding considerations.        

25
 

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF FNB BANCORP AND SUBSIDIARY

 

Critical Accounting Policies and Estimates

Management’s discussion and analysis of its financial condition and results of operations are based upon the Company’s financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates, including those related to its loans and allowance for loan losses. The Company bases its estimates on current market conditions, historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. All adjustments that, in the opinion of management, are necessary for a fair presentation for the periods presented have been reflected as required by Regulation S-X, Rule 10-01. The Company believes the following critical accounting policies requires significant judgments and estimates used in the preparation of the consolidated financial statements.

Allowance for Loan Losses

The allowance for loan losses is periodically evaluated for adequacy by management. Factors considered include the Company’s loan loss experience, known and inherent risks in the portfolio, current economic conditions, known adverse situations that may affect the borrower’s ability to repay, regulatory policies, and the estimated value of underlying collateral. The evaluation of the adequacy of the allowance is based on the above factors along with prevailing and anticipated economic conditions that may impact our borrowers’ ability to repay their loans. Determination of the allowance is based upon objective and subjective judgments by management from the information currently available. Adverse changes in information could result in higher charge-offs and loan loss provisions.

Goodwill

Goodwill arises when the Company’s purchase price exceeds the fair value of net assets of an acquired business. Goodwill represents the value attributable to intangible elements acquired. The value of goodwill is supported ultimately by profit from the acquired business. A decline in earnings could lead to impairment, which would be recorded as a write-down in the Company’s consolidated statements of earnings. Events that may indicate goodwill impairment include significant or adverse changes in results of operations of the acquired business or asset, economic or political climate; an adverse action or assessment by a regulator; unanticipated competition; and a more-likely-than-not expectation that a reporting unit will be sold or disposed of at a loss.

Other Than Temporary Impairment

Other than temporary impairment (“OTTI”) is triggered if the Company has the intent to sell the security, it is likely that it will be required to sell the security before recovery, or if the Company does not expect to recover the entire amortized cost basis of the security.

If the Company intends to sell the security or it is likely it will be required to sell the security before recovering its cost basis, the entire impairment loss would be recognized in earnings as an OTTI. If the Company does not intend to sell the security and it is not likely that the Company will be required to sell the security but the Company does not expect to recover the entire amortized cost basis of the security, only the portion of the impairment loss representing credit losses would be recognized in earnings as an OTTI. The credit loss is measured as the difference between the amortized cost basis and the present value of the cash flows expected to be collected of a security. Projected cash flows are discounted by the original or current effective interest rate depending on the nature of the security being measured for potential OTTI. The remaining impairment loss related to all other factors, the difference between the present value of the cash flows expected to be collected and fair value, would be recognized as a charge to other comprehensive income (“OCI”). Impairment losses related to all other factors are to be presented as a separate category within OCI. For investment securities held to maturity, this amount is accreted over the remaining life of the debt security prospectively based on the amount and timing of future estimated cash flows. The accretion of the OTTI amount recorded in OCI will increase the carrying value of the investment, and would not affect earnings. If there is an indication of additional credit losses the security is re-evaluated accordingly based on the procedures described above.

26
 

Provision for and Deferred Income Taxes

 

The Company is subject to income tax laws of the United States, its states, and municipalities in which it operates. The Company considers its income tax provision methodology to be critical, as the determination of current and deferred taxes based on complex analyses of many factors including interpretation of federal and state laws, the difference between tax and financial reporting bases of assets and liabilities (temporary differences), estimates of amounts due or owed, the timing of reversals of temporary differences and current financial standards. Actual results could differ significantly from the estimates due to tax law interpretations used in determining the current and deferred income tax liabilities. Additionally, there can be no assurances that estimates and interpretations used in determining income tax liabilities may not be challenged by federal and state taxing authorities.

Fair Values of Financial Instruments

Certain assets and liabilities are either carried at fair value on a recurring or non-recurring basis or are required to be disclosed at fair value. Accounting principles have established a fair value measurement model which establishes a framework that quantifies fair value estimates by the level of pricing precision. The degree of judgment utilized in measuring the fair value of assets generally correlates to the level of pricing precision. Financial instruments rarely traded or not quoted will generally have a higher degree of judgment utilized in measuring fair value. Pricing precision is impacted by a number of factors including the type of asset or liability, the availability of the asset or liability, the market demand for the asset or liability, and other conditions that were considered at the time of the valuation.

Recent Accounting Pronouncements

Information pertaining to Recent Accounting Pronouncements is included in Note 1 of the Notes to the Company’s Consolidated Financial Statements in Item 8 below.

Recent Development – Proposed Merger with TriCo Bancshares

 

As announced by the Company on December 11, 2017 and reported in the Company’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on December 12, 2017 (the “Current Report”), the Company has entered into an Agreement and Plan of Merger and Reorganization dated December 11, 2017 (the “Merger Agreement”), pursuant to which the Company would merge with and into TriCo Bancshares, a California corporation (“TriCo”), with TriCo being the surviving corporation. Immediately thereafter, the Company’s subsidiary bank, First National Bank of Northern California, would be merged with and into TriCo’s subsidiary bank, Tri Counties Bank. Under the terms of the Merger Agreement, the Company shareholders would receive a fixed exchange ratio of 0.9800 shares of TriCo common stock for each share of Company common stock, providing the Company shareholders with aggregate ownership on a pro forma basis of approximately 24% of the common stock of the combined company. Holders of the Company’s outstanding in-the-money stock options would receive cash, net of applicable taxes withheld, for the value of their unexercised stock options. The merger is expected to qualify as a tax-free exchange for shareholders who receive shares of TriCo common stock. The transactions contemplated by the Merger Agreement are expected to close in the second or third quarter of 2018, pending approvals of the Company shareholders and the TriCo shareholders, the receipt of all necessary regulatory approvals, and the satisfaction of other closing conditions which are customary for such transactions. For additional information, reference should be made to the text of the Agreement and Plan of Merger and Reorganization, filed as an exhibit to the Current Report, and to other information regarding TriCo and the Company, their respective businesses and the status of their proposed merger, as reported from time to time in other filings with the Securities and Exchange Commission. 

Earnings Analysis

The principal source of the Company’s income is interest income on loans. The level of interest income can be affected by changes in interest rate, volume of loans outstanding, and the quality of our loan portfolio. Loans that are 90 days or more past due are placed on non-accrual status. Income on such loans is then recognized only to the extent that cash is received, and where the future collection of principal is probable. All other loans accrue interest at the stated contract rate.

27
 

Net interest income totaled $46,347,000, $42,444,000 and $36,685,000 in 2017, 2016 and 2015, respectively. Total interest income was $50,218,000, $45,513,000 and $39,282,000 for 2017, 2016, and 2015, respectively. Most of the interest earning assets are tied to the prime lending rate, which did not change during all of 2015 and the first eleven months of 2016 when the rate was 3.25%. The rate was raised 25 basis points on December 14, 2017, June 15, 2017, March 16, 2017, December 15, 2016 and December 17, 2015. These increases in the prime lending rate were loosely connected with short term interest rate changes initiated by the Federal Open Market Committee of the Federal Reserve Bank. Total nonaccrual loans were $1,940,000 and $6,647,000 as of December 31, 2017 and 2016, respectively. Payments received for loans on nonaccrual status, where principal is believed to be fully collectible, are credited to interest income when they are received. Average interest earning assets were $1,192,081 in 2017 compared to $1,099,192 in 2016, an increase of $92,889,000. Average interest earning assets were $923,700,000 in 2015. The principal earning assets were loans. Loan growth in 2017 and 2016 was obtained through the existing operating facilities of the Company. Interest expense totaled $3,871,000, $3,069,000 and $2,597,000 for 2017, 2016 and 2015, respectively. During 2017, the Bank increased their deposit rates slightly, as the interest rates that were available in the general marketplace rose. We also maintained FHLB advances throughout 2017. The cost of the FHLB advances increased 52 basis points during 2017 and decreased 16 basis points in 2016 compared to 2015. Time deposit interest rates increased 22 basis points in 2017 compared to 2016 and increased 10 basis points in 2016 compared to 2015. The Bank slowly raised the interest rates paid on our time deposits during 2017.

 

TABLE 1  Net Interest Income and Average Balances 
   2017   2016  2015 
(Dollar amounts in thousands)      Interest   Average       Interest   Average       Interest   Average 
   Average   Income   Yield   Average   Income   Yield   Average   Income   Yield 
   Balance   Expense   Cost   Balance   Expense   Cost   Balance   Expense   Cost 
INTEREST EARNING ASSETS                                             
Loans, gross (1) (2)  $823,333    $41,956    5.10%  $746,829    $38,313    5.13%  $629,814   $33,235    5.28%
Taxable securities   224,600    5,209    2.32%   209,257    4,213    2.01%   188,286    3,554    1.89%
Nontaxable securities (3)   133,467    3,653    2.74%   135,412    3,916    2.89%   103,611    3,272    3.16%
Interest on deposits-other financial institutions   10,681    126    1.18%   7,694    44    0.57%   1,989    39    1.96%
Total interest earning assets   1,192,081    50,944    4.27%   1,099,192    46,486    4.23%   923,700    40,100    4.34%
                                         
Cash and due from banks   15,168    92,889         15,041              44,774           
Premises and equipment   9,500              10,086              10,557           
Other assets   41,087              39,135              31,404           
Total noninterest earning assets   65,755              64,262              86,735           
TOTAL ASSETS  $1,257,836             $1,163,454             $1,010,435           
                                              
Deposits:                                             
Demand, interest bearing  $124,267    $121    0.10  $113,121    $123    0.11%  $92,267    104    0.11%
Money market   395,960    1,559    0.39%   424,981    1,824    0.43   368,858    1,589    0.43
Savings   88,249    91    0.10%   84,229    88    0.10%   75,861    77    0.10%
Time deposits   123,971    1,036    0.84%   120,115    745    0.62%   112,414    589    0.52%
Federal Home Loan Bank advances   86,603    850    0.98%   14,497    67    0.46%   1,452    9    0.62%
Note payable   4,050    214    5.28%   4,663    222    4.76%   5,263    229    4.35%
Total interest bearing liabilities   823,100    3,871    0.47%   761,606    3,069    0.40%   656,115    2,597    0.40%
                                              
NONINTEREST BEARING LIABILITIES:                                             
Demand deposits   300,670              274,952              240,969           
Other liabilities   17,252              17,042              12,730           
Total noninterest bearing liabilities   317,922              291,994              253,699           
TOTAL LIABILITIES   1,141,022              1,053,600              909,814           
Stockholders’ equity   116,814              109,854              100,621           
                                              
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY  $1,257,836             $1,163,454             $1,010,435           
                                              
NET INTEREST INCOME AND MARGIN ON TOTAL EARNING ASSETS (4)       $47,073    3.95%       $43,417    3.95%       $37,503    4.06%

 

(1) Interest on non-accrual loans is recognized into income on a cash received basis if the loan has demonstrated performance and full collection is considered probable.

(2) Amounts of interest earned include loan fees of $1,856,000, $1,844,000 and $1,514,000 for the years ended December 31, 2017, 2016 and 2015, respectively.

(3) Tax equivalent adjustments recorded at the statutory rate of 35% that are included in the nontaxable securities portfolio are $726,000, $973,000, and $818,000 for the years ended December 31, 2017, 2016 and 2015, respectively, and were derived from nontaxable municipal interest income.

(4) The net interest margin is computed by dividing net interest income by total average interest earning assets.

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The following table analyzes the dollar amount of change in interest income and expense and the changes in dollar amounts attributable to (a) changes in volume (changes in volume at the current year rate), (b) changes in rate (changes in rate times the prior year’s volume) and (c) changes in rate/volume (changes in rate times changes in volume). In this table, the dollar change in rate/volume is prorated to volume and rate proportionately.

TABLE 2  Rate/Volume Variance Analysis 
                         
(Dollar amounts in thousands)  Year Ended December 31 
   2017 compared to 2016   2016 compared to 2015 
   Increase (decrease) (2)   Increase (decrease) (2) 
   Interest           Interest         
   Income/   Variance   Income/   Variance  
   Expense   Attributable To   Expense   Attributable To 
   Variance   Rate   Volume   Variance   Rate   Volume 
INTEREST EARNING ASSETS:                                 
                               
Loans  $3,643   $(280)  $3,923   $5,078   $(925)  $6,003 
Taxable securities   996    687    309    659    263    396 
Nontaxable securities (1), (3)   (263)   (207)   (56)   644    (360)   1,004 
Deposits with other financial institutions   82    65    17    5    (107)   112 
Total  $4,458   $265   $4,193   $6,386   $(1,129)  $7,515 
                               
INTEREST BEARING LIABILITIES:                              
                               
Demand deposits  $(2)  $(14)  $12   $19   $(5)  $24 
Money market   (265)   (151)   (114)   235    (6)   241 
Savings deposits   3    (1)   4    11    2    9 
Time deposits   291    267    24    156    116    40 
Federal Home Loan Bank advances   783    450    333    58    (23)   81 
Interest on note payable   (8)   21    (29)   (7)   19    (26)
Total   802    572    230    472    103    369 
NET INTEREST INCOME  $3,656   $(307)  $3,963   $5,914   $(1,232)  $7,146 

(1) Nontaxable securities in this Table are shown on a tax equivalent basis.

(2) Increases (decreases) shown are in relation to their effect on net interest income.

(3) Tax equivalent adjustments recorded at the statutory rate of 35% that are included in the nontaxable portfolio are $726,000, $973,000 and $818,000 for the years ended December 31, 2017, 2016 and 2015, respectively, and were derived from nontaxable municipal interest income.

There were no fed funds sold in 2017 and 2016 and nominal amounts of federal funds sold in 2015. Yields on deposits at other financial institutions averaged 1.18%, 0.57% and 1.96% in 2017, 2016 and 2015, respectively. On the interest expense side, the interest rate increase in Time Deposits and FHLB advances during 2017 was due to increases in short term market interest rate increases that occurred due to actions taken by the Federal Open Market Committee of the Federal Reserve Bank.

29
 

Allowance for Loan Losses

 

The Board of Directors has the ultimate oversight responsibility over the processes utilized in assessing the overall risks in the Company’s loan portfolio, assessing the specific loss expectancy, and determining the adequacy of the loan loss reserve. The level of reserves is determined by management and documented with internally generated credit quality ratings, a review of the local economic conditions in the Bank’s market area, and consideration of the Bank’s historical loan loss experience. The Bank is committed to maintaining adequate reserves, identifying credit weaknesses through frequent loan reviews, and updating loan risk ratings and changing those risk ratings in a timely manner as circumstances change.

 

Loans outstanding (net of deferred loan fees and allowance for loan losses) increased by $47,281,000 to $829,766,000 in 2017; $59,738,000 to $782,485,000 in 2016 compared to 2015, and $139,032,000 to $722,747,000 in 2015. Bank management has consistently maintained conservative underwriting standards which generally require borrowers to maintain at most a loan-to-value ratio of 70%; maintain a debt service coverage ratio of at least 1.25; and requires borrowers to make monthly mortgage payments out of documented cash flows.

 

The allowance for loan losses totaled $10,171,000, $10,167,000, and $9,970,000 at December 31, 2017, 2016 and 2015, respectively. This represented 1.21%, 1.28%, and 1.36% of total loans outstanding on those dates. These balances reflect amounts that, in management’s judgment, are adequate to provide for probable loan losses based on the considerations listed above. Management performs stress testing of our loan portfolio to gain a better understanding of the portfolio effects of additional declines in real estate values and expected cash values. Management also evaluates all commercial loans, secured and unsecured, at least quarterly.

Loans acquired in the Oceanic Bank acquisition in 2012 and the America California Bank acquisition in 2015 were accounted for at fair value, resulting in a discount at the time of the acquisition, due in part to credit quality. If expected potential credit losses are actually incurred, they will be evaluated against the net book discount remaining. Only those losses that occur after the acquisition date or exceed the amount of discount remaining on the acquired Oceanic Bank loan portfolio will be charged to the allowance for loan losses. At December 31, 2017, 2016, and 2015, the remaining discount related to the Oceanic Bank and America California Bank acquisitions totaled $443,425 $1,336,000, and $1,397,000, respectively.

TABLE 3  Allocation of the Allowance for Loan Losses 
   (Dollar amounts in thousands) 
                                         
       2017       2016       2015       2014       2013 
       Percent       Percent       Percent       Percent       Percent 
       of loans       of loans       of loans       of loans       of loans 
       in each       in each       in each       in each       in each 
       category       category       category       category       category 
       to total       to total       to total       to total       to total 
   Amount   Loans   Amount   Loans   Amount   Loans   Amount   Loans   Amount   Loans 
Commercial real estate  $5,495    54.4%  $6,392    53.1%   $6,059    54.5%   $5,549    53.6%   $5,763    57.8%
Real estate construction   388    4.2%   617    5.5%   589    6.1%   849    6.7%   734    6.1%
Real estate multi family   1,496    12.5%   389    13.3%   243    8.7%   206    9.1%   293    8.2%
Real estate 1 to 4 family   2,008    20.6%   2,082    21.5%   2,176    23.4%   1,965    21.7%   1,788    19.0%
Commercial & industrial   440    6.6%   650    6.2%   853    7.1%   1,073    8.7%   1,237    8.6%
Consumer   344    1.7%   37    0.4%   50    0.2%   58    0.2%   64    0.3%
Total  $10,171    100.0  $10,167    100.0   $9,970    100.0   $9,700    100.0   $9,879    100.0
30
 

Table 4 summarizes transactions in the allowance for loan losses and details the charge-offs, recoveries and net loan losses by loan category for each of the last five fiscal years ended December 31, 2017. The amount added to the provision and charged to operating expenses for each period is based on the risk profile of the loan portfolio.

TABLE 4  Allowance for Loan Losses 
   Historical Analysis 
(Dollar amounts in thousands)  For the year ended December 31, 
   2017   2016   2015   2014   2013 
Balance at Beginning of Period  $10,167   $9,970   $9,700   $9,879   $9,124 
(Recovery of) provision for loan losses   (360)   150    (305)   (1,020)   1,385 
                          
Charge-offs:                         
Real Estate   (91)   (35)   (45)   (328)   (728)
Commercial   (39)   (165)   (23)   (28)   (57)
Consumer   (8)   (18)   (13)   (26)   (7)
Total   (138)   (218)   (81)   (382)   (792)
                          
Recoveries:                         
Real Estate   183    52    591    1,065    88 
Commercial   319    213    60    154    73 
Consumer           5    4    1 
Total   502    265    656    1,223    162 
Net recoveries (charge-offs)   364    47    575    841    (630)
Balance at End of Period  $10,171   $10,167   $9,970   $9,700   $9,879 
                          
Percentages                         
Allowance for loan losses/total loans   1.21%   1.28%   1.36%   1.63%   1.76%
Net (recoveries) charge-offs/real estate loans   -0.08%   -0.08%   -0.08%   -0.14%   0.13%
Net (recoveries) charge-offs/commercial loans   -0.50%   -0.10%   -0.07%   -0.24%   -0.03%
Net charge-offs/consumer loans   0.06%   0.51%   0.51%   1.52%   0.36%
Net (recoveries) charge-offs/total loans   -0.04%   -0.01%   -0.08%   -0.14%   0.11%
Allowance for loan losses/non-performing loans   524.28%   118.65%   118.65%   171.74%   134.39%

 

The level of yearly charge-offs were primarily attributable to problems that were identified with specific borrowers rather than problems with a particular segment of the loan portfolio. In particular, borrowers who had exposure to real estate projects outside of San Mateo and San Francisco counties were identified as having a relatively higher risk profile than those operating solely within these two counties. If real estate values or lease rates decline in the future, additional increases in our allowance for loan losses may be warranted. 

31
 

Nonperforming Assets

 

Nonperforming assets consist of nonaccrual loans, foreclosed assets, and loans that are 90 days or more past due but are still accruing interest. The accrual of interest on non-accrual loans is discontinued when, in management’s opinion, the borrower may be unable to meet payments as they become due. For the years ended December 31, 2017, 2016 and 2015, had non-accrual loans performed as agreed, approximately $664,000, $569,000, and $460,000, respectively, would have been recognized in additional interest income.

Table 5 provides a summary of nonperforming assets for the most recent five years. Nonperforming loans were 0.2%, 0.8% and 1.2% of total loans at December 31, 2017, 2016 and 2015. Management believes the current list of past due loans as of December 31, 2015 are collectible and does not anticipate future significant losses that exceed the current allowance for loan losses.

TABLE 5  Analysis of Nonperforming Assets 
(Dollar amounts in thousands)  December 31 
   2017   2016   2015   2014   2013 
Nonaccrual loans  $1,940   $6,647   $7,915   $5,648   $7,351 
Other real estate owned   3,300    1,427    1,026    763    5,318 
Total  $5,240   $8,074   $8,941   $6,411   $12,669 

Nonaccrual loans at December 31, 2017 consist of commercial real estate loans, single family residence loans, commercial loans and some commercial and industrial loans. The Bank is working with its borrowers to develop strategies that can give the borrowers time to work through their financial difficulties.

 

There are two properties reported in other real estate owned. The first property is a commercial building with a net book balance of $1,483,000, $1,427,000 and $1,026,000 as of December 31. 2017, 2016 and 2015, respectively. This commercial property has environmental issues related to soil contamination from the property’s use by previous owners. The building is fully leased on a triple net lease and the market value of the building, supported by appraisal and other market data, is greater than the net book value of the property as of December 31, 2017. During February 2018, the property was sold to an unrelated third party for $2.8 million. The Bank loaned $1.2 million to the buyer and in accordance with the purchase and sale agreement has agreed to incur the costs necessary to continue monitoring the property and continue our efforts to obtain a final signed remediation agreement with the local Water Board. The purchase and sale agreement requires a set-aside reserve of $500,000 to cover the costs that are anticipated to be incurred by the Company. The set-aside reserve will be funded with a portion of the net cash provided by the sale of the property. During 2017, 2016 and 2015, toxic remediation costs were incurred with the goal of obtaining a final definitive remediation agreement with the Water Board. All remediation costs leading up to the sale date were capitalized into the net carrying value of the property. The remediation efforts performed included soil replacement, soil treatment and drilling water monitoring wells. These capitalized costs have increased the carrying value of the property while at the same time the appraised market value of the property has steadily increased. On an annual basis, the net investment in the property has been reviewed for potential impairment, and to date, no impairment has been found. From the time this property was obtained through foreclosure until the date of the sale and the transfer of ownership of the property, the estimated market value of the property has consistently been more than the property’s net book value plus estimated future toxic remediation costs. However, the Company does not yet have a signed final remediation plan with the Water Board and the Company has no guarantee as to when or if that might occur. Management has obtained cost estimates from our soil engineering and consulting company consultant related to the estimated future cost of remediation using a remediation plan that has been submitted for approval to the local Water Board. The estimated future costs are expected to total approximately $725,000, but could vary in the future. At the time of sale, management established a set-aside monetary fund of $500,000 which was deposited into an insured depository account that was funded from the purchase and sale contract that closed escrow in February 2018. The second property is an elderly care facility located in Lafayette, California that was acquired in November 2017 and has a net book balance of $1,817,000. A potential purchaser of this facility has been identified and the Bank is working with the potential buyer to complete the sale of this property, which is expected to occur in either March or April of 2018. For additional information regarding these two properties, please see Note 7 and Note 23 to the Company’s 2017 Consolidated Financial Statements.

32
 

A troubled debt restructuring occurs when the Bank offers, at favorable terms, a modification of loan terms and conditions because management believes the borrower may not be able to make payments at their original note rate and terms. There were no troubled debt restructurings in 2017 or 2016. There was one troubled debt restructuring in 2015 that consisted of one 1 to 4 family real estate loan. Total restructured loans outstanding as of December 31, 2017 and 2016 were $7,708,000 and $13,268,000, respectively.

 

Noninterest Income

The following table sets forth the principal components of noninterest income:

TABLE 6  Noninterest Income   Variance   Variance 
   Years ended December 31,   2017 vs. 2016   2016 vs. 2015 
(Dollar amounts in thousands)  2017   2016   2015   Amount   Percent   Amount   Percent 
Service charges  $2,264   $2,461   $2,501    (197)   -8%   (40)   -2
Net gain on sale of available-for-sale securities   210    438    339    (228)   -52%   201    59%
Earnings on bank-owned life insurance   390    402    364    (12)   -3%   5    1%
Other income   996    1,294    1,292    (298)   -23   333    26%
   Total noninterest income  $3,860   $4,595   $4,496   $(735)   -16%  $499    11%

Total noninterest income consists mainly of service charges on deposits. The gain on sale of available-for-sale securities during 2017, 2016 and 2015 was derived primarily from the sale of U. S. government agency, mortgage-backed securities, municipal securities and U. S. Treasury securities. A significant source of other income was dividends on equity securities, which totaled $558,000, $775,000, and $651,000, in the years 2017, 2016, and 2015, respectively. The equity securities that are owned by the Bank are either highly illiquid securities or investments in government sponsored entities that cannot be bought and sold in open market transactions.

33
 

Noninterest Expenses

The following table sets forth the various components of noninterest expense:

                             
TABLE 7  Noninterest Expenses   Variance   Variance 
(Dollar amounts in thousands) 

Years ended December 31,
   2017 vs. 2016   2016 vs. 2015 
   2017   2016   2015   Amount   Percent   Amount   Percent 
Salaries and employee benefits  $19,366   $19,474   $18,523   $(108)   -1   951    5
Occupancy expense   2,747    2,528    2,517    219    9%   11    0%
Equipment expense   1,646    1,765    1,926    (119)   -7%   (161)   -8%
Professional fees   1,482    1,363    1,471    119    9%   (108)   -7%
FDIC assessment   400    600    600    (200)   -33%   0    0%
Telephone, postage, supplies   1,267    1,199    1,074    68    6%   125    12%
Advertising expense   451    524    500    (73)   -14%   24    5%
Data processing expense   571    657    1,076    (86)   -13%   (419)   -39%
Low income housing expense   472    284    283    188    66%   1    0%
Surety insurance   349    347    381    2    1%   (34)   -9%
Directors expense   288    288    288                 
Other real estate owned expense (recovery), net   80    (5)   4    85    -1700%   (9)   -225%
Other expense   1,430    1,668    1,282    (238)   -14%   386    30%
 Total noninterest expense  $30,549   $30,692   $29,925   $(143)   0%  $767    3%
                                    

Salaries and employee benefits were $19,366,000, 19,474,000 and $18,523,000 in 2017, 2016 and 2015, respectively. Salaries and employee benefits represented 63%, 63%, and 62% of noninterest expense for the years 2017, 2016, and 2015, respectively. Decreases in salary and employee benefits in 2017 were primarily related to open, unfilled positions within the Company. Increases in salaries and employee benefits in 2016 and 2015 were related to normal salary progression, changes related to executive salary continuation agreements and the purchase of America California Bank.

Occupancy expense increased $219,000 and $11,000 in 2017 and 2016, respectively and decreased $256,000 in 2015. The increase in occupancy expense during 2017 was primarily due to maintenance and repair costs of heating and air conditioning systems and the resurfacing of our parking lots at our branch and home office facilities. The decrease in 2015 was primarily related to the sale of our South San Francisco South Airport Boulevard branch late in 2014.

The increase in other real estate owned expense during 2017 was primarily related to the foreclosure of an assisted living facility located in Lafayette, California during 2017. Toxic remediation costs incurred at the other OREO property were capitalized during 2017, 2016 and 2015 and were not a factor in the increased OREO costs during 2017.

Provision for Loan Losses

The allowance for loan losses in 2017, 2016 and 2015 was recorded at levels management believed reflected the estimated loss exposure identified in the loan portfolio during each of these years. The allowance for loan losses was $10,171,000 or 1.21% of total gross loans at December 31, 2017. During 2016 and 2015 the allowance for loan losses was $10,167,000 and $9,970,000 or 1.28% and 1.26% of total gross loans as of December 31, 2016 and 2015. During 2017, improvement in the credit characteristics of the loan portfolio resulted in a recovery of provision for loan losses of $360,000. During 2016, the Bank incurred a loan loss provision of $150,000 primarily attributable to growth that occurred within the loan portfolio. During the fourth quarter of 2015, a reversal of $530,000 in loan loss provision was recorded to reflect improving credit metrics that occurred within the loan portfolio during 2015.

34
 

The allowance for loan losses is maintained at a level considered adequate to provide for probable loan losses inherent in the loan portfolio. Management is taking steps necessary to work with borrowers and has granted modified loan terms to certain borrowers willing to make payments on loans secured by their primary residence, even though they were delinquent, and/or the value of their home had declined substantially. The purchased Oceanic Bank and America California Bank loans have a fair value discount that was created at acquisition pursuant to acquisition accounting and representing, in part, expected credit losses inherent in the acquired loan portfolio. The fair value discount is not part of the allowance for loan losses.

 

Balance Sheet Analysis

 

Total assets were $1,265,238,000, $1,219,394,000 and $1,124,349,000 as of December 31, 2017, 2016 and 2015, respectively. Total assets averaged $1,257,836, $1,163,454 and $1,010,435 during 2017, 2016 and 2015 respectively. Average earning assets represented 95%, 94% and 93% of total average assets during 2017, 2016 and 2015, respectively. Asset growth in 2017 and 2016 was through increased business developed through our existing facilities. In 2015, a significant portion of our growth was obtained from the America California Bank acquisition as well as growth in customer business generated through our branch offices.

Loans

The loan portfolio is the principal earning asset of the Bank. Gross loans outstanding (net of loan fees) totaled $839,937,000, $792,652,000 and $732,717,000 as of December 31, 2017, 2016 and 2015, respectively. During 2017 and 2016, the growth in our loan portfolio was obtained through our existing branch network. During 2015, total growth in the loan portfolio was $140,113,000. $93,000,000 of this amount was the result of our acquisition of America California Bank. The remainder was from organic growth.

Table 8 presents a detailed analysis of loans outstanding at December 31, 2013 through December 31, 2017.

TABLE 8  Loan Portfolio 
   December 31 
   2017       2016       2015       2014       2013    
(Dollar amounts in thousands)                                       
Commercial real estate  $456,992    54  $421,222    53  $399,993    55%  $318,427    54%  $325,199   58
Real estate construction   35,206    4%   43,683    6%   44,816    6%   39,771    7%   34,318   6%
Real estate multi family   105,138    12%   105,963    13%   63,597    9%   53,824    9%   46,143   8%
Real estate 1 to 4 family   173,476    21%   170,523    22%   171,964    23%   128,732    22%   106,903   21%
Commercial & industrial   55,727    7%   48,874    6%   52,033    7%   51,662    9%   48,504   9%
Consumer   14,057    2%   3,533        1,574        1,448        1,650   0%
 Sub total   840,596    100%   793,798    100%   733,977    100%   593,864    100%   562,717   100%
Net deferred loan fees   (659)       (1,146)       (1,260)       (449)       (495   
 Total  $839,937    100%  $792,652    100%  $732,717    100%  $593,415    100%  $562,222   100%
                                                  

Loans that are not guaranteed by the U. S. Government contain some level of risk of principal repayment. Real estate and loans supported by UCC filing requirements contain less risk of loss than unsecured loans. By securing loans with various types of collateral, the Bank is able to better assure repayment, either from the liquidation of collateral or from the borrower. For commercial loans, both secured and unsecured, the Bank will generally require personal guarantees from our borrowers. These financial guarantees allow the Bank to initiate collection activity against the borrowers individually if the liquidation of collateral is insufficient to repay the loan. The underwriting policies of the Bank require our borrowers to document the source of repayment for their loans, maintain equity positions in any secured financings, and provide ongoing financial statement information. Current appraisals, financial statements, and tax returns allow Bank management to evaluate our borrower’s repayment ability on at least an annual basis. Commercial loans are generally variable rate in nature. Real estate loans more than five years to maturity generally contain variable interest rates. Loans that mature in five years or less may be either fixed or variable rate in nature, with fixed rate loans containing initial rates that are higher than those with variable rates. A borrower’s preference and interest rate risk tolerance will generally dictate whether to utilize fixed or variable rate financing. The following table shows the Bank’s loan maturities and sensitivities to changes in interest rates as of December 31, 2017.

35
 

TABLE 9               
       Maturing         
   Maturing   After 1   Maturing     
(Dollar amounts in thousands)  Within   But Within   After 5     
   1 Year   5 Years   Years   Total 
Commercial real estate  $25,702   $76,323   $354,967   $456,992 
Real estate construction   27,279    4,740    3,187    35,206 
Real estate multi family   3,130    18,892    83,116    105,138 
Real estate 1 to 4 family   11,007    22,777    139,692    173,476 
Commercial & industrial   33,604    17,958    4,165    55,727 
Consumer   1,294    391    12,372    14,057 
 Sub total   102,016    141,081    597,499    840,596 
Net deferred loan fees   (104)   (323)   (232)   (659)
 Total  $101,912   $140,758   $597,267   $839,937 
                     
With predetermined fixed interest rates  $15,459   $55,977   $195,757   $267,193 
With floating interest rates   86,453    84,781    401,510    572,744 
 Total  $101,912   $140,758   $597,267   $839,937 

 

Investment Portfolio

The primary purpose of the Bank’s investment portfolio is to ensure the Bank has sufficient available funds to fund the Company’s liquidity needs, including the ability to fund loans or pay down liabilities. The Company’s primary source of funds is the deposit base. If more funds are needed, investment maturities, calls and sales from the investment portfolio may be used. The Bank’s investment portfolio is composed primarily of debt securities of U. S. Government Agencies, mortgage-backed securities that have their principal guaranteed by U. S. Government Agencies, and in obligations of States and their political subdivisions. The Bank believes this provides for an appropriate liquidity level and minimal credit risk.

The following table sets forth the maturity distribution and interest rate sensitivity of investment securities at December 31, 2017:

TABLE 10                                          
           After       After                         
   Due   1 Year       5 Years       Due           Maturity     
(Dollar amounts  In 1 Year   Through       Through       After       Fair   In   Average 
in thousands)  Or Less   Yield   5 Years   Yield   10 Years   Yield   10 Years   Yield   Value   Years   Yield 
U. S. Treasury securities  $      $1,975    1.88%   $    %   $      $1,975    2.92    1.83
Obligations of U. S. Government Agencies   6,000    1.10%   35,822    1.74%       1.77%           41,823    3.12    1.59%
Mortgage-backed securities           44,580    2.48%   31,732    2.61%   43,481    2.78%   119,792    11.03    2.35%
Asset-backed securities                   1,628    2.43%   2,058    3.95%   3,686    9.71    3.32%
Obligations of states and political subdivisions   4,636    2.54%   81,470    2.33%   54,503    2.62%   10,493    3.73%   151,103    5.11    2.45%
Corporate debt   2,011    1.70%   26,272    2.64%   8,136    5.14%   1,060    5.84%   37,478    4.32    3.95%
 Total  $12,647    1.72%  $190,119    2.29%  $95,999    2.83%  $57,092    3.06%  $355,857    6.76    2.54%
36
 

The following table shows the securities portfolio mix at December 31, 2017, 2016 and 2015.

TABLE 11   
   Years Ended December 31, 
   2017   2016   2015 
(Dollar amounts in thousands)  Amortized   Fair   Amortized   Fair   Amortized   Fair 
   Cost   Value   Cost   Value   Cost   Value 
U. S. Treasury securities  $1,989   $1,975   $977   $987   $7,004   $7,000 
Obligations of U.S. Government Agencies   42,247    41,823    60,773    60,545    84,842    84,609 
Mortgage-backed securities   121,087    119,792    85,709    84,284    61,579    61,663 
Asset-backed securities   3,734    3,686                 
Obligations of states and political subdivisions   150,724    151,103    151,988    151,618    132,125    135,190 
Corporate debt   37,409    37,478    63,277    62,671    41,045    40,745 
 Total  $357,190   $355,857   $362,724   $360,105   $326,595   $329,207 

 

Deposits

During 2017, 2016 and 2015 total average deposits were $1,033,117,000, $1,017,398,000 and $890,369,000. The prime lending rate was revised upwards on three separate occasions in 2017, and once in both 2016 and 2015. Time deposit interest rates have moved higher in a steady fashion over the last few years. Average time deposit interest rates were 0.84%, 0.62% and 0.52% in 2017, 2016 and 2015, respectively. Bank management has made a conscious effort to keep transaction based deposit account, such as interest bearing demand, savings and money market rates stable.

 

The following table summarizes the distribution of average deposits and the average rates paid for them in the periods indicated:

TABLE 12   
   Average Deposits and Average Rates paid for the period ending December 31, 
  

2017
   2016   2015 
(Dollar amounts  Average   Average   % of total   Average   Average   % of total   Average   Average   % of total 
in thousands)  Balance   Rate   Deposits   Balance   Rate   Deposits   Balance   Rate   Deposits 
Interest-bearing demand  $124,267    0.10   12  $113,121    0.11   11   92,267    0.11   10
Money market   395,960    0.39%   38%   424,981    0.43%   42%   368,858    0.43%   42%
Savings   88,249    0.10%   9%   84,229    0.10%   8%   75,861    0.10%   8%
Time deposits $100,000 or more   89,594    0.91%   9%   83,942    0.43%   8%   78,842    0.36%   9%
Time deposits under $100,000   34,377    0.66%   3%   36,173    0.19%   4%   33,572    1.60%   4%
Total interest bearing deposits   732,447    0.38%   71%   742,446    0.37%   73%   649,400    0.36%   73%
Demand deposits   300,670        29%   274,952        27%   240,969        27%
Total deposits  $1,033,117    0.27%   100%  $1,017,398    0.21%   100%  $890,369    0.21%   100%
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The following table indicates the maturity schedule of time deposits of $250,000 or more:

TABLE 13      

                             

    Analysis of Time Deposits $250,000 or more at December 31, 2017  
         
(Dollar amounts in thousands)                
                       
Total                          
Deposits of         Over Three   Over Six   Over  
$250,000 or   Three Months   To Six   To Twelve   Twelve  
More   Or Less   Months   Months   Months  
$         63,678           $ 8,397      $ 26,580      $ 14,932      $ 13,769  

  

Capital

The increases in retained earnings were primarily attributable to retention of net earnings less cash dividends paid in 2017, 2016 and 2015. Net earnings totaled $10,711,000, $10,501,000 and $8,197,000 in 2017, 2016, and 2016 respectively. Cash dividend payments totaled $3,634,000, $2,890,000 and $2,447,000 in 2017, 2016 and 2015, respectively.

Under regulatory capital guidelines, qualifying capital is classified into two tiers, referred to as Tier 1 (core) and Tier 2 (supplementary) capital. The Company’s Tier 1 capital consists of common shareholders’ equity and preferred stock issued to the U.S. Treasury during 2011. The Company’s Tier 2 capital consists of eligible reserves for possible loan losses. Total capital is the sum of Tier 1 plus Tier 2 capital. Risk-weighted assets are calculated by applying risk percentages specified by the FDIC to categories of both balance sheet assets and off-balance sheet obligations. The FDIC also requires the calculation of a leverage ratio requirement. This ratio supplements the risk-based capital ratios and is defined as Tier 1 capital divided by quarterly average assets during the reporting period. This requirement established a minimum leverage ratio of 3.0% for the highest rated banks and ratios of 100 to 200 basis points higher for most other banks. To qualify as “well-capitalized” as defined by regulation, the Banks must maintain a leverage ratio, common equity Tier 1, Tier 1 and total capital ratios of at least 5.00%, 6.50%, 8.00% and 10.00% respectively. “Well-capitalized” financial institutions must also maintain a capped conservation buffer in additional capital across all capital ratios as of December 31, 2017.

38
 

Table 14

The capital ratios for the Company and the Bank are presented in the table below: 

           Required         
           for Capital   To be Well-Capitalized 
           Adequacy Purposes   Under Prompt Correction 
Dollars in thousands          Effective January 1, 2017   Action Regulations 
   At December 31, 2017                 
Regulatory Capital Ratios  Amount   Ratio   Amount   Ratio   Amount   Ratio 
Leverage Ratio(1)                              
     Company  $115,364    9.09%  ≥   $50,768    4.00%(2)   N/A    N/A 
     Bank   117,180    9.23%  50,768    4.00%(2)  $63,460    5.00%
Tier 1 Common Equity Capital Ratio                              
     Company   115,364    11.57%  57,342    5.75%(2)   N/A    N/A 
     Bank   117,180    11.75%  57,342    5.75%(2)   64,822    6.50%
Tier 1 Capital Ratio                              
     Company   115,364    11.57%  72,301    7.25%(2)   N/A    N/A 
     Bank   117,180    11.75%  72,301    7.25%(2)   79,781    8.00%
Total Capital Ratio                              
     Company   125,712    12.61%  92,246    9.25%(2)   N/A    N/A 
     Bank   127,528    12.79%  92,246    9.25%(2)   99,726    10.00%

(1) The leverage ratio consists  of Tier 1 Capital divided by the most recent quarterly average total assets, excluding certain intangible assets.
(2) Includes 125% capital conservation buffer.
   
           Required         
           for Capital   To be Well-Capitalized 
           Adequacy Purposes   Under Prompt Correction 
Dollars in thousands          Effective January 1, 2016   Action Regulations 
   At December 31, 2016                 
Regulatory Capital Ratios  Amount   Ratio   Amount   Ratio   Amount   Ratio 
Leverage Ratio(1)                              
     Company  $106,971    9.02% $47,443    4.000%(2)   N/A    N/A 
     Bank   109,538    9.27%  47,248    4.000%(2)  $59,060    5.00%
Tier 1 Common Equity Capital Ratio                              
     Company   106,971    11.32%  48,441    5.125%(2)   N/A    N/A 
     Bank   109,538    11.59%  48,441    5.125%(2)   61,437    6.50%
Tier 1 Capital Ratio                              
     Company   106,971    11.32%  62,618    6.625%(2)   N/A    N/A 
     Bank   109,538    11.59%  62,618    6.625%(2)   75,615    8.00%
Total Capital Ratio                              
     Company   117,315    12.42%  81,522    8.625%(2)   N/A    N/A 
     Bank   119,882    12.68%  ≥    81,522    8.625%(2)   94,518    10.00%

 

(1) The leverage ratio consists  of Tier 1 Capital divided by the most recent quarterly average total assets, excluding certain intangible assets.
(2) Includes 125% capital conservation buffer.

 

Liquidity

The Company’s primary source of liquidity on a stand-alone basis is dividends from the Bank. The payment of dividends by the Bank is subject to regulatory restrictions. See the discussion under “Dividends” in Item 1 above.

Liquidity is a measure of the Company’s ability to convert assets into cash. Liquidity consists of cash and due from correspondent bank accounts, including time deposits, federal funds sold, and securities available for sale. The Company’s policy is to maintain a liquidity ratio of 5% or greater of total assets. As of December 31, 2017, the Company’s primary liquidity was 29.6%, compared to 30.8% and 30.4% as of December 31, 2016 and 2015, respectively. There were total liquid assets of $374,340,000, $376,068,000 and $341,726,000 as of December 31, 2017, 2016 and 2015, respectively. The objective of liquidity management is to ensure that the Company has funds available to meet all present and future financial obligations and to take advantage of business opportunities as they occur. Financial obligations arise from withdrawals of deposits, repayment on maturity of purchased funds, extension of loans or other forms of credit, payment of operating expenses and payment of dividends.

Core deposits, which consist of all deposits other than time deposits, have provided the Company with a sizeable source of relatively stable low-cost funds. The Company’s average core deposits represented 87% of average total liabilities of $1,050,295 for the year ended December 31, 2017, 85% of average total liabilities of $1,053,600,000 for the year ended December 31, 2016 and 71% of average total liabilities of $909,814,000 for the year ended December 31, 2015.

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As of December 31, 2017, the Company had contractual obligations and other commercial commitments totaling approximately $284,438,000. The following table sets forth the Company’s contractual obligations and other commercial commitments as of December 31, 2017. These obligations and commitments can be funded from other loan repayments, the Company’s liquidity sources such as cash and due from other banks, federal funds sold, securities available for sale, as well as from the Bank’s lines of credit with the Federal Home Loan Bank of San Francisco and the Federal Reserve Bank of San Francisco. For additional information, please see the Consolidated Statements of Cash Flows, in Item 8 of this Form 10-K.

 

TABLE 15  Payments Due by Period 
                     
(Dollar amounts in thousands)      1 year   Over 1 to   Over 3 to   Over 
Contractual Obligations  Total   or less   3 years   5 years   5 years 
Operating Leases  $4,991   $1,150   $1,701   $1,612   $528 
Salary Continuation Agreements   13,399    172    344    294    12,589 
Federal Home Loan Bank Advances   75,000    75,000             
Note payable   3,750    600    3,150         
Total Contractual Cash Obligations  $97,140   $76,922   $5,195   $1,906   $13,117 
                          
   Amount of Commitment Expirations Per Period 
   Total                     
(Dollar amounts in thousands)  Amounts   1 year   Over 1 to   Over 3 to   Over 
Other Commercial Commitments  Committed   or less   3 years   5 years   5 years 
Lines of Credit  $131,737   $43,272   $38,992   $29,064   $20,409 
Standby Letters of Credit   5,286    5,286             
Other Commercial Commitments   51,472    49,333    842        1,297 
Total Commercial Commitments  $188,495   $97,891   $39,834   $29,064   $21,706 

 

The largest component of the Company’s earnings is net interest income, which can fluctuate widely when significant interest rate movements occur. The Company’s management is responsible for minimizing the Bank’s exposure to interest rate risk and assuring an adequate level of liquidity. By developing objectives, goals and strategies designed to enhance profitability and performance, management is also able to manage the Bank’s interest rate exposure to within predefined Board approved levels.

In order to ensure that sufficient funds are available for loan growth and deposit withdrawals, as well as to provide for general needs, the Company must maintain an adequate level of liquidity. Asset liquidity comes from the Company’s ability to convert short-term investments into cash and from the maturity and repayment of loans and investment securities. Liability liquidity is provided by the Company’s ability to attract deposits and obtain short term credit through established borrowing lines.

The primary source of liability liquidity is the Bank’s depository customer base. The overall liquidity position of the Company is closely monitored and evaluated on a daily basis. The Company has Federal Funds borrowing facilities for a total of $30,000,000, a Federal Home Loan Bank line of credit of up to 30% of eligible total assets, and a Federal Reserve Bank of San Francisco borrowing facility of approximately $56,000,000. Management believes the Company’s liquidity sources at December 31, 2017 are adequate to meet its operating needs in 2018 and into the foreseeable future.

40
 

Effect of Changing Prices

 

The results of operations and financial conditions presented in this report are based on historical cost information and are not adjusted for the effects of inflation. Since the assets and liabilities of banks are primarily monetary in nature (payable in fixed, determinable amounts), the performance of the Company is affected more by changes in interest rates than by inflation. Interest rates generally increase as the rate of inflation increases, but the magnitude of the change in rates may not be the same.

The effect of inflation on banks is normally not as significant as its influence on those businesses that have large investments in plant and inventories. During periods of high inflation, there are normally corresponding increases in the money supply, and banks will usually experience above average growth in assets, loans and deposits. Also, increases in the price of goods and services will result in increased operating expenses. The following table includes key ratios, including returns on average assets and equity for the Company.

TABLE 16            
   Return on Equity and Assets 
   (Key financial ratios are computed on average balances) 
             
   Year Ended December 31, 
   2017   2016   2015 
Return on average assets   0.85   1.02   0.81
Return on average equity   8.86%   10.88%   8.15%
Dividend payout ratio (accrual basis)   33.46%   27.52%   29.85%
Average equity to assets ratio   9.61%   9.44%   9.96%

 

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Risk

Closely related to the concept of liquidity is the concept of interest rate sensitivity (i. e., the extent to which assets and liabilities are sensitive to changes in interest rates). Management uses an asset/liability model that considers the relative sensitivities of the balance sheet, including the effect of interest rate caps on adjustable rate mortgages and the relatively stable aspects of core deposits. As such, management can model a change in economic value of equity and net interest income simulation that is designed to address the probability of interest rate changes and behavioral response of the balance sheet and net interest income to those changes. The economic value of equity represents the fair value of the net present value of assets, liabilities and off-balance sheet items as of a point in time. The projected net interest income represents the amount of net interest income expected during the subsequent 12 calendar months. The starting point (or “base case”) for the following table is the Company’s net equity position at December 31, 2017 and the Company’s net interest income for the year ended December 31, 2017. Using current discount rates and accountholder behavior assumptions, a simulation is run designed to produce an estimate of the economic value of equity and the Company’s annual net interest income under a variety of changing interest rates assuming that the Company’s interest-sensitive assets and liabilities remain at December 31, 2017 levels.

The “rate shock” information in the table shows estimates the changes in the economic value of portfolio equity from levels that existed at December 31, 2017. Net interest income changes are based on the initial value of net interest income that was recorded for the year ended December 31, 2017 assuming fluctuations or “rate shocks” of plus and minus 100 and 200 basis points above and below current market rates. Rate shocks assume that current interest rates change immediately and then remain constant once the change has occurred. The information set forth in the following table is based on significant estimates and assumptions, and constitutes a forward-looking statement within the meaning of that term set forth in Rule 175 under the Securities Act of 1933 and Rule 3b-6(c) of the Securities Exchange Act of 1934.

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TABLE 17   
   Interest Rate Risk Simulation 
(Dollar amounts in thousands)  Change in Economic Value of Equity 
   As of December 31, 2017 
                     
   Rates Decline       Rates Increase 
Rate change   (2%)    (1%)    Current    +1   +2
                          
Projected market value of equity  $99,814   $112,398   $119,280   $118,648   $115,773 
Change from current  $(19,466)  $(6,882)       $(632)  $(3,507)

 

   Change in Annual Net Interest Income 
   12 Month Time Period 
                     
(Dollar amounts in thousands)  Rates Decline       Rates Increase 
Rate change   (2%)    (1%)    Current    +1%    +2% 
                          
Projected net interest income  $45,267   $46,092    46,347    44,206    41,888 
Change from current  $(1,080)  $(255)        (2,141)   (4,175)
42
 

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

INDEX TO FINANCIAL STATEMENTS

 

  Page
Management Report on Internal Controls over Financial Reporting 44
   
Report of Independent Registered Public Accounting Firm 45
   
Consolidated Balance Sheets, December 31, 2017 and 2016 47
   
Consolidated Statements of Earnings for the years ended December 31, 2017, 2016 and 2015 48
   

Consolidated Statements of Comprehensive Earnings for the years ended December 31, 2017, 2016, and 2015

49

   
Consolidated Statement of Changes in Stockholders’ Equity for the years ended December 31, 2017, 2016, and 2015 50
   
Consolidated Statements of Cash Flows for the years ended December 31, 2017, 2016 and 2015 51
   
Notes to Consolidated Financial Statements 53
43
 

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

 

Management of FNB Bancorp (the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting, and for performing an assessment of the effectiveness of internal control over financial reporting as of December 31, 2017. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. The Company’s system of internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of Management and Directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.

Management performed an assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2017 based upon criteria in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this assessment, Management determined that the Company’s internal control over financial reporting was effective as of December 31, 2017 based on the criteria in Internal Control - Integrated Framework (2013) issued by COSO.

Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2017 has been audited by Moss Adams LLP, an independent registered public accounting firm, which expresses an unmodified opinion, as stated in their report which appears on the following page.

Dated: March 13, 2018

44
 

Report of Independent Registered Public Accounting Firm

To the Shareholders and Board of Directors of
FNB Bancorp

 

Opinions on the Financial Statements and Internal Control over Financial Reporting

 

We have audited the accompanying consolidated balance sheets of FNB Bancorp and subsidiary (the “Company”) as of December 31, 2017 and 2016, the related consolidated statements of earnings, comprehensive earnings, changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 2017, and the related notes (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2017 and 2016, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2017, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by COSO.

 

Basis for Opinions

 

The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company's consolidated financial statements and an opinion on the Company's internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

 

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.

45
 

To the Shareholders and Board of Directors of
FNB Bancorp
Page 2

 

Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures to respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

 

Definition and Limitations of Internal Control Over Financial Reporting

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

/s/ Moss Adams LLP

 

Sacramento, CA

March 13, 2018

 

We have served as the Company’s auditor since 2005.

46
 

FNB BANCORP AND SUBSIDIARY
Consolidated Balance Sheets
December 31, 2017 and 2016
 

 Assets        
(Dollar amounts in thousands)  2017   2016 
         
Cash and due from banks  $18,353   $15,758 
Interest-bearing time deposits with financial institutions   130    205 
Securities available-for-sale, at fair value   355,857    360,105 
Other equity securities   7,567    7,206 
Loans, net of deferred loan fees and allowance for loan losses of $10,171 and $10,167 on December 31, 2017 and December 31, 2016   829,766    782,485 
Bank premises, equipment, and leasehold improvements, net   9,322    9,837 
Bank owned life insurance   16,637    16,247 
Accrued interest receivable   5,317    4,942 
Other real estate owned, net   3,300    1,427 
Goodwill   4,580    4,580 
Prepaid expenses   825    856 
Other assets   13,584    15,746 
 Total assets  $1,265,238   $1,219,394 
           
 Liabilities and Stockholders’ Equity          
           
Deposits          
 Demand, noninterest bearing  $313,435   $296,273 
 Demand, interest bearing   130,988    121,086 
 Savings and money market   467,788    487,763 
 Time   138,084    114,384 
 Total deposits   1,050,295    1,019,506